After the Health Care Donnybrook, Tax Changes Will be Even Harder to Pull Off

After last week’s ignoble (for those who wanted it) defeat of the effort to restrict and reduce the cost of health care in the US, the president is currently calling for yet another vote on the topic. More rational members of his team feel that coming back to the matter so soon after the 49-51 vote would risk a defeat of an even greater magnitude, and are counseling to address the matter after tax changes are debated and, hopefully, enacted. If nothing else, this might give the administration a much needed win that will help establish their credibility and hopefully pave the way for additional legislative successes.

(Note my use of the term “tax changes” as opposed to the more common “tax reform”. “Reform” implies an improvement for almost everyone, which the administration fervently wishes to portray. “Changes” acknowledges that any modification of the tax code will produce winners and losers, and that by definition they will not be the same parties.)

Anyone who feels that changes in the tax law will be an easier sell than health care is in for a surprise. About two-thirds of the country is currently covered by health insurance of some kind, be it Medicaid, Medicare, military, government, employer, or the like. Only one-third of the country lacks health insurance. By contrast, almost everyone is affected by changes in the tax code. This is why various organizations hire expensive lobbyists to buttonhole legislators to, at minimum, preserve the tax perks of their clients, if not expand them.

The original idea was to take the savings from restricting health care, plus a tax on imports, to pay for significant reductions in the marginal tax rates for both individuals and businesses, as well as build a wall with Mexico. However, since there are no health care tax savings to be had, and large importers like Walmart and the like have lobbied to prevent an import tax, the only way to change the tax law is going to be to swap out higher taxes in one area for lower taxes in another. This rearranging is due primarily to the fact that Congress is now legally required to show that any change in the tax code is “revenue neutral”, meaning that it does not impact the ability of the government to take in as much in the aggregate as it does before the tax changes. 

For true fiscal conservatives, even this criterion is too liberal. The federal government is on target to have an estimated deficit of $693 billion dollars in the fiscal year ending September 30, 2017. For some fiscal conservatives, this number should be a surplus before any tax reduction is proposed. Such believers, including most members of the Tea Party, will not even discuss tax changes until either spending is reduced, or revenues are raised to wipe the federal deficit out completely, a feat not done on an annual basis since the last years of the Clinton presidency. Expect such fiscal conservatives to try to block expansion of the debt ceiling to make their presence felt.

Most of the time, tax conversations focus on reducing spending referred to as “government waste”, as if there is enough of that to balance the budget. In reality, over 85 percent of the federal budget is addressed by the following categories: defense spending, Social Security, and Medicare/Medicaid. Of the $3.21 trillion in government receipts, $2.56 trillion supports entitlement spending (Social Security and Medicare/Medicaid), and $516 billion is for defense. An additional $307 billion is paid out in net interest on government borrowings of over $15 trillion. This leaves $343 billion of government receipts which, with the aforementioned deficit, cover everything from spending in excess of receipts for food safety, the post office, air traffic control, park and land management, PBS, agricultural advisement, the Small Business Administration, disaster relief, the federal share of infrastructure spending, the FBI, the CIA, and so on. 

Even if one were to assume that the current $693 billion annual deficit is something that can be lived with, there is still the problem of who will have either benefits cut or taxes increased to pay for tax reductions or spending increases elsewhere. Enter the lobbyists. Ideas like elimination of the tax deductibility of interest (including mortgage interest) or charitable deductions never get seriously considered because of the power of associations to send representatives such as real estate developers and agents or donor organizations to remind elected officials that doing something that would adversely affect the organization’s members would not be wise in terms of fundraising come re-election time. 

The last time taxes were radically changed was 1986. It came about due to the strong personal relationship between President Ronald Reagan, a Republican, and Thomas “Tip” O’Neill Jr., the Democratic Speaker of the House. They got together, away from the din of lobbyists, and created changes in the tax law. Imagine such an incident today. 

There is one last cookie jar being kicked around. There is an estimated $2.6 trillion of profits of US corporations earned abroad, which has not been remitted back to the United States due to the fact that such remittances would result in the funds being taxed at the corporate rate of 35 percent. This amount is well in excess of what foreign subsidiaries need for working capital. What companies are holding out for is a lower corporate tax rate on the funds remitted back to the US, with the ideal rate being zero.

The last time this situation was addressed was in the younger Bush’s administration. At that time, there was a one-time tax holiday declared to permit the funds to come back to the US on the assumption that such money would be used for capital spending and job creation. Instead, the funds for the most part were deployed into buying back stock, which was oftentimes rewarded to management in the form of stock options. What was proposed and what actually happened were two different things.

In an effort to keep everyone honest, it has been proposed that companies could remit the funds back to the US tax-free, but only if they were to use the funds to purchase government bonds to fund an infrastructure bank, which would spend $1 trillion over ten years to repair and expand our roads, bridges, airports, and the like. When the bonds mature in ten years from issuance, companies would be free to use the proceeds from the maturing bonds as they so choose. This would acknowledge that bringing the offshore funds back to the US would be a one-off event, and that tax policy cannot be built around such happenings. The interest rate on such bonds would be set by auction. Companies would have to decide on having the funds tied up for ten years versus paying the corporate tax to access the funds now.

The Economy

Economic activity continues to be one of slow and steady growth. Recent retrenchment in the sale of autos has been offset by greater exports and capital spending.

It is assumed that such growth of two plus percent will continue for some time, at least until interest rates increase. While such growth is slow by some standards, it is in line with the long-term trends of Europe and Japan, two other areas of developed economies with minimal population growth, if not outright population declines.

Interest Rates

The Federal Reserve has indicated that the unwinding of the Fed’s bond portfolio will begin as soon as September. In truth, no one has any idea how markets will respond, since such a program has never been done on this scale. At this time, the total bonds being held by the Federal Reserve total about $4.5 trillion. Over ten years, reductions to this amount could reach $450 billion per year.

Further complicating this portfolio reduction program is the fact the tenure of Federal Reserve Chairman Janet Yellen expires in 2018. She has indicated that she does not plan to stand for reappointment. Whether her successor would suspend, accelerate, or reverse the program is anyone’s guess. 

The current consumer savings rate is 3.8 percent, an incredible figure given the returns on cash which are mostly close to zero. It is assumed that many of these funds are finding their way into the stock market, which begs the question of what will happen when interest rates do rise.

Inflation and the Stock Market

Much hand-wringing is being done by central banks all over the world as to why, in spite of so much stimulus in the form of cheap and available money, there is no inflation in consumer prices. The answer is that the funds are not flowing into the economy. They are flowing into financial markets.

Proof of this is the high valuations being posted by various indexes. Measures of valuation such as Price/Earnings (P/E) ratios, and the like, are in record territory. Such valuations are considered to be the inverse of interest rates. As interest rates go up, the competition of fixed income to stocks will increase, and valuations will regress to the mean.

If this line of reasoning is accepted, the challenge facing the central banks is one of how to raise rates and not have a stock market collapse. This will require some sensitivity and some evasion of the reality of what is going on. The implication is for lower aggregate returns on stocks going forward. Some sectors may do better than others, but the average investor in market-wide exchange-traded funds (ETFs) will not benefit from such.

Warren M. Barnett, CFA
July 31, 2017

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Warren Barnett

Warren Barnett is the founder and President, and Portfolio Manager for Barnett & Company. He was associated with the investment banking firm of Kidder, Peabody & Company and the investment counseling firm of Davidge & Company in Washington before returning to Chattanooga to accept a position in the trust department of a local bank. Perceiving the local need for the type of firms with which he was associated in Washington, he established Barnett & Company in 1983. He obtained the Chartered Financial Analyst professional designation from the Institute of Chartered Financial Analysts, Charlottesville, Virginia in 1986. Mr. Barnett graduated from The McCallie School in Chattanooga. He received his Bachelor of Science degree in Accounting from the University of Tennessee at Knoxville and his Master of Business Administration degree in Finance from the Owen School of Management at Vanderbilt University.
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