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Brian Andrew, CFA

Wow — $666 Billion

When discussing budgets, how often does a conversation at work or home focus only on revenues? Any discussion about financial planning, whether personal or professional, usually incorporates the opportunity to raise revenue and cut expenses in order to meet a plan or improve on last year’s results. Congress approaches the budget discussion differently, which may provide some insight into how the tax reform conversation affects the economy.

When the Office of Management and Budget (OMB) reported the results for the Federal government’s last fiscal year, which ended on Sept. 30, it indicated that the deficit was $666 billion. Despite the fact that the current administration has been slow to replace key positions and used regulatory reform to shrink some agencies, the deficit still managed to grow by 13.7% over the prior fiscal year. A larger deficit results in more government borrowing. The federal budget deficit has grown by over $200 billion during the last several fiscal years. Add to that the $100 trillion in unfunded liabilities from social programs, and we have a real drag on economic performance.

As illustrated in the chart below, one of the reasons for a larger deficit is that revenues have declined from their peak in 2013. In addition, federal spending has risen faster than revenues for the last two years. If the economy runs more slowly, i.e., less consumption and business profitability, then the federal government’s tax receipts will decline as well. This year’s pick-up in growth should help with that.

 
Federal Reserve & Outlay Growth
 

Tackling tax reform in an environment where deficits have expanded is difficult, both from a fiscal and public policy perspective.

Tax Reform

The Senate had already passed a budget resolution and the House passed one narrowly today. The resolution begins the process of debating the tax reform bill. It creates a challenge because it also requires some of the reform to be paid for. In order for the Republicans to pass a tax bill without help from the Democrats, they passed a resolution that lays out the upcoming year’s budget guidelines and restricts the tax reform legislation from permanently raising the deficit by more than $150 billion per year over the next ten years. This means that for every tax cut, they need to find some revenue to pay for it, and that’s the rub.

Fiscal conservatives in the Republican Party will have a hard time passing any tax cut, corporate or personal, if it isn’t paid for with some increase in tax revenue in other areas. This could be good news because it requires a reform of the tax code to get to a package that doesn’t materially raise the deficit. Here is an example.

One of the propositions in the tax reform plan is to reduce the top corporate tax rate to 20% from 35%. This would cost approximately $1.5 trillion over the next 10 years. If there was a new limit placed on the interest deduction for corporations, it is proposed to bring in an additional $900 billion over 10 years, almost offsetting the rate reduction. This kind of horse trading between the government’s revenues (taxes) and expenses is how tax reform gets done.

If you were to include the benefit of increased business investment from the lower corporate tax rate (what’s known as “dynamic scoring”), then almost all of the cost of the rate reduction would be offset because that increased investment results in greater corporate profitability. Corporate profitability, in turn, should jump start economic growth and job creation.

Here, we have to be careful. Not all economists agree with the notion that tax cuts result in greater economic growth, or at least not the magnitude of growth that comes from reducing corporate tax rates. As a result, the dynamic scoring process can be perilous because cuts may not generate the growth needed to provide the offset. This is where reform becomes difficult and the Republican Party becomes fractured, as some fiscal conservatives in the party require tax cuts to be offset by additional revenues without the growth factored in.

This explains why tax reform is hard and takes time. Some estimate that the proposed cuts could add .25% to .5% to next year’s economic growth rate if passed by year-end. Why not more?

A Few Reasons

The U.S. economy has been expanding for almost a decade without a recession. This is a very old growth cycle. Adding stimulus at this stage isn’t the same as adding it in the early stages of expansion. Later in the business cycle, companies may see moderate demand. In addition, the labor market is already tight, with unemployment approaching just 4%.

We know that much of the labor force is employed. Those who are not or are underemployed are probably lacking the necessary skills to take the better paying jobs available. Adding stimulus at this time will not likely change the balance in the labor market as much as a change in our policy approach to education (we’ll leave that for another commentary).

In addition, the Fed has begun to raise interest rates, which ultimately has the effect of reducing growth. Thus, the tax plan has to fight the headwind of higher interest rates.

Do It Anyway

We are not suggesting that reform shouldn’t be undertaken. Any measures taken to simplify a complicated tax system and create a tax environment relative to our global competitors should be welcome as long as it doesn’t meaningfully add to a problem that already exists (the deficit).

More importantly, some reform of the corporate and personal tax systems could be a boon for business investment and consumption as the next expansionary cycle takes hold. As this cycle winds down, we may go through a normal business cycle recession in a year or two, which would provide the normal reduction in leverage and elimination of poor competitors that usually happens. The lower tax rates put in place now may dampen the effects of a business cycle downturn and create an environment for greater business investment and greater consumption.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.