A Taxing Problem

US Tax Plan Trump

Without question, over the past several years, heavy-handed government policies have had an increasing influence on financial markets around the world. Events such as the UK’s now infamous Brexit vote, last year’s controversial American election and more recently Emmanuel Macron’s political victory in France have had an outsized impact on currencies, securities prices and overall market volatility.

Massive government-mandated central bank stimulus since the credit crisis in 2008 has also contributed to an underlying reflationary trend which has finally begun to show up in the global economic growth data series. But to keep the party going, political leaders have further promised to pile fiscal stimulus on top of the already extraordinary monetary policy initiatives which include historically low interest rates everywhere and the ongoing money-printing exercises in Europe and Japan.

The robust U.S. stock market rally over the past five months is at least partly attributable to optimism over America’s new government and hope that some of its pro-business campaign promises will come to fruition. However, unlike Europe and Japan, the U.S. has begun pulling the plug on monetary policy initiatives. Short term interest rates are being nudged higher making progress on fiscal stimulus which is much more important.

American financial markets are looking for Washington to deliver on three essential fiscal promises: reduced regulations, increased government spending on infrastructure and lower taxes. Moving forward on all these plans requires a budget which pushes the President’s tax plan onto center stage; and it is here where Trump has promised a complete overhaul.

Key components of the proposed U.S. tax plan include reducing the highest corporate income tax rate from 35% to 15%, simplifying personal income taxes and scheduling a tax holiday for repatriation of around $2 trillion in cash held overseas by U.S. companies. House Republicans are also keen to eliminate the 3.8% surtax on investment earnings currently levied on high income earners to help pay for the Affordable Care Act.

Trump’s tax plan, if eventually implemented, could have dramatic effects globally. For one thing, his proposal would take the U.S. from being the highest tax country within the Organization for Economic Co-operation and Development (OECD) at a headline rate of about 35% to being the lowest tax country within the 35 member group of developed economies. That would make America very competitive with corporation-friendly jurisdictions such as Ireland and the U.K., which advertise headline tax rates of 19% and 12.5%, respectively. One might even wonder what effect this change might have on smaller “tax haven” countries with no published corporate taxes such as Bermuda and Cayman Islands.

The President’s advisors are certainly keen on the idea of a major corporate tax reduction. Newly-appointed Treasurer, Steven Mnunchin referred to the proposed plan as the “biggest tax cut” in U.S. history” while White House chief economic advisor, Gary Cohn said a 15% business tax would give the U.S. a huge advantage globally – borrowing one of the Donald’s favorite adjectives.

On the personal income tax side, the White House proposal intends to broaden the tax base and lower tax rates there, too. The proposal calls for collapsing the existing seven tax bracket system and replacing it with one of only three: 10%, 25%, and 35%. Furthermore, the standard deduction, which is available to everyone, would be doubled. As an offset to lower tax rates, almost all of the itemized deductions, with the exceptions of mortgage interest, charitable donations, and retirement savings would be eliminated.

Perhaps the most controversial part of the new tax plan is the elimination of the federal tax deduction for payment of state and local taxes. Individuals from high tax states such as California and Massachusetts, have historically received a credit for the amount of tax liability on their federal income tax return. On this point, we are likely to see pushback from Republicans representing those high-tax states just as we saw friction against House Speaker Paul Ryan’s initial border tax proposal from special interests in those sectors which would be disadvantaged.

The one thing all politicians seem to agree on is that the system is too complicated. When U.S. income taxes were first implemented in 1913, the tax form was literally like filling out a post card with no more than four pages of information required. Currently, the tax rules alone for individual 1040 returns now take up more than 106 pages.

U.S. government debt has essentially doubled from approximately $10 trillion eight years ago to about $20 trillion now. Common sense would suggest America (like most other large countries) really needs to spend less and collect more taxes in order to reduce debt, thereby creating a more balanced budget.

But in an uber-connected world defined by instant gratification, voters have no patience for practical politicians. Besides, the U.S. was founded by opposition to taxes. Thus, the world’s largest economy is now looking at Trump’s own version of ‘supply-side’ economics. Lowering taxes and increasing spending may create a boost in the short term, but will likely cause bigger deficits and ultimately a less stable economy down the road. At least this was lesson learned from Ronald Reagan’s economic program which arguably helped lift a moribund economy from during a difficult time – but at the cost of rapidly rising deficit levels and exploding debt servicing costs.

One possible solution to the budget balancing conundrum could involve greater consumption taxes. Residents of Bermuda are familiar with the import tax which ranges around 22% or more, depending upon the item. As a small island which imports most goods, the import tax effectively represents a consumption tax applied to just about everything purchased by its residents. Yet many people prefer this form of taxation as it allows citizens to gain greater control over their tax liabilities – spend less, pay less tax.

Elements of a consumption tax are evident in Trump’s more recent suggestion to increase the gasoline tax to help pay for infrastructure spending on roads and the transit system. This idea actually makes good sense considering the American Society of Civil Engineers gave the U.S. a report card grade of “D” for its crumbling transportation infrastructure.

Given the divisiveness in Washington and even within Trump’s own Republican Party, the road ahead for a U.S. tax plan will be bumpy. The political arena could be further clouded by the President’s recent firing of James Comey as head of the FBI last week. We hope the inevitable backlash against his decision is relatively benign, but other outcomes are possible. Political analyst, Greg Valliere believes that if a more scandalous scenario unfolds, it could block the new administration’s progress on many fronts, including the implementation of badly needed tax reform in 2017.

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