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Best Guess on Tax Reform

            Welcome back from the Thanksgiving holiday. It’s always a favorite and I hope everyone had a chance to get a little goofy with friends and family, as life is just a bit too serious these days. This is a big week for the widely anticipated legislation on “sweeping” tax reform. The ball is in the Senate’s court. Here’s how I see things shaking out as well as three scenarios for a reaction from the US stock market.

Change Is Good

            I look at politics and the trail of policies, laws, orders, standards, etc as a pendulum. Clearly, under Obama, the pendulum swung way left over a period of 8 years with significantly higher taxes for high-income earners and major wealth redistribution programs like the Affordable Care Act (ACA). Don’t hate me for calling that out. We swung wide with an expansion of social safety nets and entitlement programs aimed at supporting the growing number in our country who truly needed help. Obama was also a bridge builder with our foreign partners. You may or may not like all of the agreements made with our trading partners, but we made a lot of them right? If I were to package all of Obama’s efforts, most of them were really about closing the wealth inequality gap in our country. Was it successful? Probably not if one were to really measure wealth inequality in 2008 and then again in 2016. The needle didn’t really move much, which speaks more to the realities of where power and influence still lie in our country.

            Thus far after more than a year in office, Trump has had zero legislative wins. His attempt to Repeal and Replace the ACA was rejected by Congress, twice. Looking back, we can only put our finger on a storm of executive orders, several of which have been rejected by the supreme courts as unconstitutional. Honestly, I would love for the Senate to find some way to amend the House proposal on tax reform so we can see some change in our tax system. I would hope that the “broadest sweeping tax reform we have seen in nearly three decades” would beneficially touch all income earners and businesses in a lasting and meaningful way. After all, taxes are a financial headwind to everyone, especially those who tend to spend most of what they make.

            So, while there is plenty of reason for our leaders to get together on an equitable solution to tax reform, I don’t see it going smoothly.

Expect No Agreement Anytime Soon

            Ask yourself this question. Why would Congress suddenly find common ground on taxes, especially the current House proposal? There is so little in the proposal that could be considered neutral or Senate friendly, I just can’t imagine the Senate will roll over and accept the current proposal, or even a minority part of it. Several key Republicans in the Senate have been suggesting as much all week. With high confidence, I will say that upon return from the holiday break, Congress will not find common ground on the current tax reform proposal this week. Maybe by year end in a highly modified form but probably not until 2018 if at all. Don’t forget, Congress never settled on a budget either, nor DACA, nor the debt ceiling or anything really. All issues were kicked down the road with a December 8th deadline. In fact, I’ll wager that we see another government shutdown before Christmas.

Corporate Tax Cuts Will Not Increase Wages

            Just as Obama’s entire tenure in the White House was aimed at supporting lower-income families, those without healthcare, the elderly, etc. Trump’s Administration is just the opposite. He is working hard to swing the pendulum fast and hard in the opposite direction. He is about supporting big business, business owners and generally the owners of investment assets. It should be no surprise that the House bill on tax reform has very little substance that would benefit middle and low-income households. If you look under the hood of the House approved tax reform bill, you will find proposals to permanently cut taxes for corporations and businesses, including pass-through type businesses like S corps and LLCs. You will also find small offsetting changes to the tax code that will mildly impact households who do not own businesses or tend to be simple wage earners. However, these are temporary changes with expiration dates. We hear about the estimates that most wage-earning households will see up to a net $2000/ year change in their take-home income. Now match this up against the proposed benefit to big corporations who can potentially pocket net benefits measured in hundreds of millions.

            Tax cuts for corporations and businesses are being sold on the basis of Reagan era trickle down theory; if business does well, then business will raise wages and the economy will expand. Well, it didn’t happen with Reagan and it won’t happen now. Why? Because corporations are already sitting on a record $1.7 Trillion in cash. Free cash flow is also healthy, as are earnings. Look at the stock market! Corporations have been actively using some of their huge treasure chests to affect share buybacks, increase dividends to shareholders and acquire other companies. Does this sound like a segment of our country that is suffering under the heavy weight of high taxes? Not at all, in fact, their effective tax rate is not 35% but in the mid 20% range which happens to be very competitive with global standards. And, lowering corporate taxes will not trickle down into higher wages given the current situation.

Why not?

         If corporations felt compelled to raise wages in order to attract or retain talent in the last three years of near full employment in our country, they certainly have had the cash to do so. Cutting taxes for these same cash-rich corporations will NOT compel them to raise wages. That’s ridiculous. What is really happening is that whenever there is any scent of rising wages or falling profits, employees are quickly outsourced or replaced by software, automation or the internet. Our working class knows too well that their jobs are disappearing or becoming obsolete (coal, manufacturing, grocery, retail, etc). Make no mistake; wage pressure (up) in our country is gone for a while in most industries. Handing corporations higher net income with a lower tax rate will do nothing to help the working class in our country. Absolutely nothing. It will just add cash to the current pile of cash. Yes, earnings and corporate balance sheets can improve but Trickle Down isn’t a valid selling point.

         Likewise, a wealthy person with very high income does not spend more when they experience lower taxes as Trickle Down Theory also suggests. Wealthy people spend what they want to spend always and invest the rest. They are not economically as sensitive as the rest of the country. A tax break might mean a little more investment dollars but they will not buy more than they already do naturally. Actually, sadly, the wealthy tend to be less charitable when taxes are lower. Yes, you guessed it; charitable giving is largely about cutting your tax bill in our country. Lower taxes means fewer reasons to make charitable donations. No offense to those who are genuinely and graciously giving for all the right reasons but you must know you’re in a small group.

            All said the Trickle Down pitch is not one that is widely accepted in our country. So the very root of the current tax reform bill is also not very acceptable in its current form. Any deal in the Senate will have to be less dependent on this false premise.

Market Reaction – 3 Scenarios

Let’s break this into three scenarios.

1 - The first will be one in which the Senate magically approves the current House bill and the tax reform bill becomes law more or less as is.

Likelihood – 2% chance (there’s always a chance right?) 

Outcome - Under this scenario, the stock market could have another reasonably good year in the range of 10-12% gains for 2018 as earnings and investment would continue to expand allowing valuations to remain somewhat constant. The Fed would be more aggressive about raising rates, however, putting a lid on the prospect of a blow out year (higher).

Winners- Stock market, corporations and the wealthy who own a lot of stock.

Losers – the 2/3rds of our country who will not see much change in their net worth or who don’t have much in the way of financial assets. Remember that the average American has less than $15,000 in retirement investment assets.

2 - The second scenario is a highly modified version of the Tax bill which gives more permanent breaks to lower income households and less of a cut to corporate taxes and businesses.

Likelihood – 60% chance

Outcome – A more muted return for the stock market in 2018 in the range of 4-5% with the lower boost to earnings, lower level of additional investment from the wealthy and a consistent headwind of the Feds raising rates gradually.

Winners – Most everyone, as the economy could grind higher, household and business balance sheets would improve slightly providing a generally favorable economic picture.

Losers – Not many!

3 - The third scenario is no deal at all as Congress remains deadlocked and fails to get the 51 votes needed in the Senate.

Likelihood – 40% chance

Outcome – LESS THAN 0% gains for US stocks in 2018. The risk of recession rises as the sharply higher costs of Healthcare and rising rates begin to cut into GDP, earnings, and consumer spending. Note – the bond market is currently forecasting this outcome as witnessed by the nearly inverted Treasury Yield curve which has a long history of occurring near the beginning of recessions.

Winners – The US government debt and the Fed who would no longer be held responsible for crushing the economy.

Losers – Just about everyone. The unemployment rate suddenly starts to rise, earnings struggle to improve on a year over year basis, corporations cut back on expansion plans and get defensive again.

Looking across all three scenarios, it’s pretty obvious that our legislators are in a very tough spot. Compromise is a career ending move politically, but no deal could easily be the catalyst for our next down cycle in the economy. Some variety of tax reform is almost critically necessary at this point to keep our economy (jobs, stocks, activity) slogging forward. Let’s hope for a deal of some sort.

These are important times in our country and the outcome of tax reform (or not) could very well shape the direction of the financial markets in the upcoming year. As always, it is not the news that matters but the market’s reaction to it. Let’s all pay attention, both hands on the wheel now.

Please join us on December 7th for our final Solution Series of the year. The topic? Tax Reform presented by Dustin Nelson our capable CPA wealth management partner! We are almost full so please RSVP if you have not already done so to secure your spot.


Hope to see you soon.

Sam Jones