The Republican tax reform will be signed by the President this week. The corporate tax is lowered from 35% to 21% with retailers among the big winners. The top individual tax rate is reduced to 37%, but individual tax measures expire in 2026. The repatriation tax rates of 8% and 15.5% are higher than expected.

 

The tax cuts are likely to offer some support to growth in the short run, but are unlikely to push up potential growth substantially. Without cuts to spending, the federal debt is set to increase, and the Federal Reserve should raise interest rates more than is currently expected.

 

A done deal

In the end, the Republican desire to cut taxes beat whatever concerns individual members had. Senator Rubio was brought onboard with an enhanced child tax credit. Senator Corker decided cutting taxes was more important than deficit implications, and Senator Collins extracted promises of action in other areas – a leap of faith that could be frustrated at a later stage. The tax proposal will be approved this week and signed before Christmas. Senator McCain has returned to Arizona for recovery as Republicans have enough votes without him.

 

The process of reconciling the two versions has been smooth. The corporate tax rates ended at 21% (down from 35%) with the top individual tax rate cut from 39.6% to 37%. As in the Senate version, the corporate tax cuts are permanent, while the individual cuts expire in 2026. Republicans assume that future Congresses will extend the individual cuts.

 

Some of the unintended consequences in the Senate bill – such as the hit to foreign financing of wind and solar projects – were mitigated. The repatriation tax on accumulated foreign profits was increased in the final version to 8% for illiquid investments and 15.5% for liquid assets. That is significantly higher than expected and as this is a mandatory tax, it amounts to something akin to a confiscation. It is estimated that more than USD3,000 billion of assets could be subject to the tax. Going forward, the US will use a territorial-based system, where only domestic profits are taxed. This is a global standard.

 

More unintended consequences are set to emerge as tax attorneys and accountants start the work of implementing the law. Loopholes could be significant – and the tax code has not become simpler as was the initial goal. Normally these glitches are fixed in ensuing legislation, but as Republicans denied Democrats the ability to fix Obamacare glitches, it would not be surprising if Democrats deny Republicans the necessary votes in the Senate (it takes 60 votes to do tax legislation without a budget reconciliation framework).

 

Winners…

Corporations are the most obvious winners, but some stand to gain more than others. Retailers are among the biggest winners as they have fewer deductions under the current system and hence pay a higher effective tax rate. The result is even more remarkable considering that the original proposal was based on the introduction of a border tax, which would have hit retailers particularly hard. A double win and extra big bonuses must the in the offing for the retail industry’s Washington lobbyists. The fossil fuel industry also did well, keeping their deductions – and with more federal land now open for drilling.

 

Pass-through corporations (where corporate earnings “pass through” to the personal tax code) stand to gain substantially through lower rates and new deductions. This is mostly small businesses and part of the reason for the surging small-business optimism. Republicans have inserted limitations on health, law and financial services for political reasons. It remains to be seen what loopholes are still present. Many high-income earners file taxes as pass-throughs, which is why they emerge as some of the biggest winners in the tax reform.

 

Among households, lower rates and the increase in standard deductions and child tax credits creates winners in the middle class – at least until 2026, when these provisions expire.

 

… and losers

There are not many losers initially as the tax-cut fairy dust has been spread liberally. Among corporations, highly-indebted companies are hurt by new limitations on interest deductibility. In some way the reduced deductibility serves as implicit interest rate increases and is (in my opinion) one of the best provisions in the tax reform, if it manages to limit a further increase in corporate leverage. It could hit debt-financed M&A activity and share buybacks.

 

In the personal tax code there are losers as well. Higher middle-class earners with no kids in high-tax states and cities will lose on the new maximum deduction of USD10,000 for state and local taxes. While not a broad problem, it is a problem in New York and California. High-income earners in these states benefit from a reduced top tax rate, but that only applies to incomes above USD500,000 (single filers). It hits a lot of households in Washington DC. Without the individual mandate to hold health insurance, it is estimated by the Congressional Budget Office that 13 million Americans will forego health insurance.

 

Good luck, America

The biggest loser is the American economy and not least future generations. The tax cuts will add USD600 billion to the debt (same as current deficit) under very favorable growth assumptions, but USD1,500 billion under standard assumptions. There are no offsetting savings, although Speaker Ryan now talks about entitlement reform (Medicaid, Medicare and Social Security). Republicans do not have the votes to do this, and the planned additional military spending is likely to be partly matched by more spending demands on domestic non-military items – if Democrats are to get onboard. In total, fiscal initiatives in 2017/18 should increase the accumulated ten-year deficit by USD1,200-2,000 billion.

 

Republicans like to point to the Reagan tax cuts in 1981 as a role model, but tend to forget that taxes subsequently were raised between 1982 and 1993 (Bush the elder lost the 1992-election on this). Even deeply-red Kansas has raised taxes after a tax-cut experiment failed to produce the expected economic growth and government revenues. If Republicans think they are able to convince the American voters that cuts to pensions and health care for the elderly are necessary to preserve tax cuts for corporations and high incomes, they have not read opinion polls – or demographic trends.

 

While the short-term growth outlook has received a boost, few economists expect the tax cuts (and deregulation) to sustain a long-term increase in potential growth. Most likely, the higher after-tax profits will be returned to shareholders through increased dividends and/or share buybacks. That is what the stockmarket is signalling. Cogan, Hubbard, Taylor, and Warsh (cheerleaders of the Republican agenda) warned in July that “It is important to emphasize that tax reform and spending reductions go hand-in-hand. Without significant spending restraint, even with positive effects on economic growth, the tax rate reductions would likely be limited and temporary, limiting their economic benefits.” One potential spoiler is the Federal Reserve, currently undergoing a significant transformation as President Trump fills the vacancies on the board. I expect four rate hikes in 2018. That would take away some of the benefits of tax cuts.