One of the reasons why the torrid dollar rally of the past few weeks appears to have plateaued, at least for the time being, is that just like earlier in the year, doubts have emerged about the viability of the “new and improved” tax plan, which according to the Tax Policy Center would mostly benefit the “Top 1”, even as it eventually pushes taxes for the upper middle class progressively higher. One catalyst is a Bloomberg report overnight, in which Bob Corker was quoted as saying that the White House is showing “softness” on ending the $1.3 trillion federal tax deduction filers get for their state and local taxes, warning that it raises questions about the GOP’s “intestinal fortitude” and could imperil a tax overhaul.
The framework that President Donald Trump and Republican leaders released Wednesday calls for deep rate cuts and would abolish existing tax breaks to help pay for them. Without such “pay-fors,” Congress might have to settle for only temporary tax cuts.
Needless to say, temporary tax cuts would have far less of an impact on both stocks and the dollar than if Trump’s “biggest ever” tax reform is permanent.
But it’s not only the suddenly shaky future of SALTaxes. As Goldman’s economists write overnight in a report looking at “what could possibly go wrong” with tax reform, they note that while “recent developments on tax reform have been positive” with the Senate’s “tentative budget agreement likely headed for passage in the Budget Committee this week” and the Big Six framework signaling narrower tax policy differences, there’s “plenty that could still go wrong.”
Some of the notable hurdles that could lead to Trump’s first year to have zero major legislative victories are as follows:
- Revenue target hasn’t been finalized; Senate’s $1.5 trillion “tax cut instruction” is at high end of potential outcomes; legislation reducing revenue that much might face opposition from some Republican centrists
- Major details remain unknown, particularly which tax preferences would be curbed to help offset costs
- Some tax increases proposed to offset costs are likely to be very difficult to achieve, such as a repeal of state/local tax deduction, especially with Corker adding more fuel to the fire overnight.
Still, Goldman’s Washington analyst Alec Phillips concludes on the optimistic side and sees a 65% probability that “tax legislation will be enacted by 2018.”
There will be more details once the Senate Finance Committee holds a hearing on international tax reform today at 10am.
Until then, here is the full Goldman note:
Tax Reform: What Could Possibly Go Wrong?
- Recent developments on tax reform have been positive. The tentative budget agreement announced in the Senate two weeks ago has been formally proposed and appears headed for passage in the Senate Budget Committee this week. The House also appears likely to pass its budget resolution this week, and the framework on tax reform released by the “Big Six” on September 27 signals a narrowing of tax policy differences.
- That said, there is plenty that could still go wrong. First, the revenue target has not yet been finalized, and it is becoming increasingly clear that the Senate’s $1.5 trillion tax cut instruction is at the high end of the potential range of outcomes. It is possible that tax legislation that reduces revenues that much might still face opposition from some Republican centrists.
- Second, while the recently released framework demonstrates greater consensus among the House, Senate, and White House than appeared to exist a few months ago, there are major details that remain unknown, particularly which tax preferences would be curbed to help offset the cost of the tax cuts.
- Third, some of the tax increases that have been proposed to offset the cost are likely to be very difficult to achieve, such as repeal of the state and local tax deduction.
- That said, in light of the increased flexibility the tentative $1.5 trillion revenue target would provide for tax reform efforts, we currently believe there is a 65% probability that tax legislation will be enacted by 2018.
The prospects for tax reform have increased markedly in the last couple of weeks as a result of the recently released budget agreement in the Senate and, to a lesser extent, the framework on tax reform released by the “Big Six”. While we have noted these positive developments several times recently, in today’s US Daily we focus on the long road ahead and the obstacles tax reform is likely to encounter along the way.
Tax reform is moving on two tracks. The first track involves the budget resolution for fiscal year (FY) 2018, which congressional Republicans hope to use to include “reconciliation instructions” for tax reform. These instructions typically carry three pieces of information: (1) which committees must carry out the instructions, (2) the fiscal goal of the policy change (to raise or reduce taxes, spending, or the deficit), and (3) the deadline by which the committees must pass the relevant bill. The draft budget resolution that was released on September 29 by the Senate Budget Committee instructs the House Ways and Means Committee and Senate Finance Committee to pass legislation to reduce revenues by $1.5 trillion over the next ten years by November 13, 2017. As shown in Exhibit 1, the Senate must then pass the resolution, and the House and Senate must the agree on a single, common version of the budget resolution, which could happen through a House-Senate conference committee, or by the House simply accepting the Senate’s resolution once the Senate has passed it. Once a final resolution has been agreed upon by simple majorities in the House and Senate, the second track begins in earnest.
The second track involves the passage of detailed legislation that reforms the tax code. While the draft resolution’s deadline for passage by the tax-writing committees is currently November 13, we expect them to take a little longer to pass a tax bill, given that there is no penalty for missing the deadline and there are still a number of issues to be worked out. That said, it is certainly possible that the House Ways and Means Committee will pass tax reform legislation in November. Passage in the full House is likely to follow no sooner than late November and more likely December. Senate consideration is unlikely to start until December and is likely to carry over into 2018, in our view. Even if the Senate were able to pass a bill by December, it seems unlikely to us that the House and Senate would be able to resolve all of their differences before year end, so enactment in Q1 2018 is our base case.
The budget resolution looks likely to include a placeholder for a tax cut… The Senate’s draft budget resolution includes a placeholder for a tax cut of $1.5 trillion over ten years. With around $450bn in expiring tax provisions over the next ten years, this implies a $1.05 trillion tax cut compared with the tax that would be collected if current policy was simply extended. The revenue effects of the tax cut might be estimated on a “dynamic” basis, where the Joint Committee on Taxation (JCT) and Congressional Budget Office (CBO) would consider the economic growth implications of the tax bill and add back the resulting tax receipts to the estimate, lowering the overall cost of the tax bill. In the past, JCT dynamic scoring models have typically reduced the cost of a tax cut by around 10% to 20% compared with a conventional estimate. Depending on whether the dynamic score is applied to the $1.5 trillion or the $1.05 trillion figure, this could allow for a “real world” tax cut up to $1.2 trillion (0.4% of GDP) to $1.4 trillion (0.6% of GDP) over the next ten years.
…but this is a limit and the final tax cut could be smaller. The risk appears to be to the downside of the Senate’s tax reform placeholder, for two reasons. First, the House and Senate need to finalize their “reconciliation instruction” and the House’s draft takes a much more conservative approach, calling for revenue-neutral tax reform combined with $200 billion in spending cuts. While we expect that the instruction included in the final budget resolution will resemble the Senate’s version, changes are possible and the $1.5 trillion figure is more likely to move lower than higher if it does change.
Second, the instruction sets a limit on the size of a tax cut, and political constraints could lead to a smaller change. If the tax legislation cuts taxes by more than instructed under the budget resolution, it would trigger a procedural objection in the Senate that would take 60 votes to waive. Assuming Democrats will largely oppose the tax bill, this effectively limits the size of the tax cut to whatever amount is included in the reconciliation instruction. However, centrist Republicans might try to force the size of the tax cut down further. For example, Senator Corker (R-Tenn.) has indicated he plans to oppose any tax legislation that adds to the deficit over the long term beyond the cost of extending expiring tax provisions and the amount of tax cut that might be offset by a “reasonable” estimate of the revenue gain from economic growth under dynamic scoring. While it is hard to gauge what Sen. Corker might deem to be reasonable when it comes to dynamic scoring, there is a possibility that he and other like-minded centrist Republicans in the Senate would oppose a tax bill that cuts taxes as much as allowed under the $1.5 trillion reconciliation instruction, even if they have voted for the budget resolution that allows it. With Senator McCain (R-Ariz.) suggesting he might oppose legislation that is not considered under “regular order” with bipartisan support (as opposed to the reconciliation process), any further opposition from the remaining 50 (out of 52) Senate Republicans could sink the bill.
The tax policy debate is just getting started but key details remain unknown. The release of the “unified framework” on tax reform on September 27 represented a small step in reaching consensus on tax reform among the key White House and congressional leaders (Exhibit 2). However, there are many details that have not yet been clarified, including the income levels at which the new tax rates for individuals would kick in; without this detail it is impossible to determine the size of the tax cut for individuals, or whether it would be a tax cut at all.
Reliance on repeal of the state and local tax (SALT) deduction to pay for individual tax cuts is risky. The Tax Policy Center estimates repeal of the state and local deduction would generate $1.3 trillion in new revenue under the proposal. However, with 28 House Republicans representing the highest tax states of New York, New Jersey and California and dozens more representing states with slightly lower taxes, the odds of repeal are low in our view. While a limitation of some kind—a percentage limitation, a dollar cap, converting the deduction to a credit of a reduced amount, or repealing only the income tax deduction and allowing deductibility of only property taxes –is possible, this would raise substantially less revenue than outright repeal.
On the corporate side, the proposal is more detailed, but may not be affordable… The framework calls for a 20% corporate tax rate, which would reduce revenues on a “static” basis by around $1.8 trillion over ten years. Other corporate changes would add slightly to this total. The proposal also calls for a 25% rate on pass-through income earned by partnerships, sole proprietorships and other entities. The effect on tax receipts would depend on how much wage and other individual income was recharacterized as pass-through income, but a recent estimate by the Tax Policy Center puts the cost around $770bn over ten years. Most of the other business tax proposals in the framework are smaller and work in both directions, roughly offsetting each other. Nevertheless, this suggests that the business tax cuts account for at least a $2.5 trillion revenue loss.
…And will probably need to be substantially scaled back… The cost of the corporate provisions is far beyond the $1.5 trillion maximum revenue loss envisioned in the Senate’s budget resolution, and perhaps even farther beyond what centrist Republican senators might be willing to accept. Moreover, passing a large corporate tax cut while leaving individual taxes roughly unchanged on the whole would be difficult to sustain politically, suggesting that the business tax cut figure will need to come down well below the $1.5 trillion revenue target.
…Or phased in gradually. White House officials and the president himself have repeatedly stated that they are unwilling to negotiate on the 20% corporate tax rate. However, with the fiscal math as it is, it will be very difficult to achieve a corporate rate of 20% over the next ten years. In 2001, tax writers solved a similar issue by phasing in rate reductions over several years, which allowed them to pass legislation with much lower terminal tax rates than would be possible if rate reductions were phased in immediately. We expect that this could come into play on the corporate side, in particular, since it would allow congressional Republicans and the White House to announce a low headline rate even if it takes several years to achieve. By contrast, we would expect individual tax cuts to take effect more quickly, since lawmakers are likely to want to provide voters with a tangible benefit ahead of the 2018 midterm election.
Budget rules still pose a challenge. There are two important technical obstacles that must be overcome to pass tax reform via reconciliation. First, pay-as-you-go (PAYGO) rules constrain the consideration of deficit-increasing legislation. While most of these rules can be circumvented, one that could be difficult to get around is the statutory PAYGO rule enacted in 2010, which imposes automatic spending cuts via sequestration to offset the effect of any deficit increasing legislation Congress passes. This would not prevent Congress from passing a net tax cut, but might serve as a deterrent. Second, the “Byrd” rule in the Senate prohibits reconciliation legislation from increasing the budget deficit outside of the window covered by the budget resolution (traditionally 10 years). This is less of an issue regarding individual tax cuts, which might be allowed to expire after ten years under the assumption they would be extended later. However, it could pose problems for corporate tax changes, which tax writers hope to make permanent. Waiving either rule requires 60 votes in the Senate, so tax legislation will need to work within these constraints.
The next political test will be the upcoming Senate vote on its budget resolution. This week’s votes on the House Floor and in the Senate Budget Committee do not appear to pose much risk, as each chamber’s respective budget resolution looks likely to pass without substantial changes. There is somewhat greater uncertainty later in October, for two reasons. First, when the Senate resolution reaches the Senate, Republican centrists may attempt to reduce the size of the tax cut further, though at the moment our expectation is that whatever can pass the Senate Budget Committee can probably pass the full Senate as well. Second, and more importantly, the House and Senate resolutions are substantially different, as noted above. While we expect the Senate version to largely prevail, changes are possible before the final version is agreed to.
We see enactment of tax legislation by Q1 2018 as the base case, despite these risks. We upgraded our outlook on tax reform following the tentative budget agreement in the Senate two weeks ago, and believe there is a 65% chance that tax reform will be enacted by 2018. This is mainly because of the flexibility that the $1.5 trillion tax cut placeholder in the budget resolution gives tax writers, who will be able to avoid making as many politically difficult choices in order to lower tax rates, which increases the odds of tax reform, in our view. The tax cut placeholder also makes possible the enactment of a simple tax cut in 2018 if broader tax reform efforts fall through. As outlined above, there are a number of potential risks along the way, but at this point the arguments in favor of enactment of tax legislation by 2018 outweigh the arguments against it.