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Treasury & Taxation

Tax Reform Has Many Rivers to Cross

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May 08, 2017

Deutsche Bank sees a Plan B or even a Plan C as likely outcome of Trump's tax reform proposals.

IRS and dollarPresident Trump and the Republican Congress’s struggle to repeal the Affordable Care Act (ACA) has made tax reform and its ensuing economic boost more challenging, but trying to facilitate passage with more modest reforms may have less-than-sought-after economic impact.

“Earlier this year there appeared to be a 60% or 70% chance of comprehensive tax reform, and now it’s well below 50%,” said Tom Joyce, capital markets strategist at Deutsche Bank who provided the bank’s views on what reform could realistically look like to participants in NeuGroup’s April Treasurers’ Group of Thirty Large-Cap Edition (T30LC). “The probability of a plan B has gone up, because the Republican Party and President Trump need a win.”

Plan B would likely comprise a modest tax cut and “a bit of reform around the edges,” Mr. Joyce said, adding that the most contentious and expensive items—a border adjustment tax (BAT), eliminating tax deductibility and the state and local tax deduction, and 100% capex expensing—are unlikely

In a later exchange with iTreasurer, Mr. Joyce said there’s a “good chance we only get a Plan C,” comprising even less reform. That could mean simply renewing the “tax extenders” scheduled to expire this year, cutting the corporate tax rate slightly, and tossing in a few small items such the Ivanka Trump-inspired child care tax credit, or getting rid of Obamacare’s medical device tax.

In terms of corporate tax cut, Deutsche Bank views lowering it to the 28% to 30% range as the most realistic scenario, requiring fewer eliminations of tax deductions. To get down to the 20% to 24% is possible, but it would require eliminating nearly all deductions and adding revenue generators such as the contentious BAT or something similar. President Trump’s current proposal looks to slash the corporate tax rate to 15%.

Another highly contentious issue that would raise nearly as much revenue as BAT potentially losing state and local tax deductions. Joyce noted that the same issue “almost killed the Regan 1986 tax plan.”

Mr. Joyce said a positive aspect of the Trump Administration’s page-long tax reform outline is that he’s now on the record and actively pushing tax forward; on the downside, it’s clear that so far the Administration only has a skeleton of a plan, and there’s “no clear legislative path or revenue producers.”

The comprehensive proposal described by the Ryan-Brady blueprint published last summer would cut the corporate tax rate to 20% and repeal the corporate AMT, as well as provide 100% capital expenditure expensing, putting the government an estimated $4 trillion in the red. Because tax reform will likely necessitate using the reconciliation process that requires only a 51-senator majority rather than a filibuster-proof 60 votes, the bill must be revenue neutral.

Eliminating the ACA and its $1 trillion in taxes was supposed to help in reaching revenue neutrality. Now the tax reform must rely on other revenue-generating components.

One of those could be the BAT, which is estimated to raise $1.2 trillion, and eliminating debt deductibility could raise a similar amount. The BAT, which taxes imports but not exports, also furthers the Republican goal of incenting companies to manufacture in the US, although major importers have raised alarms about the impact on their businesses,

President Trump has alternately expressed support for the BAT proposal and called it too complicated to administer. The Administration’s proposal excludes a BAT, drawing criticism that it would significantly increase the deficit, with some estimating that the 15% corporate tax rate alone would increase the national debt by as much as $2 trillion over 10 years. The proposal would also eliminate the AMT, but it did not address writing off capital expenses and other key issues. Estimates place the total cost of the Trump Administration plan at $5.5 trillion or more over 10 years.

The Congressional Budget Office has yet to score the Ryan-Brady blueprint because no bill has actually been presented. However, the rule of thumb, Mr. Joyce said, is that every 1% cut in the US corporate tax rate results in $100 billion in foregone revenue to the US government over 10 years. He added that Republicans have philosophical reasons for pursuing BAT and eliminating the debt deduction, but in the context of current tax reform they are essential revenue generators necessary to lower the tax rate.

“Tax experts have told me that if BAT isn’t included, you can’t get the corporate tax rate below 26%,” Mr. Joyce said. “So these will be the negotiations taking place over the next nine months.”

A likely scenario for the legislative process, Mr. Joyce said, is that the House pushes its bill sometime before the summer break, the Senate proceeds with its process in the fall, and they go into conference to reconcile their differences late in the year and perhaps into early 2018. Beyond March it will be difficult to complete legislation because Congress will start turning their attention to elections in the fall.

Bargaining chips during the conferencing process might include the highly contentious BAT, perhaps a watered-down version that is phased in over five years to give the USD a chance to appreciate, a necessity—if still theoretical—to offset importers’ higher costs.

And what could the impact be on economic growth and interest rates? Deutsche Bank estimates that should the likelihood of the full-blown Brady-Ryan blueprint becoming law increase significantly, the Federal Reserve will likely hike rates an additional two or three times this year and the 10-year Treasury bond will peak in the 3% range. That’s upwards of 1% higher than today, but the 10-year dropped 80 basis points in the first half of 2016 and increased by 120 basis points in the second half, Mr. Joyce reminded, so significant moves are not unusual.

If Republicans bungle tax reform as well, with little to show for their efforts, rates are likely to fall to closer to where they were on election day, around 2%, Mr. Joyce said. Growth and rate projections were not yet available for the Trump Administration’s proposal.

“What’s interesting is if we get the middle scenario, which I think is the most probable,” Mr. Joyce said, adding that should that happen the rate on the 10-year Treasury is unlikely to also fall somewhere in the middle. “Talking to our rate strategist and others it’s more likely to be lower, because the stimulus impact is later and it’s on the small side. There’s not a direct correlation in terms of how it impacts growth and the markets.”

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