Trump Releases Tax Reform Guidelines

In the lead up to the tax plan announcement, I made the point that if Trump was vague about his plan, stocks would rally on hope. Trump was vague, but it didn’t boost stocks because he was vague on the most important point stocks care about which is the repatriation tax holiday. Stocks care about the income and corporate tax rates, but the repatriation holiday affects short term equity prices the most. We saw that result play out after the disappointment as the stocks with the most cash overseas, namely Apple, Microsoft, and Alphabet sold off. It makes sense that stocks would care the most about a measure which would directly lead to more buybacks since buybacks are the backbone of this entire rally.

The administration doesn’t want firms to plow this money into buybacks, but that’s what has historically happened. It’s worth keeping in mind that the administration wants firms to invest in new initiatives to grow the amount of jobs in the economy and boost wage growth. This is like a scenario where a parent gives a child $20 to get lunch. The parent knows the child has enough money to buy candy, but doesn’t put any restrictions to prevent it from buying candy. Hope isn’t a good strategy as the child will buy the candy and firms will use the repatriated money to buy back stock. Firms can argue that they must work in the best interests of their shareholders.

I don’t think buying back stock at record highs in the best interest of shareholders, but it certainly depends on which firm we’re discussing. The point I’m making is there’s a possibility some restrictions to prevent buybacks are put in place. I wouldn’t call it likely because it’s the corporations’ money, but the fact that they won’t be using the money to invest in new initiatives must upset the Trump administration. I mentioned that the infrastructure plan was tied to the repatriation plan where firms would reinvest money into America to pay a lower rate than the already low holiday rate. This was the incentive which could have stopped the buyback parade which will do nothing to improve productivity growth or boost hourly earnings. This infrastructure plan clearly won’t happen by the time tax reform passes given struggle to get anything done. To recap, the repatriation tax cut will funnel to buybacks, which is great for short-term stock performance and bad for productivity growth.

The repatriation tax cut is the best situation because it raises revenue and still is a tax cut. The corporate tax cut relies on dynamic scoring to bring in revenue as businesses are expected to expand when taxes are lowered. The repatriation tax cut doesn’t rely on that as the money wouldn’t have funneled into America otherwise.

The market was hoping for Trump to say specifically that a 10% repatriation tax holiday would be put into effect, but instead the administration said it would be “very competitive.” I disagree with the market’s response to this because the Trump administration’s goal for a 10% rate is still in place. The philosophy on taxes clearly hasn’t changed as the rates which were discussed were all low. It’s not as if Trump will get everything done exactly according to plan anyway. This new plan does nothing to change my expectation for a 10% rate. This is why the selloff was moderate. Given all the leaks about the plan, this was a non-news event, so stocks shouldn’t have moved at all.

The number of income tax brackets will be lowered to three which are 10%, 25%, and 35%. The corporate tax rate was set at 15% with no border tax. This means the tax will add to the deficit. The initial calculus going into this plan was that Trump would need 60 votes in the Senate because the Byrd rule doesn’t allow for budgets which raise deficits outside of a ten-year window to be passed through the reconciliation process which requires only a majority. At this point, I think the Byrd rule will have to be eliminated because it’s the only option to getting tax reform done. This hasn’t been talked about extensively in the media, but it’s the only way for a plan close to this to get passed. The Trump administration already used the nuclear option to get Judge Gorsuch nominated to the Supreme Court, so it has experience with changing the rules to avoid needing 60 Senate votes to get things done. The other possibility is this plan is kabuki theater meaning that Trump knows it is unlikely to pass, but wants to make it known to the public that he tried to get the lowest rates possible.

One issue with this plan is called ‘pass through.’ This is when a rich person claims to be a business to pay the corporate tax rate instead of his/her correct income tax rate. Congress must outsmart tax lawyers to prevent this. That’s a major hurdle as they are experts at getting their clients to pay as little tax as possible. Clearly that language to prevent pass throughs wasn’t in the guidelines released by Trump as it was only one page.

One other point is the plan eliminates the 3.8% investment tax on individuals earning $200,000 and couples earning $250,000. This should boost investments into the stock market. This tax is part of Obamacare. It represents an initial tug at the ball of yarn which is Obamacare.

Conclusion

Stocks sold off moderately because there weren’t specifics on the repatriation tax rate. As a bear, I’m always willing to see the negative side to events. However, I don’t see one because this doesn’t change the chances of a 10% repatriation tax from being enacted. What this does do is make it more likely that the Byrd rule will be abolished. I’m not sure how that will get done, but the specifics don’t matter to the stock market as long as it happens. The elimination of the 3.8% Obamacare investment tax will also boost equity investing. This plan is a win for stocks if it passes