Today The House passed the 2018 budget resolution in a 219-207 mostly party-line vote (18 republicans voted against the resolution along with all Democrats), representing the first step toward the Republican goal of sending tax-reform legislation to President Trump. Republican lawmakers hailed the vote as meaningful because the due to the budget reconciliation rules, the incorporate tax measures would allow Republicans in the Senate to pass tax reform without any Democratic votes, though Senate Majority Leader Mitch McConnell can only afford two defections (this proved to be a terminal hurdle in repealing Obamacare).
“We haven’t reformed this tax system since 1986. We need to pass this budget so we can help bring more jobs, fairer taxes and bigger paychecks for people across this country,” Speaker Paul Ryan said during House floor debate.
News of the passage provided a fresh burst of upside to the S&P which closed at fresh all time highs, driven by both tech and US-focused small-cap stocks, while the VIX dropped to new all time lows.
To be sure, for the past month, all trader eyes have been focused on the prospect of US tax legislation which has fast become the only catalyst for equity valuations, and especially following last week's release of the proposed Republican tax plan, as well as the failure (again) of the party’s efforts on healthcare. Additionally, the tragedy of three major hurricanes hitting Texas, Florida, and Puerto Rico has superimposed a new agenda onto Congress given the urgency of relief needs (which could also open the door to longer-term infrastructure improvements). As a result, how recovery and reconstruction may reshape the fiscal agenda —and the potential of getting it all done — is the main question Goldman asks in its latest "top of mind" periodical publication.
The question is critical because while today's budget resolution passage suggests a beneficial tailwind far tax reform, there are many who warn that the real work, and major hurdles - not to mention bickering within the Republican party - is only just starting.
So to get a sense of the complexities that lie ahead, here is Goldman's Washington economist Alec Phillips, laying out the next steps and assessing the prospects for the passage of both tax reform and fiscal policy, one which now faces substantial obstacles.
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An update on the DC fiscal agenda
The recent fiscal deal cleared the decks…
The urgent need to provide hurricane relief funding drove the recent bipartisan deal to suspend the debt limit and extend spending authority, clearing the agenda of near-term fiscal deadlines several weeks earlier than had been expected. As a result, Congress has several more weeks before year-end to consider tax reform and other measures.
…but kicked the can.
However, this newfound breathing room won’t last long. Spending authority must be extended again by December 8 and the debt limit must be raised by late February or March 2018, when Congress is likely to be in the thick of debate on other issues like tax reform. We are not particularly worried about the risk of a shutdown in December but we do believe that the need to raise the debt limit during the final stages of the tax-reform effort poses risks for both issues.
Bipartisan cooperation could increase…
The recent fiscal deal also raised hopes for other bipartisan agreements on immigration, tax reform, and an infrastructure program. We think the chances for bipartisanship in a few areas might have indeed increased, for two reasons. First, additional hurricane funding could compel fiscal conservatives to support spending initiatives that they might otherwise oppose. Second, the positive public reaction to the recent fiscal deal might motivate the White House to pursue more discussions across the aisle.
…but is unlikely to become the norm…
There is simply not much overlap at the moment between lawmakers of each party on key issues under consideration, like healthcare or taxes. In addition, while the president has shown interest in a narrow bipartisan agreement on immigration, his core supporters appear to be strongly opposed.
…particularly where reconciliation could be used.
Republicans can use the reconciliation process to change the tax code or the Affordable Care Act (ACA) and are apt to do so if they can. While a bipartisan process could allow for a wider range of policy changes and would lead to more durable reforms, the drawback is that reaching an agreement is less likely. By contrast, an approach that relies on the majority party alone is likely to succeed even if it faces greater procedural constraints on the types of changes that can be made.
Health reform is off the agenda for now…
The recent Senate debate over healthcare legislation demonstrates that even reconciliation legislation is not guaranteed to pass. We had never expected Congress to repeal the insurance subsidies provided through the ACA, but we did expect Republicans to make changes to ACA policies either a repeal of a few politically unpopular provisions like the individual mandate, or devolution of control over the program to state governments. The Senate attempted to pass both but neither had sufficient Republican support. The most that appears possible in the near term is a set of targeted changes to improve the program for 2018. With the reconciliation strategy on healthcare put aside for now, a bipartisan agreement in this area looks possible, though with potentially modest effects.
…but might return.
Congressional Republicans might make another broader ACA repeal push at some point before the midterm election, by using the reconciliation process in either the FY18 or FY19 budget cycle. At this point, the House and Senate differ, with the House resolution instructing the committees with oversight of the ACA to pass legislation cutting spending by $72bn over the next 10 years, which could come from ACA subsidies or unrelated programs, like Medicare. In the Senate, the draft resolution includes no such instructions and would be incompatible with ACA repeal. We expect the Senate approach to prevail for FY2018, effectively pushing the next repeal/replace opportunity to mid-2018 or, more likely, 2019.
Tax reform is moving forward on two tracks…
With health legislation finally out of the way, the focus has shifted to tax reform. Congressional Republicans expect to use the reconciliation process to pass tax reform, which would require two steps: First, the House and Senate budget committees must lay the procedural groundwork with a budget resolution for FY18 that instructs the tax-writing committees to cut taxes by a certain amount, a process that is underway. Second, once a final budget resolution has passed in the House and Senate, the tax-writing committees—the House Ways and Means and Senate Finance Committees—write the detailed tax legislation that would carry out those instructions. This must also first pass at the committee level, then the full House and Senate, and finally a conference committee to resolve any differences. In all of these votes, only a simple majority would be required because it is part of the budget process, which is governed by special rules.
…and the recent news on tax reform has been positive…
Over the last few weeks, three developments have raised the odds of tax reform, in our view. First and most importantly, a tentative agreement was struck by Senators Corker (R-Tenn.) and Toomey (R-Penn.) that allows for the FY18 Senate budget resolution—released on September 29—to include instructions to the tax-writing committees to cut taxes by up to $1.5tn over 10 years. This was a critical development since, once finalized, it would allow for a cut in tax rates with less broadening of the tax base than would be necessary under a revenue-neutral instruction, allowing lawmakers to avoid making the most politically difficult choices. Second, the framework released by the “Big Six” signals modest progress on agreeing on a single set of reforms, though the details are not yet fully formed.Third, the public support from the House Freedom Caucus for the framework and the upcoming budget resolution suggests that its members are unlikely to be a major obstacle to enactment. While the second and third items were not particularly surprising, we believe the tentative budget agreement was likely one of the more important turning points in this debate.
…but there are still plenty of obstacles to overcome.
There are two important technical obstacles that Republicans must overcome to pass tax reform via reconciliation. First, pay-as-you-go (PAYGO) rules constrain the consideration of deficitincreasing 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). Waiving either rule requires 60 votes in the Senate.
A more fundamental obstacle is political.
Thin Republican majorities in the House and Senate have made it difficult to reach consensus so far this year. Tax reform needs support from 50 of 52 Senate Republicans, and we expect the 50th vote to come from the same group of centrists who were among those who recently blocked the health bill. These senators might press to keep the size of the tax cut even smaller than the $1.5tn over 10 years allowed under the Senate budget resolution. However, our expectation is that these senators are more likely to limit the size of the tax cut, rather than block the bill entirely as they did with the health bill (find a more detailed look at tax reform prospects here).
The fiscal boost from tax changes will likely be small.
Financial markets are more focused on fiscal stimulus than Congress. However, while we believe there is a 65% probability that Congress will enact tax legislation in 2018, we expect the size of the potential fiscal boost to be fairly small. The Senate budget resolution includes a tax cut placeholder of $1.5tn over 10 years; since roughly $450bn in existing tax breaks are already scheduled to expire over the next 10 years, this works out to around a $1.05tn net tax reduction. The revenue effects of the tax cut might be estimated on a “dynamic” basis, which considers the economic growth implications of the tax bill when determining its cost. Depending on whether the dynamic score is applied to the $1.5tn or the $1.05tn, this could allow for a “real world” tax cut worth 0.4-0.6% of GDP. All else equal, we expect that this would boost growth by around 0.2pp in 2018 and 2019.
Hurricane relief funding presents some upside risk.
The prospects have risen for a year-end agreement that combines hurricane relief funding, a few targeted infrastructure financing mechanisms, and an increase in the caps on defense and non-defense discretionary spending. Following similarly sized hurricanes in the past, Congress appropriated funds equal to about 60% of the total damage estimates; this suggests that Congress could approve as much as $75bn in funding for Hurricanes Harvey and Irma. The total would rise further with damages from Maria. This would not only boost federal spending directly, but could also allow for an agreement to lift the caps on other spending (emergency spending for disaster relief is exempt from the caps). While we are not particularly optimistic that an agreement will be reached on a broad infrastructure program, hurricane spending could represent a similar amount of funds going to similar types of projects.
Finally, here is the full summary of the US budget process: