Goldman Sachs' Chief US Political Economist Alec Phillips writes that tax reform faces a risk of failure, but tax cuts remain likely... in 2018 and investors need to stay realistic about the impact of fiscal stimulus.
President Trump’s campaign proposals initially raised expectations of several forms of fiscal stimulus, driving investor optimism on both infrastructure spending and various elements of tax reform. However, we expect only tax cuts to have a meaningful effect on growth over the next couple of years. Three risks are behind this view: tax reform failure, fiscal constraints, and delayed enactment.
Debates, delays, distractions
First, tax reform faces a real risk of failure. If Republicans pursue revenue-neutral tax reform, they are likely to encounter the same challenges they encountered in passing their health legislation. Inclusion of controversial proposals like the border-adjusted tax (BAT) or even the repeal of corporate interest expense deductibility, for example, could sink the effort. Views on these issues do not follow traditional party lines, which could easily lead to some Republican opposition (we have already seen significant opposition to the BAT, for example). With few if any Democratic lawmakers likely to vote for the tax bill, Republicans would need nearly unanimous support from their own party. Thus, while revenue-neutral tax reform might be preferable from a policy perspective, imposing this restriction would lower the odds of enactment by next year.
In light of the challenges tax reform faces, we believe that President Trump, who did not emphasize revenue-neutrality during the campaign, is likely to eventually endorse more limited reforms that result in a net tax cut. However, the size of such a cut would be limited by fiscal constraints; centrist Republican lawmakers seem especially likely to balk at large tax cuts that would eventually require deep spending cuts to maintain fiscal sustainability. Dynamic scoring and other budget accounting strategies might provide several hundred billion dollars’ worth of room for a tax cut in 10-year budget projections, but alone would allow for only a very modest cut. Our current expectation is a tax cut of $1.75tn over ten years, taking effect in 2018.
While Republican leaders have prognosticated that they might take the first vote on tax legislation as soon as May and enact a bill by August, the risk is skewed toward delays, in our view. Enactment of simple tax cuts should not take long—it took the Bush administration until only May to enact the 2001 cuts—but a lengthy debate over complex tax reform that ultimately fails could cause delays. Likewise, an effort to revive health legislation could also push the start of the tax debate to mid-year or later. And, while not directly related, fiscal deadlines such as the April 28 and September 30 expiration of spending authority and the debt limit deadline we expect between August and October are likely to distract from tax legislation.
A peek at the fiscal impact
We expect Congress to pass tax legislation sometime between 4Q2017 and 1Q2018. However, the potential fiscal impact is likely to become clear in the next couple of months, for two reasons. First, the White House is expected to submit a budget proposal to Congress in mid-May, and will need to clarify its intentions on the size of a tax cut at that point. Second, in order to pass tax legislation via the “reconciliation” process, Congress must first agree on a budget resolution providing instructions for the tax-writing committees to do so. These instructions must include a specific amount by which revenues should be reduced; once this figure is finalized, which we expect in May or June, a larger tax cut would not be possible without bipartisan support.
Holding out hope
While we expect the outlook for fiscal stimulus to become much clearer in the next couple of months, the consensus view is harder to discern. Our basket of high-tax stocks has given up all of its post-election relative gains (see pg. 10). That said, we believe the market consensus view is still for some tax legislation to pass. Prediction markets, for example, suggest around 60-70% odds of individual and corporate tax cuts being enacted this year. And the equity market continues to react negatively to perceived setbacks on tax reform, indicating that hopes of tax reform continue to be at least partly priced in.
A tax, not a spending story
Other forms of fiscal stimulus are likely to be fairly minor. The outlook on infrastructure is uncertain, and we expect changes to consist mainly of tax policies aimed at boosting private-sector activity rather than public spending. President Trump has also proposed a $54bn (0.3% of GDP) per year increase in defense spending, but we expect a smaller increase in overall net spending. One potential offset to the stimulus we expect is a reduction in subsidies under the Affordable Care Act (ACA), but our estimates assume no change in subsidies at this point.
The economic upshot
If fiscal policy plays out as we expect, the boost to growth would be worth around 0.3pp each in 2018 and 2019. The effects will likely be concentrated in 2018 but extend into 2019, as the policy changes will likely take more than one year to be fully reflected in the level of spending and tax receipts. All told, market participants anticipating fiscal stimulus will need to look farther out for the positive impact they expect.