Trump takes on US tax system – What’s it mean for investors? 

David Lafferty

Since the election of President Trump in November last year, markets have had an on-again off-again love affair with the prospects for comprehensive tax reform.

With both houses of Congress and the executive branch in Republican hands, the stock market, US interest rates, and the US dollar rose dramatically from election day through February. However, as dysfunction emerged within the GOP on everything from healthcare to immigration policy, interest rates fell back and the US dollar weakened.

Through it all, global equity markets have managed to grind higher on stronger economic data. Then, in late September, Republicans released their much-awaited “framework” for tax reform, collapsing individual tax brackets and dramatically reducing corporate rates – much of it paid for by reducing or eliminating specific tax deductions. This gave markets yet another shot in the arm, reminiscent of those first post-election days in November.

$1 trillion deficit hurdle

We believe markets are somewhat naive about what can be accomplished on the tax front. Global investors have largely misunderstood the “Republican Sweep” in Washington to mean that legislative gridlock has been vanquished.

Deep divisions within the GOP call into question what can be accomplished as multiple factions within the party squabble over the details. While core Republicans within the leadership push for lower tax rates, they will be met with intense opposition from a growing caucus of fiscal hawks who are unlikely to sign off on the resulting larger deficits – currently forecast at an additional $1 trillion over 10 years. Even this math is optimistic, given it assumes another trillion in revenue from eliminating the “SALT” deduction for state and local taxes paid.

This is likely to be a non-starter for the 20+ Republican legislators from high-tax states like CA, NY, and NJ. With only a slim margin in the Senate – and zero help from Democrats – any meaningful tax reform must have almost unanimous appeal across these GOP factions.

The current framework, while just a starting point for negotiations, hardly meets this standard. For now, the tax math is devoid of political reality: You cannot simultaneously lower rates, hold the line on deficits, and preserve cherished tax breaks.

Three scenarios for tax reform

At this point, we handicap three possible scenarios: One, a complete breakdown of tax reform resulting in no meaningful change in legislation – à la “repeal & replace” (45%). Two, minimal tax reform in 2018 with only modest reductions in rates (both individual and corporate) and few revenue offsets (45%). And three, a damn-the-torpedoes deficit-swelling tax cut where fiscal hawks acquiesce for fear of being seen as obstructionist going into the mid-term elections (10%).

Given my estimate on the likelihood of these scenarios, equity investors would be wise to base their optimism on the slowly strengthening global economy, rather than the hope of meaningful Keynesian tax stimulus.

By David Lafferty, CFA, Chief Market Strategist, Natixis Global Asset Management