A taxing problem
Markets have been on the upswing over the past few months and have recently hit brand new highs. Accommodative central banks around the world have helped stoke this rally, but at least a portion of the gains are likely attributable to optimism over America’s new government and hope some of its pro-business promises will come to fruition. Unlike Europe and Japan, the US has begun pulling the plug on monetary policy (interest rate cuts and quantitative easing), making progress on advertised fiscal stimulus programmes (tax cuts and greater government spending) that much more important.
To keep the party going, financial markets are looking for Washington to deliver in three essential areas: reduced regulation, infrastructure spending and lower taxes. Moving forward on these projects requires a budget and that pushes American tax policy onto centre stage; and here, the GOP has promised a complete overhaul.
Key components of the proposed US tax plan include reducing the highest corporate income tax rate from 35 per cent to 15 per cent, simplifying personal income taxes and scheduling a tax holiday for repatriation of around $2.6 trillion in cash held overseas by US companies. House Republicans also wish to eliminate the 3.8 per cent surtax on investment earnings, previously applied to high income earners to help pay for the Affordable Care Act.
The Republican tax plan, if eventually implemented, could have dramatic effects globally. For one thing, the proposed corporate tax reduction would take the US from being the highest tax country within the Organisation for Economic Co-operation and Development (OECD) at a headline rate of about 35 per cent to being one of the lowest within the 35-member group of developed economies.
Even if the corporate tax rate is dropped to just 20 per cent, that would make America much more competitive with corporation-friendly jurisdictions such as Ireland and the UK, which advertise headline tax rates of 19 per cent and 12.5 per cent, respectively. One might even wonder what the effect this change might have on smaller “tax haven” countries with no published corporate taxes such as Bermuda and Cayman Islands.
The President’s advisers are certainly keen on the idea of a major corporate tax reduction. Newly-appointed Treasurer, Steven Mnunchin referred to the proposed plan as the “biggest tax cut in US history” while White House chief economic adviser Gary Cohn said a 15 per cent business tax would give the US a huge advantage globally — borrowing one of The Donald’s favourite adjectives.
On the personal income tax side, the White House proposal intends to broaden the tax base and lower tax rates here, too. The latest plan calls for collapsing the existing seven tax bracket tiers down to only three: 10 per cent, 25 per cent and 35 per cent. Furthermore, the standard deduction, which is now available to everyone, would be doubled. As an offset, almost all of the itemised deductions, with the exceptions of mortgage interest, charitable donations, and retirement savings would be eliminated.
Perhaps the most controversial part of the new tax plan is the elimination of the federal tax deduction for payment of state and local taxes. Individuals from high tax states such as California and Massachusetts, have historically received a credit for the like amount of tax liability on their federal income tax return.
On this point, we are likely to see pushback from Republicans representing those high-tax states just as we continue to see resistance against House Speaker Paul Ryan’s border-tax proposal from special interests in those sectors with complex supply chains which would be disadvantaged.
The one thing all politicians seem to agree on is that the system is too complicated. When US income taxes were first implemented in 1913, the complete tax form was literally like filling out a post card with no more than four pages of information required. Currently, the tax rules alone for individual 1040 returns now take up more than 106 pages!
US government debt has essentially doubled from approximately $10 trillion eight years ago to about $20 trillion now. Common sense would suggest America (like many other countries) really needs to spend less and collect more tax in order to reduce debt and thereby move towards a more sustainable budget position.
But these days voters have little patience for practical politicians. And besides, the US was founded on opposition to taxes. Therefore, the world’s largest economy is now looking a new version of ‘supply-side’ economics made popular during the Reagan era.
Lowering taxes and increasing spending may create a short-term growth boost, but is likely to cause bigger deficits and ultimately a less stable economy down the road. Renowned hedge fund manager Ray Dalia probably sums it up best with his recent quote: “Big picture, the near term looks good, but the longer term looks scary.”
One possible longer-term solution to the budget-balancing conundrum could involve greater consumption taxes. Residents of Bermuda are familiar with the import tax which ranges around 22 per cent or more, depending upon the item. As a small island which imports most goods, the import tax effectively represents a consumption tax applied to just about everything purchased by its residents. Yet many people prefer this form of taxation as it allows citizens to gain greater control over their tax liabilities — spend less, pay less tax.
An element of consumption tax is evident in Trump’s recent suggestion of increasing the gasoline tax to help pay for infrastructure spending on roads and transit systems. This idea is sensible considering the American Society of Civil Engineers gave the US a report card grade of “D” for its crumbling transportation infrastructure.
Given the divisiveness in Washington and even within Trump’s own Republican Party, the road ahead for a US tax plan will be bumpy. The political arena could be further clouded by the Washington politics and a possible showdown over the Trump investigation.
We hope the final result is relatively benign, but other outcomes are possible. Some strategists and political analysts believe that if a more scandalous investigation scenario unfolds, it could block the new administration’s progress on many fronts, including the implementation of tax reform in 2017.
Bryan Dooley, CFA is the general manager and senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority
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