Tax Reform Approved – An Economic Boost to Come in 2018
What to Expect Going Forward
The new tax bill, formerly known as the Tax Cuts and Jobs Act, was approved by the House and Senate and is to be signed into law by President Trump. In short, it lowers tax rates, doubles the standard deduction, and increases the child tax credit—while capping or eliminating many deductions. For corporations, the new tax bill lowers the tax rate from 35% to 21% and adds full expensing of capital investments, while moving towards a territorial tax system for corporate profits.
Compared to previous tax cuts over the post-World War II period, the absolute size of tax relief for 2018-19 is material, yet relatively modest, compared to historical cuts. In addition, tax cuts generally do not pay for themselves. A higher deficit, and the fact that many personal income tax provisions expire in 2025, increases uncertainty about future fiscal policy, given the potential for a reversal of stimulus over the medium term.
Historical Tax Cuts vs. the New 2017 Tax Bill (% of GDP)
Sources: Committee for a Responsible Federal Budget, Joint Committee on Taxation (JCT), 2017. Shows tax revenue impact, relative to gross domestic product (GDP), for the key years of impact (first year before 1968, average of first two years thereafter) by year of enactment. The estimate for 2017 is the average revenue impact for 2018 and 2019, as a percentage of GDP projected by the Congressional Budget Office (CBO) in its June projection. Tax cut size estimate is based on JCT’s official scoring of the Conference Agreement (joint House/Senate bill), 12/18/17.
We expect it to deliver a modest boost to economic growth in 2018-19. We may also see economic forecasts continue to move higher, as displayed in the chart below. The most decisive factor to watch is business capital spending, as corporations adapt to the new corporate tax regime.
Economic Forecasts on the Move
Sources: Bloomberg, Thomson Reuters I/B/E/S, 2017.
With many 2018 growth forecasts likely to be upgraded, the news is supportive for equity markets in general. Small- and mid-cap stocks, financials, industrials, consumer staples, and telecoms currently pay the highest effective tax rate, and thus, stand to benefit the most from a reduced tax rate (click here to see how tax rates differ by size and sector). Meanwhile, a boost to the economy at a time of low unemployment will add to the pace of interest rate normalization by the Federal Reserve. Repatriation of cash held overseas could potentially strengthen the dollar, but this effect may be partly offset by higher deficits.
Impact on Households
Reduced tax rates are set to provide tax relief for most households. On average, tax relief amounts to a 2.2% increase in disposable income in 2018, which should lift consumer spending.
Percent Impact on After-Tax Income by Household Income Level
Source: Tax Policy Center analysis of the Conference Agreement (joint Senate/House bill), 12/18/17. The estimated impact is for 2018.
At 17-year highs, it may be hard to imagine a substantial boost in consumer confidence. Still, the gap between widely held negative perceptions of the bill and its actual near-term impact on after-tax income, indicates the potential for an upside surprise on consumer confidence and spending for 2018.
Perception Is Not Reality
*Sources: CBS News poll, 12/7/17, and Tax Policy Center analysis of the Conference Agreement (joint House/Senate bill), 12/18/17.
Tax reform will make the U.S. corporate tax system more competitive in international comparisons. This will affect incentives for multi-national corporations to invest in plants and equipment in the U.S. versus abroad, as well as where to locate headquarters.
State Property Tax Deductions, Interest Deductions, Deficit, Health Care, and an Aging Population
- State Property Tax Deductions. A cap on state property tax deductions raises concerns for some housing markets. With a newly imposed $10,000 limit on deductions for state and local property and income taxes, households in high-tax states will experience offsets to the other cuts in the new tax bill. For some homeowners, for example, in New Jersey and New York, the cap on state tax deductions could mean a higher tax burden overall. The impact of this on regional housing markets also bears watching, as it could affect housing affordability in states with relatively high home prices and property tax rates.
- Interest Deductions. A lower cap on mortgage interest deductions for mortgages with principal above $750,000 (previously $1 million) may also affect housing markets in some regions. Likewise, a cap on corporate interest deductions at 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA) could put pressure on highly indebted companies – a pressure that would increase if the economy slows, potentially amplifying defaults. The effect of these caps bears watching.
- A “Fiscal Cliff 2” in 2024-25. To contain the projected impact on the deficit over the CBO’s 10-year window, most personal income tax cuts were made temporary. Full expensing of business capital spending “sunsets” after five years, while most personal income tax cuts sunset at the end of 2025. This sets Congress up for new battles on “Fiscal Cliff” versions 2 and 3 during 2022 and 2024-25. Absent new legislation, tax hikes would be in store on January 1, 2023 and 2026. If personal income tax cuts are extended beyond 2025 without spending offsets, the impact on deficits and deficits will be even larger.
- Neutralizing the Individual Health Care Mandate. The new tax bill reduces the penalty for not having health insurance to zero dollars, effectively neutralizing the Affordable Care Act (ACA) health care mandate. If this leads healthy policyholders to withdraw from health care exchanges, it could raise the cost of health insurance for the roughly 16% of Americans who buy health insurance on the ACA exchanges. Congress seems likely to pass legislation that will mitigate this impact over the short run.1 Nonetheless, the potential side effects on a large group of consumers should be monitored.
- Rising Deficits and an Aging Population to Pose Challenges. While the bill provides a boost to the near-term economic outlook, it adds further uncertainty about future fiscal policy and sustainability. Deficits are already projected to rise over the next decade due to rapid growth in spending for retirement and health care, as well as rising interest payments on government debt. Spending is already projected to outpace federal tax revenue. It is projected that deficits will drive up debt held by the public to its highest level, as a percent of GDP, since shortly after World War II.
Tax Bill: Four Positive Impacts
- Corporate tax reform could enhance capital spending and foreign direct investment in the U.S.
- Tax cuts could boost consumer spending.
- The move toward a territorial corporate tax system could increase repatriation of offshore capital.
- Multi-national corporate headquarter decisions could be affected in favor of the U.S.
Tax Bill: Four Negative Impacts
- A cap on state property tax deductions could impact regional housing markets.
- We may face new “Fiscal Cliff” situations in 2022 and 2024-25.
- An increase in the U.S. deficit and debt levels will create lingering questions about fiscal sustainability over the long term.
- Cap on corporate interest deductions may put pressure on highly-indebted companies in the next downturn.
Tax Reform ApprovedDiscover our additional thoughts on the impact on business capital spending and more in the full white paper.
1. In the Senate, there is bipartisan support for the Health Care Stabilization Act, co-sponsored by Senators Alexander and Murray.
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