Trump Good For Markets, Bad For Economy

by: Shareholders Unite

Summary

We think Trump's economic policy would not revive the economy as it shifts income from low savers to high savers.

However, it would work as a supercharged variant of the model underpinning high share prices.

But we think that model is running into decreasing returns.

Donald Trump proposes to revitalize economic growth with a mixture of tax cuts, tariffs and less regulation (for details see the Tax Policy Center).

Since the details of these plans are sometimes sketchy and subject to change, we look at the underlying logic and ask whether this approach can indeed revitalize the economy.

Larry Kudlow and Stephen Moore, some of Trump's economic advisers, have given some background on the rationality of these measures. Here is Larry Kudlow:

But the fact remains that Hillary Clinton's proposals to raise taxes on so-called rich people, rich corporations, Wall Street, investors (capital gains, dividends, and financial transactions), and estates will greatly harm middle-income wage earners who have essentially not had a pay raise since the year 2000.

Kudlow seems to be saying that taxing the rich will hurt the middle class, so tax relief would do the opposite. How does that work? He cites some academic sources explaining this:

Let me begin with AEI economists Aparna Mathur and Kevin Hassett. They have written extensively on the adverse effects of high corporate taxes on worker wages. They argue that high taxes drive capital out of the high-tax country, like the U.S., which leads to lower domestic investment. That in turn reduces the productivity of the worker, who will lack the latest advances in technology and machinery. And since there is a tight link between worker productivity and pay, lower wages result.

So wages are stagnating because companies don't invest. Companies don't invest because taxes (and regulation) are too burdensome, which reduces the quality and quantity of the capital stock and hence productivity and wages.

We don't think this sits well with the facts as we understand these. We give you some stylized facts:

  1. US corporate taxes are not high
  2. US corporations do not lack funds to invest
  3. Wages are not stagnating because of slow productivity growth

Corporate tax

While nominally, the 35% corporate profit tax is high (Kudlow actually argues US corporate tax is the highest in the world), but in reality few companies are burdened with that. Here is CTJReports:

U.S. corporate income taxes have declined sharply as a percentage of GDP since 1945. [2] Part of the reason corporations are paying less in taxes today than they did 70 years ago is due to copious changes in the tax code. Yet there is a growing and vocal movement among well-financed lobbying groups to push federal lawmakers to lower the corporate tax rate. These business-backed groups claim that the U.S. corporate tax rate is too high, citing the 35 percent federal statutory tax rate. But that narrow argument ignores critical facts such as the many large tax breaks, loopholes and other corporate tax exceptions that big businesses have successfully lobbied to embed in the tax code. A 2014 study by Citizens for Tax Justice examined five years of data and found that Fortune 500 companies paid an average federal effective corporate income tax rate of only 19.4 percent, which is just over half of the nominal U.S. statutory rate of 35 percent. That same study found that many profitable, large U.S. corporations such as Boeing, General Electric and Verizon paid no federal corporate income taxes at all.

Internationally, the US corporate tax isn't particularly high, it's actually below average:

Business Investment

It is true that business investment is somewhat disappointing, but would a massive tax cut revitalize this? We have our doubts, as companies do not lack the means to invest:

  • Corporate profits sit at record highs
  • Corporate cash sits at record highs
  • Interest rates sit at record lows

Indeed, here is Larry Summers:

At a moment when capital costs are close to zero, the stock market is at a record high and businesses are earning record profit margins, we do not need to bribe businesses to make investments that now do not seem worthwhile to them. There is no case for reducing already low corporate taxes or removing regulations, unless it can be shown that these have costs in excess of benefits.

Indeed, companies do invest, although not so much in expanding capacity as in returning money to shareholders in the form of stock buybacks and dividends.

Together, these form the payout ratio, which sits at an unprecedented 90%+, according to William Lazonick:

Corporate profitability is not translating into widespread economic prosperity. The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings-a total of $2.4 trillion-to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.

Curiously enough, Kudlow blames this high payout ratio on monetary policy:

ultra-low interest rates have led to financial engineering rather than the deployment of excess corporate cash for productivity-enhancing investment.

But he never explains why this is so, and we don't see any reason why low interest rates would favor share buybacks, rather than investment.

So it's difficult to argue corporations don't have the funds to invest and need a massive tax cut to be 'bribed' into investing more.

It is often argued that the Reagan tax cuts produced a revitalization of the economy. Insofar as it did, it's not because it unleashed a wave of business investment (Moneynews):

Since 1980, U.S. investment as a percentage of GDP was sliced in half, from nearly 24 percent to 12 percent, leaving the United States 174th in the world. The result was a dearth of real value added products and productivity.

Now, there are probably some structural factors at work here as well, like the decline in the cost of investment goods and new sectors being less capital intensive.

On the other hand, there was the mother of all interest rate cuts in the early 1980s, which should have boosted business investment.

Also, systematic studies show little support. Not for tax cuts (CBS):

As Nobel Prize-winning economist Peter Diamond and John Bates Clark medalist Emmanuel Saez have noted, since the 1970s no clear correlation exists between economic growth and top tax-rate cuts across Organization for Economic Cooperation and Development countries.

And neither for the size of the public sector (Bernstein):

In the century and a half since then, government expenditures as a share of GDP have risen sharply in these countries. Yet they didn't experience a slowdown in their longrun economic growth rates. The fact that economic growth has been so stable over this lengthy period, despite huge increases in the size of government, suggests that government size probably has had little or no impact on growth.

Wages and productivity

Kudlow argues that taxes deter investments, which deteriorates the capital stock (both qualitatively and quantitatively), and that depresses wage growth. However, wages have been stagnating for decades, and its relation with productivity has been severed.

This graph also suggests a different dynamic. Rather than excessive taxes or regulation, investment has been sluggish mainly because the wage stagnation has depressed demand.

This was masked, first by the influx of women into the labor market, and second by an unprecedented surge in borrowing, but neither of these could be expanded indefinitely and after the financial crisis the reckoning has set in.

Tax cuts

But perhaps, Trump's tax cuts could revive spending power. This seems to be the case, but not without a cost. Here is the Tax Policy Center:

The proposal would cut taxes at every income level, but high-income taxpayers would receive the biggest cuts, both in dollar terms and as a percentage of income. Overall, the plan would cut taxes by an average of about $5,100, or about 7 percent of after-tax income. However, the highest-income 0.1 percent of taxpayers (those with incomes over $3.7 million in 2015 dollars) would experience an average tax cut of more than $1.3 million in 2017, nearly 19 percent of after-tax income. Middle-income households would receive an average tax cut of $2,700, or 4.9 percent of after-tax income. The significant marginal tax rate cuts would boost incentives to work, save, and invest if interest rates do not change. The plan would also reduce some tax distortions in the allocation of capital. However, increased government borrowing would push up interest rates and crowd out private investment, offsetting some or all of the plan's positive incentive effects. Offsetting a deficit this large would require unprecedented cuts in federal spending.

So this strategy has several potential downsides for demand:

  • Most of the tax cuts go to the very top, exactly the people who have already done extremely well the last couple of decades. They also save a much higher percentage of their income (or put it in tax havens), which reduces the demand effect.
  • The public deficit and debt are likely to surge, which can lead to a combination of public sector cuts and/or rises in interest rates. Both of these will partly, or even completely compensate the demand boost from the tax cuts.

In general, those who argue the US could easily coast to higher growth should also take the following into consideration (Robert Gordon, NYT):

Presidential candidates who promise faster growth will have to face up to the labor-force constraint. In the 1970s and 1980s, millions of women entered the labor force. Since the mid-1990s, however, female participation has leveled off, and baby boomers are retiring. This labor-force reversal by itself shaves about one percentage point from the growth that is realistic over the next decade compared with the last quarter of the 20th century.

The markets

So we don't see much evidence that Trump's economic program will significantly boost economic growth. But that doesn't mean it won't be good for the markets; after all, these have done rather spectacular in the last half decade even when growth was rather tepid.

Will Trump be good for investors? That is another story and might very well be the case. Several of the proposed tax cuts are deeply regressive and as such favoring investors.

Despite what you might have heard, it's also good for hedge fund managers (EPI):

But Trump would go one step further, creating an enormous tax loophole for the rich by applying his 15 percent corporate rate to "pass-through" entities as well. Pass-through entities are businesses whose income are not taxed at the corporate level, but rather passed through entirely to the businesses' owners and then taxed at the owners' individual income-tax levels. High-income households can easily avoid paying their full income tax bill by reclassifying their income as pass-through income. This loophole allows Trump to claim that he is closing the carried interest loophole, while actually lowering the rate that hedge fund managers would pay from 23.8 percent to 15 percent. Incidentally, this loophole has already been tested, which proved disastrous for Kansas Governor Sam Brownback.

It might seem funny, as Trump is posing as the anti-establishment candidate, but we see these policies as a continuation of the present model, if not more so:

  • Shifting income upwards
  • Shifting income from labor to capital

These trends have been going on for some time, and this has been good for the markets, even if we don't think they're good for the economy.

One thing we wonder is how much mileage there might be left in this model. If the labor market tightens any more labor cost will start to rise, which will be good for the economy, but probably not for the markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.