The Trump Market Rally: Justified If Reaganesque Tax Reform But Not Bushie Tax Cuts

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Summary

Trump’s original tax-cut plan was graded as giving 62% of the benefit to the top 10% of income and would’ve had blown up the deficit with minimal economic impact.

Trump’s Treasury nominee, Steven Mnuchin, claims that the plan will only benefit middle/lower income groups due to loss of deductions, eliminating any benefit to upper income groups.

If Mnuchin is right, this could result in a Reaganesque plan that more or less pays for itself and helps generate annual GDP growth around 4%.

If Mnuchin is just talking the talk and actually implements a top-loaded tax plan, expect a Bush-like slow growth economy (2-3%) with exploding deficits.

The stock market (NYSEARCA:SPY) has rallied almost 7% since Trump was elected President and some pundits are warning "Stay out of stocks at your own risk."

This the second article in this series and it's going to address tax effects of the disclosed Trump tax reform.

A continuing rally is only going to happen if Trump's team does something different than he promised during the election. His policies' statements were often contradictory and designed to have maximum media impact rather than outline effective policy.

Media interviews show that Trump's nominees are talking about doing tax reform that is much more effective than what Trump claimed he would do during the election. The CNBC Squawk Box interview of Steven Mnuchin and Wilbur Ross, nominated respectively for Treasury and Commerce secretaries, lacks specifics but is strong on technically correct claims.

The problem with analyzing any tax reform is political: Today, Republicans seem to think all tax cuts are good while Democrats think that all Republican tax cuts are for the wealthy. The reality is more complicated.

Reagan came in and made very sophisticated changes to tax policies with the intent of lowering rates to encourage both investment and additional participation by labor. This was a supply side solution that was appropriate for a shortage of supply situation where corporate bonds interest rates were at a historical high of 17%.

The current situation with interest rates is exactly the opposite: a demand side problem with interest rates at historical lows. As shown in the investment grade Baa Corporate bond yield, the last time bond yields were this low is right after WW2, when war buildup in production capacity took until the mid-50s to absorb.

Investment Grade Corporate Bonds

The situation today is caused by excess export capacity buildup in Asian markets, which has led to decreased investment demand, which results in excess savings across the world. This is a basically unstable situation, as in the long term, savings must equal investment. When things get enough out of whack, there can be a serious value adjustment event such as a stock market crash. A crash reduces savings by vaporizing investment value.

A tax policy which increases savings even more by cutting taxes to savers (the upper 10%) will make the problem worse (downward pressure on interest rates) while tax policies that increase the income of spenders (the lower 90%) will increase demand and corporate profits, use up capacity resulting in higher investment demand, and ultimately, increase interest rates.

Trump in his original recommendation for a tax-cut did something very similar to Ryan's House plan with some Reaganesque twists: treatment of income equally (elimination of carried interest) and replacing the estate tax with a capital gains tax at death. All of these are very sophisticated, very theoretical tax treatments that are consistent, if not identical, with Reagan's administration policies that minimize redistribution.

Because he was basically doing a copy of Ryan's plan, 62% of the benefit went to the top 10%. This is worse than Bush's plan where 55% of the cuts went to the top 10%.

Reagan combined tax cuts with deduction eliminations and usage fee increases that offset much of the tax cuts so it's difficult to determine how much went to the top 10%. If you are not concerned about increasing income inequality, the problem for Reagan was that increased spending, not decreased tax receipts, caused the deficit to explode, forcing his successor Bush 1 to raise the top capital gain rate to 31%. This did not quite eliminate deficit growth so Clinton raised the top income rate to 39.6%, a rate that proved to be a little high as it rapidly started to pay off the deficit.

The American Taxpayer Relief Act of 2012 tried to achieve the correct balance by only reinstating the pre-Bush tax cuts rates on higher income above $250,000.

The chart below of historical GDP, government spending, receipts and debt graphically shows the effect of each tax cut. Note the dark blue government expenditure line is relatively smooth while the government total receipts (taxes) is relatively smooth up until Bush 2 when the effects of the "Bushie" tax cuts results in wild gyrations that continue into the Great Recession and the Obama years.

It's visually obvious that the Reagan tax policies were much less disruptive than the Bushie tax cuts. This is because they were tax reforms targeting specific objective problems rather than straight tax cuts. Also note the flattening/decrease in total government spending during the Obama era. This decrease is sufficient to explain the current slow economic growth.

Trump has always presented his program for reducing the top current federal rate of 39.6% to 33% as a middle and lower class tax cut that is deficit neutral. Mnuchin has stated that he does not believe analysis that show it would increase the deficit and that this is a middle/lower class tax-cut.

Mnuchin seems to understand that Reagan's plan could justify tax savings for the wealthy because it increased the available money (savings) for investment during a time of high interest rates that were limiting investment.

He also seems to understand that currently, there is ample money for investment but not enough demand to justify additional investment. More investment requires more demand.

I tried to illustrate this with the chart below of Real GDP (blue) compared to three of the common concerns: PCE inflation (red), Fed spending Surplus or Deficit (green), and personal savings rate (purple). There's no correlation currently evident against GDP because none of these measure the base problem: Demand.

Real GDP, PCE Inflation, Fed Surplus or Deficit, Personal Savings Rate

You'd have to go back to 1929/33 to see a period more deficient in demand. You can't easily show demand shortages on a chart because there is no indicator of deficient demand like there is for inflation, deficits, or interest rates.

It appears that Trump's advisors realize this will be a wildly successful tax program if they can simplify the tax code and get rid of enough deductions that most tax savings falls to the bottom 90% who will spend it.

It's an uphill battle for them as Ryan's tax plan is heavily weighted towards the top 1% and it would be much easier to simply go along.

It will be easy to tell if Mnuchin and Ross are successful: There will be a lot of complaints about elimination of deductions. A rationale tax program will be a good indicator for all of Trump's programs because it shows his advisors understand what needs to be done in today's economy.

If they are Reaganesque, we should avoid a market crash and anticipate good profit increases, though stock increases may be moderated by P/E deflation as interest rates rise; the opposite of Reagan's era when values were aided by P/E expansion. If supported by other appropriate policies, average GDP growth might increase 1 to 2% of GDP, and be in the 4% range of pre-Bush 2 Presidencies.

If the tax cuts look Bushie, it's very unlikely that there will be a positive effect on the stock market. Deficit increases may drive some profit increases (a la Minsky), but probably not enough to offset the ongoing weakness in demand.

The next analysis will be on the budget or possible lack thereof.

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.

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