How A Corporate Tax Cut Will Impact The U.S. Economy

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Summary

It is complicated but I will try to connect some of the dots to make it easier to understand.

It will have short and long-term implications both domestically and globally.

World trade, jobs and the budget require a deft balancing act by the new Administration and Congress Are they up to the task?

Practical application of my line of reasoning to Apple as an example.

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Identifying the Dots to be Connected

First, there are a few assumptions I need to make and these will be based only on what was said in the campaign, which at the moment at least seems to be the expectation of what may actually happen. The two may be the same or could be very different and, if reality is too different from promises, we will need to revisit the possible outcomes in the future. For now, though, we can only assume that expectations are the reality.

What is expected? The corporate tax rate will be reduced to 15 percent. Interest rates should be allowed to rise. Trade agreements need to be renegotiated to level the table. Excessive regulations need to be rescinded or adjusted to be less costly, especially for small businesses. The federal government needs to be downsized and spending needs to be brought under control. Those are the most important, so I will start with this list. I will start with a view from 40,000 feet and then drill down and start to connect some of the dots.

If the corporate tax rate is reduced from 35 percent to 15 percent it is expected that many manufacturing and assembly plants will be relocated back onto U.S. soil. This is true to a certain extent, but not as promising if taken by itself.

If the Fed continues to raise interest rates as promised recently by Janet Yellen, Chair of the Fed, it will mean that the USD (U.S. dollar) should continue to gain in value relative to other major currencies. This would have a negative effect on multinational corporation earnings due to adverse currency translations.

Every trade agreement was entered into by the U.S. with concessions on both sides but, in reality, the biggest concessions seem to have been made by the U.S. in order to create growth abroad and new markets for U.S. multinational corporations. The idea would have been that if enough jobs were created overseas our companies would be able to expand globally, which they did. But it was not supposed to end up with so much of our manufacturing base migrating to foreign soil. But it did. So, the argument is that agreements need to be reassessed and modified to level the playing field on a broader scale and covering more industries. We will see how that works out.

Regulations that hamper economic growth without providing significant social or economic benefits need to be eliminated, pared back or modified. The total cost of regulations borne by U.S. companies is estimated at more than $2 trillion per year. If this happens in a big enough way it could pave the way for some companies to expand and lead to a larger number of small business formations. Again, taken alone, the impact could be positive but not enough to rev up growth to the three percent level.

Reigning in government spending is a key element necessary to achieving the growth in the private sector and jobs here at home. The government debt will become a huge drag on economic growth at some point when interest rates do finally normalize. Interest payments will require and ever expanding portion of the federal budget unless spending is controlled and may triple over the next decade.

Global Competitiveness

The current corporate tax of 35 percent is among the highest in the developed economies and creates a disadvantage, from a cost perspective, for companies creating products here to be exported. It adds cost of every product made in the U.S. and reduces the competitiveness of companies that manufacture or assemble products to be exported. The cost of regulations imposed here but not in competing economies (especially emerging markets but not Europe) also add to this problem. A stronger dollar also makes American goods more costly overseas. Trade agreements that provide preferences on certain goods or services to some countries but not others also make some of our products less competitive. Taken together, all these headwinds have (and would continue to) created a drag on economic growth relative to the emerging economies.

There was a time when that was very beneficial to our economy because then there were fewer consumers overseas to which our companies could sell and too few geographies mired in economic malaise to sustain healthy levels of global economic growth. We were also suffering a significant decline in oil production and had become energy dependent on other regions. Things have changed. Our needs as a nation are not what they were 40 years ago (or even 10 years ago, especially in terms of energy, but in other areas as well).

Trade

That does not mean we need to withdraw from global trade, but it does mean that our future success as a nation is not nearly as dependent upon the rest of the world. Should we institute isolationist policies? No. But our path needs to be adjusted to include new realities. The existing trade agreements need to be renegotiated not eliminated. Of course, even such an effort as this would not, on its own, create a significant number of new jobs in the U.S. It will require much more of a coordinated action that includes most, if not all, of the problems listed above, to optimize our competitive position in global trade.

Interest Rates

Unless our economy falls into recession (still very possible the reasons for which will explained later in this article), interest rates are likely going to head higher. That will continue to add strength to the USD relative to other major currencies. There are both good and bad aspects of this trend. The bad is that, taken along, it makes US exports more expensive. The good is that it makes imports less expensive driving down the cost of living for US citizens. The bad (or good, depending upon how you look at it) is that it is deflationary. From another perspective, it could be considered a good thing in that it will hold down inflationary pressures. So, when a pundit tells you that there is only bad that will come from a strengthening USD, take that opinion with a grain of salt.

My sense is that because other efforts that may be coming from the new administration may be inflationary, the deflationary aspect of a strong USD, taken along with everything else, will allow our economy to grow without the normally accompanying inflationary characteristics. In the end, my score for a strong USD is neutral to positive.

Corporate Tax Rate

Now for the impact of the corporate tax rate reduction as proposed by the President. It only works most effectively if there are also reductions in spending. When President Reagan cut taxes it did help the economy grow, but he only got a promise from a Democratic Congress to cut spending and the promise was never kept. The end result was increased budget deficits.

Technology came to the rescue by creating significant productivity gains which allowed companies to increase wages in real terms (after adjusting for inflation). Growth continued, as a result of productivity gains, demographics (baby boomers hit stride as consumers), and later emerging markets began to take off. We do not have that perfect storm of positive influences at this point in history. Thus, it will be necessary to do more than just cut taxes. But that could be a good start. Here is why I think it could help.

In 2015, corporate taxes made up just 11 percent of total federal tax revenue. Reducing the corporate tax rate by 57 percent reduces total tax revenue by 6.25 percent. That is significant but, over time, there could be significant offsets. The short-term view is that it will just cause budget shortfalls forever. Reality is something quite different. I want to share a quote about a survey that makes a point.

"When Bill Archer (R-Tex.) was the chairman of the House Ways and Means Committee, the tax writing body of Congress, he often quoted a survey of 500 international companies located in Europe and Asia. When asked about the impact of the elimination of taxes on capital and labor, and instead have the taxes based on consumption, 400 of those CEO's, that is 80%, said they would build their next manufacturing plant in the United States. The other 20% said they would move their entire operation here." The quote is from an article I found by searching the phrase: "fair tax survey of companies." The source is unquestionably bias toward the Republican agenda but I believe the results of the survey make perfect sense.

A reduction to 15 percent may not summon such a robust reaction from the global corporate world, but I do believe it would create an incentive to locate plants and, more importantly, jobs in the U.S. as opposed to overseas, especially if the appeal were to be augmented by the reduction of costly regulations.

The U.S. is the consumer marketplace for the rest of the world. It makes sense that if companies could manufacture or assemble products closer to the end market at a competitive cost and reducing the added cost another leg of transportation, they would relocate new facilities and jobs in America.

A Stronger U.S. Dollar

Another aspect to consider is that the strong USD would reduce the cost paid for raw materials purchased elsewhere. Deflation in the U.S. translates to inflation in other parts of the world making raw materials more expensive to those facilities located in nations with weaker currencies.

So, again the strong USD may turn out to be a positive force for domestic job growth in the longer term. This may mean that rising interest rates will be helpful in the long term but problematic in the short term. Why? Asset values in the U.S. have been rising based upon the expectation that interest rates could remain at historically low levels for a very long time. That may be true. But all things are relative.

Deflationary forces should keep a lid on inflation and, by extension, interest rates for another five years or more. But, in the short term (as I define to be the next 12 months) there is a greater probability that rates will rise faster than over the past two years.

The Fed

I expect at least two rate hikes by the Fed; they predict three. Either way, I believe that could cause shocks to asset prices. Will it force the economy into recession? I do not know and neither does anyone else with full certainty. It could, not because of domestic problems but rather because of potential harm that a strong USD could do in other parts of the global economy which could then have a ripple effect back into the U.S. economy. But that is a discussion for another article.

The point is that I expect a roller coaster of volatility in 2017. And that may create some decent buying opportunities for both traders and long-term investors.

Regulations

Regulations need to be analyzed on the basis of cost/benefit for all affected parties. In other words, those that cost corporations too much and provide very little in the way of benefits to the economy may cost far more in lost jobs and slower growth than the benefits derived. Of course, we should not eliminate regulations that save lives or the environment. But we should consider each regulation on the basis of how much additional cost it creates for the private sector and how many jobs it eliminates against its true benefits to our nation.

Spending

That brings me to controlled spending by Congress. This, of course, is probably the most difficult objective to achieve. But there are ways to do so. I cannot go into details here as it would make the article far too long, but suffice it say that the "culture" needs to be adjusted significantly. That adjustment needs to be applied not only to Congress but across the entire federal government bureaucracy. It will not be easy, but it can be done. It will take more time than any other initiative because it is so entrenched. But that is no reason to put off starting.

Connecting the Dots

The problems we face as a nation, as noted above, need to be addressed to create future sustainable economic growth. So, now I want to discuss the interdependence of some of those situations to add some perspective with a hypothetical example. It is complicated and I am not going to solve anything here; I just want to create a better understanding of what we are up against and the path I believe we need to take and, hopefully, open up a dialogue among readers that can be constructive and informative for all.

Practical Application: How might these policies affect Apple?

Lower taxes, less costly regulation and better trade agreements could benefit many U.S. multinationals. Apple (NASDAQ:AAPL) has a huge footprint in China, especially in manufacturing. But that could change. The primary reasons that Apple located its assembly plants in China was to take advantage of cheap labor, lower taxes and less regulation. Already Foxconn is reducing its labor force and replacing people with robots. "One Foxconn plant has "reduced employee strength from 110,000 to 50,000 thanks to the introduction of robots" and "more companies are likely to follow suit," said Xu Yulian, head of publicity for the Kunshan region in the Jiangsu province, which is a manufacturing hub for the electronics industry." That represents just the beginning of a dramatic change coming to manufacturing on a global scale.

That addresses the savings from costly labor. It is no longer a reason to not build in America. Add tax cuts on the scale being considered and reductions in the cost of adhering to regulations and suddenly the barriers to relocating or building new plants in the U.S. are greatly diminished, if not eliminated. Yes, Apple does have a sweetheart tax deal in Ireland but the EU (European Union) is doing its best to unravel that advantage. It may be worthwhile for companies like Apple to reconsider where it outsources its assembly operations.

Even Foxconn is considering moving plants to the U.S. after being asked by Apple to look into such a move. In a study produced by MIT Technology Review in June 2016, the cost of assembling iPhones in the U.S. would add about five percent to the cost of each phone. But that is based upon the current tax laws and regulations and assumes that the components continued to be manufactured all over the world in current locations. The study also includes other scenarios, including one that assumes most component manufacturing is move to the U.S. This, according to the study, would add about another six percent to the cost of each phone. But, again, it does not take into consideration the policy changes which could reduce the costs significantly.

So, let us adjust the pricing of components just by the proposed reduction in corporate tax rate. Instead of paying 35 percent of profits to the government for income tax, the companies would pay only 15 percent. That increases the bottom line of each company by 20 percent, without any other change. If we assume the costs increased by six percent for component suppliers, that increase would be more than offset by the reduction of taxes alone. Then, of course, if the costs of labor can be reduced by building new plants using more robotics and if federal regulations became less costly, it may end up being cheaper to build in American than in China. Finally, add in the impact of the stronger USD that would make raw materials imported cheaper in dollar terms than in terms of any of the other major currencies (including the Chinese Yuan) and the advantages of manufacturing elsewhere to export to the U.S. could vanish completely.

The caveat is that none of the policy changes envisioned have been passed by Congress yet. And that brings me to the bottom line in my line of thought.

Conclusion

In closing I want to address the issue of a potential recession in 2017. By my estimates many assets in the U.S. are priced to perfection. That would require that all of the problems listed in this article would need to be fixed or on track for significant progress by the first half of the year. One party may control both houses of Congress and the White House but I would not advise a celebration to commence just yet.

There are still a lot of differing views on many of these issue within the Republican Party that I expect will take much longer than a year in which to reach consensus. There will be some big positive announcements (probably via Twitter) and there will be some setbacks along the way. The road to change is always bumpy but I think this one will be especially contentious. Again, I expect a lot of volatility in stocks during 2017 and, depending upon what gets done when and how much the changes differ from the status quo, the spill over into other regions could be negative enough to create a global recession which may be unavoidable due to the interconnectedness of global trade and the financial networks. So, buckle up and enjoy the ride as best you can. Don't say you haven't been warned!

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

For those who would like to learn more about my investment philosophy please consider reading " How I Created My Own Portfolio Over a Lifetime.

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Disclosure: I am/we are long AAPL.

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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