To close out last week, House and Senate leaders of the United States Congress presented the final version of the Tax Cuts and Jobs Act. The bill, which will head to the House on the 19th and continue to the Senate, is something President Trump is hopeful to enact before the Christmas holiday.
What does it do?
The final bill will drop the corporate tax rate from 35 to 21 percent by 2018. In addition, the individual tax rate will drop to 37 percent. The corporate tax cut has historically been viewed as something that propels the stock market. These are generally seen as a way to increase the bottom lines of companies and fuel growth and future gains. International businesses tend to source their profits and factories to locations with the lowest taxes. Undoubtedly, this is a proposal for a laissez-faire trickle down economic approach to taxation. Critics claim that the business tax cuts, coupled with the alteration of tax brackets, will worsen the current wealth distribution in our nation and add more to the tax bills of our future generations.
The S&P has already baked in the effects of this tax plan into its pricing. As you can see above, the market will focus on congressional members and which side of the aisle they lean toward in the coming vote. This tax plan will mean that in the short run, capital will be freed up to fund productive investment. However, tax cuts typically can be understood as a means for short-term economic growth, but contradictory to long-term growth. This is because tax cuts must be funded by other means. This will most likely happen through future tax increases or government spending—growing the national deficit.
Keith Parker of UBS argues that the bill has not been priced into the market just yet. He writes, “the bill has only been about 40 percent priced into the market and into individual stock names. It should not feel like you should sell the news.” Further stating that the S&P should be propelled to 2,800 in the near future as a result of the priced in effects. Analysts have typically refrained from accepting that these tax plan effects are 100% priced in to the market. In fact, the bond market has been the most skeptical.
Head of fixed-income strategy at Nomura, George Goncalves, states that “On the back of [this news], yields should go higher. If they don’t, the bond market is sending you a message that they don’t think this will lead to growth.” This will be the most interesting and telling warning sign to follow in the coming months. As back in October, the spread between 2-year note yields and 10-year yields narrowed to 0.75. This marks the lowest spread since before the financial crisis. In economics, the flattening of a yield curve is a predictor of economic transition. When the economy shifts from a period of expansion to slower development, long-maturity bonds fall and short-term bonds rise. If these yields completely flatten or drop into an inverse relationship, the bond market is telling you that economic growth is not strong. However, take this with a grain of salt because this economic indicator is not always foolproof. Following a yield curve inversion in January of 2006, the S&P corrected itself about 8 percent until stocks moved higher until the following October—per CNBC.
While tax reforms will propel domestic and global stocks higher in the short term, the long term growth of the United States stock market rests on the business community’s ability to grow. This tax reform excites members of the upper class in American society - mainly, major corporations and energy drillers. However, it puts a lot of more standard Americans at risk.
For example, the uninsured population of America will no longer have to pay the mandate that requires all Americans to purchase insurance. On one hand, the CBO believes 13 million people will be deprived of insurance. On the other, the elimination of the government subsidies for these low-income people will generate revenue to cover the loss of revenue from these tax cuts.
The Joint Committee on Taxation believes that the bill will add $1.5 trillion to the US deficit over the next 10 years. GOP lawmakers argue that economic growth will offset revenue loss, but this has historically not been the case with trickle-down economic tax reform. Christmas will come early for the business community this year, with President Trump expected to make a decision on the bill before the holidays. While investors realize short-term stock market gains, they must wait a few months after the Christmas leftovers are gone to reassess America’s economic growth.
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.