The Bass-O-Matic Tax Bill: Unblend Before You Invest

by: One Eyed Guide

Summary

The mash-up of tax programs in the bill means that, once the initial stock bump is over, only high taxed or tax preferenced companies/stocks will benefit.

Most professional economists don’t project any growth from the tax bill’s $1 trillion plus deficit increase.

70% of consumer think they won't benefit, so most consumers won't/can't react to the real cuts until refunds show up in 2019.

Most corporations already have plenty of cash so there is little potential for increased investment.

If the economy does heat up, the Fed has already stated it will raise interest rates to stop overheating.

The closest analogy that I could find to the logic of the reconciled tax bill is Dan Aykroyd’s famous SNL skit, Super Bass-O-Matic 76.

Just like Aykroyd did with his bass, the tax writers have taken a perfectly good idea, tax cuts to increase growth, and thrown every tax cut concept into a blender without rhyme or reason. The size of the container, a limit on the deficit increase of $1.5 trillion, was the only reason a tax cut was restricted or left out. The efforts to stay within this limits by reducing some deductions have made the tax cut skew even more to the wealthy as the very wealthy already had limits on many of these deductions. (There are other reasons for the skews but political speculation is not the focus of this piece.)

Back in the day (before the 2016 election), conservative doctrine was that increasing government deficits during times of full employment, like now, will increase inflation and interest rates, decreasing growth as private industry fights the government for funds. Other than potential increases in reported earning for highly taxed companies, the tax bill has little logic supporting GNP or general stock market growth.

In general, professional economists have been less than impressed by the growth potential from the tax cut package. For example, the Initiative on Global Markets (IGM) Economics Expert panel was almost unanimous in believing that there would be no growth from the tax package and significant increases in deficits as shown in the survey below.

The net result on demand may be negative simply due to timing differences. Up to 30% of higher income taxpayers, who tend to do tax planning, will get a tax increase in 2018 and many will adjust their spending or withholding to reflect it. On the other hand, the average taxpayer does not react to changes in tax laws so most taxpayers who have tax cuts will not feel the benefit until tax refunds are received in 2019.

On top of that, the IRS is going to have to develop an entirely new W-4 withholding system before January 1, 2018. Given that Congress has cut IRS staffing 23% and funding by $1 billion since 2010, they will probably not get this done or mess it up so much that no wage earner will be able to figure out if they got a tax cut until 2019.

Certainly, stated plans to cut spending in 2018 to pay for tax cuts will directly reduce demand as government spends 104% of the money it gets while taxpayers only spend around 97% on average, saving 3.2% in October 2017. This is a net decrease of 3% to 7% in demand from any government spending reductions used to pay for tax cuts.

There will be a definite negative demand effect from the lowering of the top tax rate from 39.6% to 37%, because it is partially paid for by removing deductions from lower earning groups. There are significant differences in the marginal propensity to consume and save between even the top 5% and top 1% of income (Dynan, Skinner, Zeldes, 2004) and shifts in income between these groups may have a significant effect on demand. While the top 5% appear to consume about 65% of incremental income, the top 1% only consume 50%, a decrease in consumption of 30%. It’s worse the lower you go in income.

The most disturbing concern is the effect on interest rates of increased government borrowing due to increased deficits. Even though there were constant warning from conservative economists about deficits and inflation from 2009 to 2016 when interest rates were hard up against the zero lower bound (ZLB), there was never a theoretical model to demonstrate how problems would occur. Now there are several.

Interest rate concerns arise not solely from the tax cut but from the combination of it and changes in Fed policy. All investors need to continue to follow the advice that made many of them wealthy: “Don’t fight the Fed.”

The Fed has successfully moved interest rates off the ZLB without tanking growth as shown in the chart below. This moves us into a situation when changes in assets and money supply will affect interest rates and, potentially, inflation (though inflation is probably harder to move than interest rates.)

At the same time the Fed is increasing short term interest rates, it is lowering asset purchases. This puts extra pressure on interest rates as the need for government financing from the public will increase much more than the approximately $100 billion per year in the tax bill. As shown in the chart below, the Fed has started reducing its bond purchase program assets. Since May, assets have dropped almost $50 billion which could mean a total need of $150 to $250 billion more per year over the next few years.

The danger is if short-term rates increase faster than long-term rates, resulting in an inverted yield curve. An inverted yield curve is where short-term rates are higher than long-term rates (they’re paying you money to borrow) and is the most reliable predictor of a recession occurring in the next 18 months. Many professional forecasters are predicting an inverted yield curve in 2018.

You can see how they come to this conclusion based on the chart below. The Fed is predicting three interest rate hikes in 2018 which would bring the short-term Fed funds range up to 2%-2.25%. You can see in the chart below that this is about where current 5 year notes are now. You can also see that long-term (30 year) rates are dropping indicating a lack of confidence in future growth and inflation.

The reason long term rates are so low is that the world is in a savings gut with corporation having $2.3 trillion in liquid assets or, as Michael Bloomberg said when he explained why CEOs didn't plan on investing the money they got from tax savings, "We don't need the money." The tax plan is too skewed to the wealthy to make a large business owner comfortable with speculative investments - they'll wait and see, another reason to expect a benefit in 2019, not 2018.

In sum, neither experts, CEO's nor the bond market anticipate much growth from the tax bill and the major anticipated affect appears to be an increase in short-term interest rates. Depending on how much these interest rates increase, effects on the market from the lower tax rate on corporate profits could be overwhelmed.

While this tax bill is unlikely to kill the market, there is nothing in it that justifies a generally higher market. Specific companies will benefit from lower tax rates so prudent investors who want to stay invested should roll out of general index funds and into highly taxed companies in sectors that will benefit from higher interest rates.

Simple sector rotation will probably leave some gains on the table as companies pay varying levels of taxes and only highly taxed companies will get the most benefit from the tax bill. Some companies that currently benefit from tax deductions that are being reduced or eliminated may end up with lower profits. For example, currently 11 of the 30 Dow components pay 21% (the new corporate tax rate) or less in taxes.

Visa (V) in Finance paying 29% in taxes might be a good investment though current valuations make this a stock only for the bold. Keep in mind that "tax rates" are subject to different methods of calculation which may change how the market reacts.

Finally, there appears to be one clear winner in the tax bill: REITs have a lower tax pass through that will help high earners reduce taxes. The only concern here is that single family real estate is probably going to take a growth hit due to the restriction on interest and local/state tax deductions, though this should not effect most REITs.

When the tax bill finally passes, there will probably be a short-term burst in general stock valuations. Once that's over, market perceptions of who benefits will be your potential for growth. Unfortunately, the Bass-O-Matic design of the tax bill makes it impossible to give a simple list of who the corporate winners will be.

Figuring it out will keep analysts employed and the writers at SA busy.

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.