The total stimulus from the tax bill recently passed is expected to be about $1.5t; with positive impacts on the economy, but negative implications for the deficit (and possibly inflation).
The magnitude of the economic impact varies depending on multiplier assumptions; but the benefits are likely front-end loaded over the 10-year window.
Corporate earnings estimates are rising (and companies are doling out special bonuses and raises!) but the spread between the new corporate tax rate and the effective rate companies are already paying could be narrower than assumed.
My section of Schwab’s 2018 outlook included a reference to—but not many details around—tax reform, as it hadn’t yet passed when we were putting pen to paper. Today’s report will take a high-level look at the anticipated impact on the economy, corporate earnings and corporate behavior.
The Tax Cuts and Jobs Act (TCJA) is being labeled tax “reform,” but I think the use of that term is a bit of a stretch. Yes, the changes are sweeping, and the tax cuts meaningful; but the reality is our tax code is now not much simpler—just a different version of complicated. This is perhaps one of the reasons it’s not been met with universal praise. Others include the bill’s timing and its impact on the budget deficit and longer-term debt.
As Schwab’s Mike Townsend noted in one of his post-passage write-ups [Sweeping Tax Bill Becomes Law], the changes are likely to “pose a significant challenge to the IRS, corporations and individuals, who will have to both get up to speed on the changes and make the necessary systems updates to handle them. It is widely expected that some delays could occur in implementation.”
Worker paychecks adjusting next month
The total fiscal stimulus coming from the TCJA is expected to be about $1.5 trillion; with more than 60% slated for individual tax cuts and the remainder for corporate and international tax reform. The good news for individuals is that the Internal Revenue Service (IRS) announced that worker paychecks will be adjusted in early February, and no action is required by employees; which means that nearly every American employee will see a bump up in their take-home pay at the same time.
The last time this occurred was in mid-2003—when President Bush’s Jobs and Growth Tax Relief Reconciliation Act’s tax cuts went into effect—and it led to an immediate boost to consumer spending and economic growth (but also higher bond yields). Real gross domestic product (GDP) growth jumped from less than 4% in the second quarter of 2003 (just before the tax cuts hit paychecks) to nearly 7% in the third quarter and 5% in the fourth quarter. It dropped back down under 3% in the first quarter of 2004.
In terms of consumer spending, personal consumption expenditures (PCE) were 1.8% in 2003’s first quarter; followed by 4.5%, 6.0% and 3.1% in the second, third and fourth quarters, respectively. I would hesitate to extrapolate the consumption gains too aggressively for this year’s outlook given that consumer spending has already been showing considerable momentum. According to the US Census Bureau, retail sales surged at an 11.3% annual rate in last year’s fourth quarter, which was the sharpest pace in seven years.
In terms of the implications for government’s coffers, the Joint Committee on Taxation (JCT)—the official Congressional scorekeeper—estimates that the TCJA will reduce government revenues by about $263 billion; of which $207 billion is due to individual tax reform (see table below).
Source: Joint Committee on Taxation (November 17, 2017, JCX-59-17), Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2018(c) Ned Davis Research, Inc. All rights reserved.).
Impact on economy
Estimates of the macroeconomic impact are being trotted out, and they vary due to calculation differences related to multiplier and other assumptions:
- The JCT said the bill will boost GDP growth by 0.8 percentage points over the next 10 years.
- The Penn-Wharton Budget Model calculates that the annual bump will be between 0.06 and 0.12 percentage points.
- Goldman Sachs estimates a boost of 0.3 percentage points in 2018 and 2019.
- The Tax Foundation—which is typically aggressive with its “dynamic scoring” of tax cuts—estimates the bill will boost growth by 0.35 percentage points this year; diminishing thereafter.
- The Tax Policy Center estimates a higher 0.6 percentage point boost this year; fading to 0.3% by 2027.
- Applying fiscal multipliers from the Congressional Budget Office (CBO), Ned Davis Research (NDR) estimates a lift of 0.1 to 0.9 percentage points during 2018 and 2019 (see table below).
Source: Congressional Budget Office, Joint Committee on Taxation, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2018(c) Ned Davis Research, Inc. All rights reserved.).
As NDR notes, the tax cuts have the potential to increase both aggregate demand and aggregate supply. Lower individual income tax rates will boost consumer spending, while the provision for immediate capital spending (capex) expensing over the next five years will encourage investment in the near-term—both of which will lift aggregate demand. Lower income tax rates could also incentivize more people to enter or re-enter the labor force or stay employed for longer; resulting in greater labor supply.
The lower corporate tax rate—which plunged from 35% to 21%—could attract foreign capital. Along with greater labor supply, it suggests an increase in aggregate supply. And the expected bump in capex could bring with it higher productivity, which could boost potential output.
Importantly though, as you can see in the chart below, the output gap has already been eliminated; i.e., the economy is operating above its potential. This is the basis for some of the criticism aimed at TCJA’s timing. Its arrival this late into the economic cycle risks a sharper pick-up in inflation; and in turn, the potential for tighter-than-expected monetary policy (which would be an offset to the tax cuts’ fiscal stimulus).
Output Gap Bites the Dust
Source: FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2018(c) Ned Davis Research, Inc. All rights reserved.), as of September 30, 2017.
Impact on corporations
At 21%, the TCJA ushers in the lowest statutory corporate tax rate since 1939 (see chart below). In the post-World War II period, there have been four other cases of federal corporate tax cuts: 1964, 1970, 1979 and 1987-1988. According to NDR, all cases were followed by sizeable increases in corporate profits and cash flows in the first two years after the tax cuts. However, profits grew below their historical average in subsequent years, even though cash flow continued to outperform.
Corporate Tax Rate Over Past 100 Years
Source: FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2018(c) Ned Davis Research, Inc. All rights reserved.), as of December 31, 2017.
The S&P 500 rose at an above-average rate in the first two years after those historical tax cuts; but the performance was mixed in years three through five. (For what it’s worth, U.S. stocks finished last week off with the best start to a year since 2003.) Capex grew at an above-average pace in all five years after the prior tax cuts; but the positive impact on real GDP was limited to the first three years. The impact on private nonfarm payrolls was mixed.
Caveats for today: Capex has already been strong recently, so any boost will be coming off a higher base than what may have been seen in the past. In addition, domestic-based corporate cash levels are already quite high. Non-financial companies (NFCs) in the S&P 500 are sitting on an estimated $1.63 trillion in cash, according to data from S&P Dow Jones Indices. And although the Federal Reserve is raising interest rates, they remain low. As such, the data—corroborated by recent business surveys—suggests stock buybacks and special dividends could also be TCJA-related beneficiaries. This would likely be better for the stock market than the real economy.
A recent survey by the Federal Reserve Bank of Atlanta showed that 59% of companies said they would not increase their planned hiring, while 39% said they would increase hiring somewhat or substantially. Another 46% said they would not change their capital investment plans, while 1% said they would. The survey provides some support to the argument that some of the newfound cash will be economically stimuluative.
The core consumer price index (CPI) was higher than average in the five years after the historical corporate tax cuts; while real average hourly earnings (AHE) were stronger in the first three years, but faded thereafter. As noted above, the TCJA is coming late in the cycle and when the output gap has disappeared, so higher inflation is a distinct possibility.
Will the real corporate tax rate please stand up?
Based on the amount of before-tax domestic corporate profits in 2016, and the amount of corporate taxes paid in the National Income and Product Accounts (NIPA), the “effective” U.S. corporate tax rate has been less than 27% in the past couple of years. But even that may be too high an estimate. The Federal Reserve’s data on NFCs confirm the terrific work my friend (and renowned economist) Ed Yardeni has been doing on the corporate tax rate: the NFC average effective corporate tax rate was only 21.6% over the four quarters through last year’s third quarter; and it’s been hovering around 21% since early 2010.
According to Ed, the net effect of the TCJA may be to simplify tax accounting for NFCs and to give them a greater incentive to keep their headquarters and operations in the United States. However, it might not boost after-tax corporate earnings as much as was originally assumed. That said—for reasons perhaps beyond just the tax effect—analysts have raised 2018 earnings estimates for S&P 500 companies to the tune of about 4-5% to-date since the TCJA was passed.
Finally, perhaps the most pleasant surprise has been the swift reaction by companies to the bill’s passage in terms of special bonuses and/or raises. Last Thursday, the nation’s largest employer—Walmart—was one of the latest companies to announce one-time bonuses or minimum wage increases related to the passage of the TCJA. Americans for Tax Reform has compiled a list showing that as of last week, more than 125 U.S. employers of varying sizes have made such announcements; with at least two million workers impacted to date.
The net is that the impact of the tax cuts is already being felt by millions of workers—with the vast majority of the remainder getting a bump in their paychecks next month. More broadly, we should get a boost to consumption, GDP, capex and corporate earnings; but there are important offsets and considerations that suggest some enthusiasm-curbing may be in order given the later-stage in the cycle in which the TCJA was passed.