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Tax reform has vaulted to the top of Republicans’ to-do list now that the effort to repeal and replace the Affordable Care Act (ACA) has stumbled. However, moving on from that defeat could prove challenging.
The health care debate revealed the stark differences dividing the moderate and conservative wings of the Republican Party. President Donald Trump and House Speaker Paul Ryan (R-WI) now face real questions about whether they can deliver legislation on the party’s other key promises, including tax reform and a spending package to make long-needed investments in the country’s infrastructure.
These divisions could also complicate their response to a more pressing issue: the potential for a government shutdown at the end of April.
Next up: An April deadline
The current agreement to keep the government operating expires on April 28. If Congress doesn’t pass an extension of funding before then, the government will have to shut down the next day.
And time is tight. The Senate will likely be occupied with Judge Neil Gorsuch’s nomination to the Supreme Court during the week of April 3. Then, both the House and the Senate are scheduled to be in recess during the weeks of April 10 and April 17.
Lawmakers are slated to return to Washington on April 24, just five days before the potential government shutdown. That’s not a lot of time to put together a deal that can be approved by both the House and Senate before the deadline.
One option would be for Congress to approve a short-term extension—say, one to three weeks—to buy itself additional time. Ultimately, though, Congress will need to approve a deal that funds the government through the remainder of this fiscal year ending Sept. 30.
We think the odds of a government shutdown are low—but last week’s failure on the health care plan muddies the picture. With some Republicans having shown a willingness to buck their party’s leaders, any bill that deals with government spending could face the same intra-party divisions that doomed the health care bill.
Moreover, Democrats don’t seem inclined to help the president solve this issue. The uncertainty may result in increased market volatility as the April 28 deadline approaches.
The bumpy road ahead for tax reform
Tensions within the Republican Party will undoubtedly complicate the path to tax reform, as well, and for reasons that go beyond politics.
Republicans decided to tackle the health care law first because repealing the ACA would have simplified the budget picture ahead of a big push on taxes. The replacement health care law included a raft of spending and tax cuts—it would have scrapped about a dozen taxes, including the medical device tax, the tax on tanning salons and, most important for investors, the Net Investment Income Tax, the 3.8% surtax on the investment income of wealthier filers. The net effect would have been to lower the budget deficit over time.
The failure to pass the replacement health care law took all those spending and tax cuts off the table, raising questions about the scope of any tax reform proposal. For example, Republicans could try to get rid of the ACA taxes as part of the broader tax reform effort, but without the replacement health care law’s spending cuts, they’ll have to find cuts elsewhere in the budget. That could prove challenging. It was already going to be difficult to find the revenue to balance out the planned tax cuts in tax reform. Now it could be even harder to do so.
On the other hand, they could just leave the ACA taxes on the books, but that would also narrow the scope of any future tax reform—and leave in place a number of taxes that Republicans had pledged to repeal.
Key elements of tax reform legislation
That said, President Trump and Congressional Republicans do share common ground on some of the core features of tax reform, including:
- Reducing today’s seven individual tax brackets to just three, with a top rate of 33%
- Eliminating the estate tax
- Eliminating the Alternative Minimum Tax
- Repealing the Net Investment Income Tax
- Lowering the corporate tax rate to 15%–20%
After that, however, things become much more complicated. There are hundreds of tax credits and deductions in the tax code today. Most are expected to be eliminated in a simplified system. But each of those tax breaks has a constituency and supporters likely to fight to preserve them. The devil is in the details.
Another challenge is the need to raise revenue to offset the loss to the Treasury that will result from tax cuts. The controversial “border adjustment tax” proposal, which would tax imports but not exports, would raise more than $1 trillion in revenue. But the proposal appears to be in real trouble on Capitol Hill because it impacts some businesses more than others.
Republicans will need to find other ways to increase revenue, either through other proposals or by scaling back some of their plans. More modest tax rate cuts, for example, would reduce the amount of revenue needed.
All of these calculations are being taken into consideration as Republicans accelerate the behind-the-scenes work of drafting the tax bill.
Timing of tax reform
While President Trump is eager to move quickly on tax reform, no bills exist yet. With the upcoming April recess and the government funding bill looming at the end of the month, the House Ways & Means Committee is unlikely to have a draft tax bill ready until well into May at the earliest.
House Republicans have set a goal of approving tax reform by August, but the Senate may not consider its version until the fall. Once the Senate passes a bill, the two chambers will need to have a conference to settle on one final version of the legislation. As a result, late 2017 appears to be the best-case scenario for final passage of tax reform. But the political challenges that lie ahead are daunting, and producing a bill that can be approved by both the House and Senate will be no easy task.
Investors should remain calm
For investors, the failure of the health care bill has raised legitimate questions about whether Republicans can deliver on other campaign promises, with tax reform topping that list. On tax reform, the prospects are more muddied than they were, but we think Republicans will work very hard to make tax cuts a reality. It’s likely to be a lengthy and convoluted process, with unpredictable hiccups along the way. Investors should be wary of reading too much into the inevitable fits and starts, and remain focused instead on their longer-term goals.
In the short term, uncertainty over whether there will be a government shutdown at the end of April could spark some market volatility, but the effect should fade.
What you can do next
- If you’ve built a solid financial plan and a well-diversified portfolio, it’s best to ignore the political noise and focus on your long-term goals. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.