A lot is riding on the tax cuts President Donald Trump has promised by the end of 2017. Stock markets have soared on the expectation of lower corporate taxes and higher after-tax earnings. Consumer confidence is up too, as ordinary Americans anticipate the middle-class tax relief Trump crowed about in his recent address to Congress.
But the path to tax cuts on Capitol Hill is narrower and riskier than upbeat investors, who have been gobbling up stocks, seem to believe. Changes in tax law always create new classes of winners and losers—and every group poised to lose under Trump’s tax reform is rapidly mounting opposition. “The odds of tax reform are always less than 50-50, and that’s true this year,” Republican economist Douglas Holtz-Eakin said at a recent conference on tax reform in Washington, DC. “We need these forces to get lined up in the White House, and that hasn’t happened yet.”
The S&P 500 stock index has risen about 11% since Trump got elected in November. It’s impossible to know exactly how much of that gain is due to tax-cut expectations. But it’s a fair bet that investors think the odds of steep tax cuts occurring this year are a lot higher than 50-50. So if Holtz-Eakin is right, overly buoyant markets are mispricing the likelihood of tax cuts, with some kind of correction due.
Trump has not yet submitted his tax plan to Congress. House Republicans, however, unveiled a tax plan last summer that is now emerging as the basis for legislation this year. And they don’t plan on just moving the furniture around. Instead, they want to boldly restructure the way businesses and consumers pay taxes. They say their plan will reduce tax dodging, give US corporations an advantage over foreign competition and substantially boost economic growth.
The same boldness could also doom the legislation, however—and this may be the part of tax reform that ebullient investors aren’t paying enough attention to. The House plan relies on a novel “border-adjustment tax,” or BAT, to revamp the way corporations pay taxes. The BAT often gets conflated with Trump’s call for “border taxes,” but these are actually two different things.
Trump’s border taxes would basically be punitive tariffs on select products or classes of products, put into place one by one to punish trading partners the Trump administration feels aren’t dealing fairly with the United States. Most economists think this kind of protectionism does more harm than good, and Trump himself may only be threatening such tariffs as a negotiation ploy.
The BAT is a much broader plan that would affect virtually all imports and exports—and fundamentally change the US tax code. The basic idea is to tax products where they’re purchased or consumed, which is how a value-added tax works in the more than 160 nations that have one. The US does not have a value-added tax, which opponents of the idea often characterize as a national sales tax.
Under the current US system, corporations are taxed based on where they’re headquartered rather than where they sell their products. That’s why some companies have “inverted” and moved their HQs to other countries, which lets them avoid paying taxes at the high US rate of 35%. It’s also why big companies like Apple (AAPL), Microsoft (MSFT) and Google parent Alphabet (GOOGL) keep billions of dollars of profits in foreign countries where tax rates are lower. The incentive to seek foreign tax shelters is one of the biggest flaws of the current system.
The BAT in the House plan would solve that, since there’d no longer be any reason for US companies to shift money out of the United States. To make it work, Washington would impose new taxes on all imports, while exports would be exempt from corporate taxes. The House plan would also cut the corporate tax rate from 35% to 20%. The new taxes on imports would be essential for offsetting revenue lost by slashing the corporate rate. And restructuring on the corporate side is necessary for reform of personal income taxes, which House Republicans also want to cut and simplify.
On the surface, the BAT would appear to harm all US companies that rely on imports, while generating a windfall for companies that export. Here’s where it gets tricky. Some economists predict that the value of the US dollar would rise by the same amount as the tariff on imports—20%, say—which means anybody purchasing imports—whether Walmart or a middle-class soccer Mom—would basically get the same deal as before. If so, the BAT would actually be an elegant way to fix perverse incentives in the current system while making the tax code much more efficient.
But there’s a catch: “We don’t have a good real-world experiment where somebody’s done something like this,” economist Rosanne Altshuler of Rutgers University said at the DC conference. And if the dollar didn’t adjust as expected, a BAT would obviously favor exporters while harming companies and consumers dependent on imports.
If the whole scheme seems too complicated to explain at a cocktail party, well, that’s the problem. “Economists are essentially convinced this will occur, and nobody else believes it,” says Howard Gleckman of the nonpartisan Tax Policy Center. A coalition of retailers, including Walmart (WMT), Kohl’s (KSS) and Best Buy (BBY) has already started campaigning against the BAT, claiming it would raise taxes on the average family by $1,700 per year. Republicans in the Senate say the BAT has no chance of passing in their chamber, and it can’t become law if it doesn’t.
This is where Trump comes in. Tax experts point out that the last time Congress passed sweeping tax reform, in 1986, the clinching factor was President Ronald Reagan’s sustained, impassioned lobbying for it. “This comes down to White House leadership,” says Holtz-Eakin. “Only the president can make the sale to the average American. Where the White House comes down on this is the crucial decision.”
Trump has already said the BAT is “too complicated,” though he left room for changing his mind. The bigger question may be whether Trump, embroiled in controversy since the day he took office, can stay focused on something as demanding and tedious as tax reform. If he can muster his considerable powers as a pitchman and persuade Americans that a tax deal built around a BAT is good for the country, Senate Republicans may have little choice but to go along. But if his attention to the matter is episodic and half-hearted, gridlock will prevail.
Without a powerful pitch from the president, the obstacles to tax reform are daunting. First, there’s Obamacare, which Republicans have vowed to repeal as their first major order of business in 2017. But there’s no plan yet for what to replace it with, and repeal-and-replace drama could dominate the legislative calendar for months, if not longer. “The slow process on ACA repeal signals that tax reform is likely to take longer than initially expected,” Goldman Sachs advised clients in a recent note. “The final tax legislation that Congress enacts is likely to be less radical than the early proposals from House Republicans and the Trump campaign.”
The slow-moving Senate already has a crowded calendar, and tax reform could simply fall off the 2017 agenda if Trump doesn’t turbocharge the pace of action. Congress could take it up in 2018, but that only gives opponents of a BAT more time to dig in and muster allies. Trump could also propose a completely different plan that doesn’t include a BAT—which would basically restart the clock on legislation Republicans have spent several years developing. That would also provoke a fight with Republican budget hawks who aren’t willing to swell the national debt for the sake of tax cuts.
If Trump has the stamina and savvy to overcome all this, then sure, tax reform is good bet for 2017, and the stock-market rally has legs. But if Trump can’t channel Reagan, the market will notice eventually. And perhaps abruptly.
