U.S. Macro Outlook for Tax Reform

Winners and Losers

Businesses are the biggest winners of the tax cuts, as seen in Exhibit 1. Larger C corporations are the beneficiaries of $650 billion in tax cuts over the next decade, as their top marginal rate is permanently reduced from 35% to 21%.

Cash-rich multinational firms enjoy a much lower tax rate on earnings they repatriate from overseas and the move from a global taxation system to a territorial one. Smaller S corporations and other pass-through entities will enjoy a lower marginal rate, giving them a $250 billion tax break through 2025 when this cut expires along with the rest of the tax cuts for individuals. Full expensing of investment through 2022 and a phaseout after that is also a plus.

High-income and wealthy households are also winners. Of the $1.1 trillion in tax cuts going to individuals over the next decade, more than three-quarters goes to taxpayers who make more than $200,000 a year in in taxable income. For context, this group accounts for just over 1/20 of all taxpayers. Wealthy households also benefit from a doubling of the estate tax exemption, and a rarefied group of private equity managers will continue to benefit from the special tax treatment of carried interest.

Lower-income taxpayers struggling to hold on to their health insurance will likely be hurt by the tax legislation. They benefit from the doubling of the standard deduction under the law; however, the legislation ends the individual mandate for health insurance, which the Congressional Budget Office concludes will cause insurance premiums to increase, knocking 13 million off the insurance rolls. In addition, the expiration of the individual tax cuts in 2025 results in a higher tax liability for the 2/3 of taxpayers who make less than $75,000 a year.

Individuals in high-tax states in the Northeast and California are also at risk of paying more in taxes, as the legislation scales back the deductions for state and local income, sales, and property taxes. This is even more likely for homeowners in these areas who have large mortgages, since the legislation limits the mortgage interest deduction to mortgage debt less than $750,000.

Overheating Threat

The deficit-financed tax cuts will act as a fiscal stimulus, temporarily pumping up growth. Based on simulations of the Moody’s Analytics macro model, which is similar to models used by the Federal Reserve, the Congressional Budget Office, and the Joint Committee on Taxation (JCT), the tax legislation will lift real GDP growth by 0.4% in 2018 and 0.2% in 2019. Without tax cuts, the economy was set to grow by 2.5% per annum through the remainder of the decade, but with the cuts, growth will be 2.9% per annum.

The problem is that the economy is arguably already operating beyond full employment, as seen in Exhibit 2. The unemployment rate is just above 4%, well below most estimates of the full-employment unemployment rate, including Moody’s own estimate of 4.5%.

The underemployment rate of 8%—a broader measure of slack in in the job market—is also signaling a fully employed economy. Even without tax cuts, unemployment was set to fall below 4%, but with them it could fall into the low 3% range. The only other time unemployment has been as low was during the Korean War in the early 1950s.

Although wage and price pressures have been largely dormant, this will not last, and the Federal Reserve will have little choice but to normalize monetary policy more aggressively. Fed policymakers are anticipating three 0.25-point rate hikes in 2018 and about the same in 2019, but they likely haven’t fully incorporated the implications of the tax cuts into their thinking. Four rate hikes each year now seems more likely.

Long-term interest rates should also increase because of the more aggressive Fed and investor expectations of larger future budget deficits. This crowding-out effect is evident in the Moody’s Analytics model, as for every 1% increase in the nation’s publicly traded debt-to-GDP ratio, 10-year Treasury yields increase in the model by an estimated four basis points. Given that the tax legislation adds 55 percentage points to the debt-to-GDP ratio, 10-year yields rise by 20 basis points, all else being equal. For perspective, the elasticity of 10-year Treasury yields to the stock of Treasury debt estimated by the Federal Reserve in the context of its quantitative easing policy is closer to six basis points.

The deficit-financed tax cuts are particularly ill timed. They will quickly juice up economic growth, but in a fully employed economy, this will result in wage and price pressures and higher interest rates. The economy threatens to overheat, which invariably leads to a much weaker economy and often-times a recession. Recession risks will be high early in in the next decade.

No Supply-side Magic

The tax legislation will also fail to provide a meaningful boost to long-term growth. The key channel through which the tax legislation would lift long-term growth is through businesses’ cost of capital. Lower marginal corporate tax rates reduce businesses’ after-tax cost of capital, which incentivizes them to invest more, adding to their capital stock and ultimately increasing their productivity and the economy’s growth.

The problem is that while the lower marginal corporate rates reduce businesses’ cost of capital, the higher interest resulting from the poor timing and deficit financing of the tax cuts increases their cost of capital and washes out most of the benefit. In the end, the long-term economic lift from the tax cuts is small, adding an estimated five basis points per annum to real GDP growth over the next decade. The tax plan will not increase growth from 2% to 2.9% per annum, as the Treasury Department has claimed, but from 2% to 2.05%.

Even well-designed tax reform that lowered marginal rates for businesses but paid for them wouldn’t come close to the growth anticipated by the Treasury; this is the clear message in the best recent research from the JCT, Congressional Research Service, and academia. A 2005 JCT study that considered a cut in the federal corporate tax rate similar to the current legislation, but paid for by cuts to government spending, found that long-term growth would increase only from 2% to 2.1% per annum.

Stocks Up, Housing Down

The legislated changes to the tax code will have substantial counter-vailing impacts, lifting stock prices but weighing on housing values. Stock prices have received a lift, given the prospects for higher after-tax earnings of large publicly traded companies, although this is partially offset by the impact of the higher interest rates on the price multiple that investors are willing to put on those earnings. Accounting for these cross-currents, and the uncertainty with regard to whether the lower tax rates will be permanent after the 10-year budget horizon, the tax plans should lift stock prices by 10% to 15%, as seen in Exhibit 3.

House prices suffer under the tax plan. The tax law changes significantly reduce the value of the mortgage interest deduction (MID) and property tax deductions, which are capitalized in current house prices. The qualifying loan amount for the MID is capped at $750,000, and the property tax deduction at $10,000; furthermore, the value of both deductions is reduced by the doubling of the standard deduction, thus significantly reducing the number of households that itemize and take advantage of the MID. Also, the higher mortgage rates that result from the higher budget deficits and debt under the plans weaken housing demand.

Considering all of this, the hit to national house prices is estimated to be near 4% at the peak of the impact in summer 2019. That is, national house prices will be approximately 4% lower than they would have been if there were no tax legislation. The impact on house prices is much greater for higher-priced homes, especially in parts of the country where incomes are higher and there are thus a disproportionate number of itemizers, and where homeowners have big mortgages and property tax bills. The Northeast Corridor, south Florida, big Midwestern cities, and the West Coast will suffer the biggest price declines. Exhibit 4shows a map of expected drops; Essex County, N.J.; Westchester County, N.Y.; Cook County, Ill.; and Delaware County, Pa. could see house prices reduced by more than 10% compared with what they would have been otherwise.

The impact on the broader national economy of the higher stock prices and lower house prices is largely a wash. The principal channel through which changing asset prices impact growth is on consumer spending via the wealth effect—the change in spending due to a change in wealth. Stock wealth increases somewhat more than housing wealth declines because of the tax law changes, but the housing wealth effect is currently a bit larger than the stock wealth effect.

Opportunity Lost

The Trump administration and the Republican Congress finally have their first major legislative win with the passage of sweeping changes to the tax code for businesses and individuals, but contrary to their hopes, the tax cuts will not meaningfully help the economy. In the immediate near term, growth will be stronger, but because the economy is at full employment, odds are good that it will over-heat unless the Federal Reserve aggressively raises interest rates. Either way, the economy will suffer early in the next decade, and any longer-run benefit from the lower marginal tax rates will be washed away by the fallout from the bigger budget deficits and government debt load. Good tax reform is difficult to do, and the tax plan lawmakers have passed into law doesn’t get it done.