Investors believe that Republican tax proposals would be dollar positive. If that were to be the case, some obvious beneficiaries would be overseas earners in markets such as the Eurozone and Japan. However, the analysis is complex and we are not convinced that the dollar has much more upside.
Donald Trump got off to a strong start with 12 executive orders in his first week. If he can keep that up, he will be the most productive president ever! The good news is that we at last have a politician doing exactly what he promised. The bad news is that it is Donald Trump.
We covered the potential outcomes of his presidency a few weeks ago in Dear Donald but thought it now worth taking a look at the House Republican tax proposals (see A Better Way). Trump seems to be leaning in that direction and many investors believe it would strengthen the dollar.
The GOP (Grand Old Party) “Blueprint” covers both personal and corporate taxation. The broad aims are: to simplify the tax system and to boost economic/job growth without increasing the budget deficit. Simplification is certainly needed — a Tax Foundation estimate suggests tax compliance will have cost $409bn and 8.9bn hours of effort in 2016.
Personal taxation is to be simplified and rates reduced (from 7 brackets to three, with the maximum rate going from 39.6% to 33% and with a bigger standard deduction). Importantly, double taxation of income from savings and investment (capital gains, dividends and interest income) will be reduced by only taxing 50% of such revenue. Of interest to small businesses, the maximum tax they face will be 25% (and estate tax is to be eliminated). Finally, the Alternative Minimum Tax (AMT) will be repealed and many deductions will be eliminated.
Those hoping for a big tax cut for the middle classes will be bitterly disappointed (Trump promised a 35% cut in taxes paid by middle class families). As usual, whenever income tax is cut, it is the top income earners who gain the most. Figure 1 (reproduced from an analysis by the Tax Policy Center) shows that most of the roughly 2% gain in total after-tax incomes will accrue to the top 1% of income earners (99.6% of such gains in 2025).
The proposals are at their most radical when it comes to corporate taxation. The current system is a worldwide, origin based income tax. It is worldwide (rather than territorial) because US companies pay tax on dividends repatriated from overseas operations. It is origin based (rather than destination based) because tax is based on where goods are made, rather than on where they are consumed. It is income (rather than consumption) based because the burden of the tax falls on the producer rather than the consumer.
Much of the complexity in the changes comes from a desire to allow border-adjustments, without adopting a VAT system. Most nations operate a VAT system (or similar consumption tax) that under WTO rules is allowed to make border adjustments (the tax is applied to imports but not to exports). The system is fair so long as all countries operate the same system (exports are not taxed in the exporting country but do get taxed in the importing country). It ensures that imports are treated in the same way as goods produced domestically.
Under the current US system, exports are taxed upon entry into a VAT country but exports from such countries are not taxed when arriving in the US (apart from import duties). Hence, the feeling that the system is loaded against the US. Of course, the simple answer would be to introduce a VAT system but there seems to be an eversion to such clarity.
So, bizarrely, under the GOP proposal the border adjustment will be made within the corporate taxation system (imports will not be included in costs and exports will not be counted as revenues). However, WTO rules only allow border adjustments on indirect taxes (the burden of which falls upon consumers), which is why these proposals are also making a shift to a cash-flow, rather than income, based system. Importantly, investment expenditure will be expensed fully and immediately (i.e. no amortisation schedule for taxation purposes). Were it not for the desire to allow expensing of wages and salaries, this could be considered as a straightforward consumer tax. Given that desire it is instead viewed as cash-flow corporate tax and it is not yet clear how other WTO members will react.
In terms of final details, the corporate tax rate will be cut to 20% (from 35%), net-interest expenses will no longer be deductible (to discourage leverage), most current deductions and credits will be eliminated and dividends remitted from overseas will not be taxed (with a one-off 8.75% tax on accumulated foreign earnings).
While not making any estimates of its own, the Blueprint calls upon numerous research projects to back up the claim that the proposals will lead to: significant capital inflows (repatriation of US corporate cash, lower corporate tax rates and border adjustment); higher investment and GDP (immediate expensing of investment and lower taxes on saving); greater efficiency and more GDP (simplification of the tax system, broader tax base and lower rates).
Based on all of the above, it is easy to see why investors believe these measures would be dollar positive. If they were, we believe it would favour the exporters and overseas earners in markets such as Japan and the Eurozone (also note the recent rebound in Asian export volumes – South Korean exports were up 25% y-o-y in the first 20 days of January).
However, there are also good reasons to doubt the support that such measures will offer the greenback. First, the UK makes a good case study and the evidence is not great. Figure 2a shows how the UK corporate tax rate has fallen from 52% in 1980 to 20% today (to where the GOP wants to take the US rate). Interestingly, the real effective value of sterling has fallen more or less hand-inhand with the corporate tax rate. Admittedly, the pound was strong in the early 1980s as a result of North Sea oil but the least we can say is that corporate tax cuts have not boosted sterling.
This brings us to Figure 2b which shows that the dollar is about 10% above its post-1980 norm in real trade-weighted terms. From that starting point, the dollar can certainly go higher but the upside may be limited. Figure 2b also suggests the path of the dollar will depend upon changes in the gap between US yields and those elsewhere.
That yield gap will depend to a large extent upon the relative performance of the US economy and the reaction of the Fed compared to that of other central banks. It was therefore interesting to see the weak US GDP data for Q4. It was not so much that growth slipped to 1.9% from 3.5% but that, without inventories, growth would have been only 0.9%. Even more worrying for dollar bulls was that net exports knocked a whopping 1.7% off GDP during Q4. This suggests to us that the US economy is struggling with the current level of the dollar and that the Fed does not need to be too aggressive.
More fundamentally, the Tax Policy Center (TPC) calls into question the economic benefits assumed in the GOP analysis. Based on the limited details available in the Blueprint, the TPC forecasts the effect on the economy, deficits and debt over the next two decades.
The GOP paper assumes that revenues will not be
impacted by the tax changes because stronger growth will compensate for cuts in rates.
Unfortunately, the TPC analysis does not agree and finds that even though GDP will be boosted by around 1% in the early years, $3 trillion will be added to national debt in the first 10 years, the crowding-out effects of which would cause debt to be $6.6 trillion higher than it would have been after 20 years (the debt/GDP ratio would be up to 19% higher). That does not sound like a recipe for a stronger dollar.
So, although it is tempting to think that GOP plans would be dollar positive, there are good reasons to believe otherwise. The dollar has weakened so far this year and is now where it was on November 16. Hardly a ringing endorsement!
Paul Jackson – Head of Research – Source
András Vig – Research Director – Source