After President Donald Trump’s election victory, the financial markets quickly priced in a highly pro-growth economic agenda. Government deregulation, infrastructure spending and tax reform would help fuel economic growth and ultimately, corporate profits. Consequently, the stock markets soared.
The president recently unveiled the signature piece to his economic agenda — tax reform. For the financial markets, tax reform represents the epicenter of the president’s economic agenda.
But why do the financial markets give such significance to tax reform? Arguably, deregulation and infrastructure spending would also have pro-growth implications. What elevates tax reform above other economic policy initiatives is its expansive potential impact on economic growth and stock valuations. So, what exactly is being proposed?
The overhaul is a structural revision to both individual and corporate tax rates. For individuals, the number of tax brackets would be reduced from seven to three: 12 percent, 25 percent and 35 percent. The standard deduction would double, from $6,350 to $12,000 for singles and from $12,700 to $24,000 for married filing jointly. But personal exemptions, the $4,050 deduction claimed for each taxpayer and dependent, would be eliminated.
The child tax credit, currently $1,000 for each child age 16 or younger, would increase by an unspecified amount. The income level that triggers phase-out of the credit would also be raised, allowing more families to participate. The majority of itemized deductions would be eliminated. However, mortgage interest, charitable contributions and deductions for retirement savings plans such as 401(k)s and IRAs would remain.
The estate tax, or death tax, on the transfer of property to beneficiaries would end, but the step-up in cost basis for calculating capital gains on inherited assets would remain. The proposal eliminates the alternative minimum tax, a supplemental tax that imposes a minimum amount of income tax be paid, despite a taxpayer’s use of deductions and loopholes.
Small businesses, which includes sole proprietorships, partnerships and S-corporations, would have their maximum tax rate reduced from a high of 39.6 percent to 25 percent. In Iowa, 97 percent of all businesses are classified as a small business. In Illinois, it’s 99 percent.
Perhaps the greatest structural change would be to corporate tax rates. With a current federal tax rate at 35 percent, U.S. corporations have the highest tax rate in the industrialized world, though corporations can currently take deductions and credits, which make the average effective tax rate 18.6 percent. Among all global nations, the 35 percent rate it is the fourth highest. Only the United Arab Emirates, Comoros, the tiny island-nation off the east coast of Africa, and Puerto Rico have higher rates. The president’s proposal reduces the corporate tax rate to 20 percent. This would be in-line with the worldwide average of 22.96 percent but slightly above the 18.35 percent rate for Europe, which has the lowest regional rate in the world.
The U.S. is one of the few top-tier industrial nations that still uses a worldwide tax system. That is, U.S. corporations must pay taxes on income whether earned in the U.S. or overseas. For overseas income, taxes are paid when the income is repatriated back to the U.S. However, it is estimated that U.S.-based companies hold $2.5 trillion of untaxed capital stashed overseas. Corporations tend to retain the income overseas rather than pay a towering tax rate to bring the funds back to the U.S.
The proposal would convert to the more commonly used territorial system, where foreign income for U.S. corporations is tax-free. Proponents argue it eliminates the tax incentive to retain profits overseas, encouraging corporations to repatriate earnings back to the U.S. to invest in production, equipment and expansion. Also, they contend, it would keep companies from moving their operations overseas to take advantage of more favorable foreign tax rates.
The tax reform initiative would go a long way in alleviating the financial market’s concern of a stalled economic agenda. Indeed, much of the stock bull market has been fueled on the expectations of such pro-growth policies. However, the realities of what actually gets passed, and in what form, has yet to be seen. President Trump and a Republican-controlled Congress continue to be mired in legislative setbacks. Given the contention between, and even within, the two political parties, the financial markets may be in for a long wait.