All You Need To Know About Trump Tax Reform: Goldman Explains

This afternoon, during a speech in Indianapolis, President Trump will unveil the long-anticipated Republican tax reform proposal that calls for substantial business and individual tax cuts. As has been leaked previously, the tax plan is anticipated to disclose a 35% individual tax rate (although Congress may push it higher), a tax rate on corporations and pass thrus that will be around 20% and 25% respectively, while doubling the standard deduction to $12,000 for individuals. While offsetting these will be such proposed tax increases as the elimination of state and local tax deductibility, according to Goldman, the proposal will likely reduce federal revenues by around $4 trillion over ten years (or 1.7% of GDP over that period).

By contrast, as Goldman's Alec Phillips writes in an overnight report,  the debate in Congress has ranged from revenue-neutral tax reform to a recently floated proposal in the Senate that might allow for a $1.5 trillion tax cut over ten years (0.6% of GDP over that period). Even if this tentative budget agreement in the Senate becomes official the forthcoming proposal would have to be scaled substantially to fit within the fiscal constraints Congress is likely to impose.

In other words, for all the hype, the final Trump tax cut - if it passes - will be a pale shadow of its initial proposal.

That said, and as the recently surging dollar has confirmed, tax reform is finally starting to move and recent developments suggest a rising probability that tax legislation will be enacted by early 2018. Following the expected release of the tax proposal this week, Goldman now expect the Senate Budget Committee to vote on its fiscal year 2018 budget resolution the week of October 2, which looks likely to include a “reconciliation instruction” for a net tax cut of $1.5 trillion over ten years. If a similar instruction is finalized by the House and Senate (probably by late October), enactment of tax reform by early 2018 would become more likely in Goldman's view, as it would allow for a corporate rate reduction and some individual tax relief while allowing lawmakers to avoid some of the most controversial base-broadening measures that might otherwise be necessary to offset the cost of the tax cuts.

So with that in mind, here are Goldman's thoughts on tax reform ahead of Trump's announcement this afternoon.

Thoughts on Tax Reform Ahead of the President’s Announcement

The White House is expected to release an outline of tax reform that is meant to represent a consensus among White House officials and House and Senate Republican leaders. Some details have begun to trickle out through various media reports, and appear to represent a middle ground between the House Republican “blueprint” on tax reform and the President’s prior proposal. Exhibit 1 compares prior proposals with what has been reported of the upcoming White House proposal and what we expect a plausible end result might be. We note that there has been little detail reported regarding a few areas, like taxation of capital income (we assume no change) and treatment of corporate interest expense (we do not expect the White House to propose repeal of interest deductibility, but some type of limitation might be floated).

Exhibit 1: Prior Tax Proposals vs. Reported White House Plan

That said, the White House proposal will represent only an opening bid, and many provisions are likely to change during the course of the legislative process. In particular, we expect any proposal to repeal the state and local tax deduction to face substantial political friction, in light of the fact that Republicans can afford to lose only 23 votes in the House, assuming no Democratic support, and there are 28 Republican House members from New York, New Jersey, and California alone, and dozens more from other states with substantial state and local income taxes. Exhibit 2 shows the cumulative number of House members in the top 20 high tax states, measured by per capita itemized income tax and property tax deductions.

Exhibit 2: Proposal to Repeal State and Local Deduction Would Likely Face Opposition

The other aspect of the reported proposal that seems likely to change, in our view, is the interplay between corporate rate reductions, full expensing of capital investment, and potential limitations on corporate interest deductibility. While House Republicans have consistently favored full expensing of business investment, the cost of which would be offset by partly repealing the deductibility of corporate interest expense, the President stopped short of endorsing this concept in the campaign and the White House tax reform outline earlier this year was silent on the issue. While the White House might propose to temporarily allow businesses to fully deduct capex for several years in return for limiting interest deductibility, many businesses appear to support the former more than they oppose the latter.

We would also expect the 20% corporate tax rate that the White House looks likely to propose to drift higher as the debate continues. The corporate income tax is projected to take in around $3.75 trillion over the next ten years (1.6% of GDP over that period); reducing the rate to 20% would take projected receipts down to around $2.1 trillion (0.9% of GDP), for a revenue loss of around $1.6 trillion (0.7% of GDP). To offset the cost of cutting the rate by nearly half, the corporate tax base would need to be nearly doubled.

However, there are simply not enough politically feasible opportunities to eliminate deductions and other tax preferences to broaden the base by this amount. For example, the Tax Policy Center recently estimated that eliminating all corporate tax preferences would allow the corporate tax rate to come down to 26% without losing revenues. However, some of the changes this would require, such as ending accelerated depreciation, are extremely unlikely to be included in a reform proposal since most lawmakers want to change policy in the opposite direction (i.e., increasing investment incentives). The Tax Foundation estimates that repealing all corporate tax preferences except for those dealing with depreciation and foreign income would raise around $900bn over ten years (0.4% of GDP) at current tax rates. However, this would only be enough income to reduce the corporate tax rate to around 28% in a revenue-neutral manner. Some of these would undoubtedly be too controversial, suggesting that a revenue-neutral tax reform would struggle to achieve a rate much below 30%.

This is why the tentative budget agreement in the Senate could be so important. As we noted last week, an agreement to allow for a $1.5 trillion (0.6% of GDP) tax cut in the upcoming budget resolution for fiscal year 2018 was reached in principle between Senator Toomey (R-PA), who has supported a larger tax cut, and Senator Corker (R-TN), who has been cautious on tax cuts, citing deficit concerns. If an agreement is finalized over the next few weeks that allows for a tax cut of around $1.5 trillion to pass via the budget reconciliation process, a corporate rate cut would become much easier since a portion of the cost would not need to be paid for.

At this point a budget agreement calling for a net tax cut looks like the most likely outcome, but three hurdles need to be overcome. First, the Senate Budget Committee is likely to vote as soon as next week on a draft budget resolution for FY 2018, which looks likely to include a reconciliation instruction to the Senate Finance Committee to cut taxes by around $1.5 trillion over ten years (the details could be released later this week). Second, the full Senate will debate and vote on the resolution. This will take only 51 votes to pass, but some Republican senators might raise concerns related to the fiscal implications of the tax cut. A few Republicans have also recently raised the possibility that they will seek to pair tax reform with another effort to repeal and replace the Affordable Care Act (ACA), which would be a major setback for tax reform if it occurred. Third, the House also needs to pass its own version of the budget resolution, and an earlier version called for revenue-neutral tax reform. We expect the House will end up closer to the tax cut called for under the tentative agreement in the Senate, but this remains a source of uncertainty. We would not expect the budget resolution to be finalized until late October.

Even if the budget agreement calls for a meaningful net tax cut, the proposed changes the President looks likely to announce on September 27 seem likely to be scaled back as the congressional debate progresses, given the likely cost of the proposal the White House is likely to release compared with the fiscal constraints the plan will face in Congress. Without a detailed proposal it is difficult to estimate the cost of the plan, but as a very rough estimate we expect policies similar to those laid out in recent press reports would reduce tax receipts by around $4 trillion over ten years on a static basis. Even if the upcoming budget resolution targets a tax cut of $1.5 trillion over ten years, this suggests that the plan released this week will need to be scaled back substantially.