If you think that filing your annual tax return is a complicated process, it is nothing compared to the difficulty of passing tax reform through the US political system. Financial markets have responded to hopes of progress, as President Trump's single page doument of April has been expanded to nine (widely-spaced) pages released by key players in the process.
Details are still sparse, and there is a long way to go, with many obstacles to negotiate, before tax reform can become reality, but at least there is hope.
The first step is that both the Senate and the House need to pass budgets. This might be harder than it sounds, as some Republicans oppose any material increase in the deficit; others want more spending on defence and less on welfare; some want to protect existing entitlements. Failed healthcare reform showed that agreement can be diffcult, although Republicans should find it easier to unite around proposals to cut taxes. No budget would mean no tax reform.
The budget will tell us the size of the tax cut. At the moment a figure of $1.5tr (over ten years) is being used, which is about 0.6% of GDP on an annual basis.
This is does not look a large enough number to have much of an impact on Fed policy, although it would give support to their plan to keep raising interest rates.
If Congress can approve a budget, perhaps by Thanksgiving in late November, then attention turns to tax reform, with the aim of passing a bill in early 2018, ahead of mid-term elections.
Reform will be difficult for two reasons. First, the nine-page proposals would increase the deficit by far more than $1.5tr (most estimatest are at least twice as much). That means the proposed 20% corporate tax rate is more likely to end up as 25%, but it also means that lawmakers will need to be aggressive in eliminating tax exemptions.
This leads to the second problem, which is that we will see a frenzy of lobbying, as interest groups try to maintain favourable parts of the tax code. Plans to limit the deducibility of interest expenses are likely to be particularly controversial. Some elements are uncontroversial - such as 10% tax to repatriate foreign earnings - but most are not.
The probability that income tax reform will mainly benefit the rich seems unlikely to be a barrier (other than by further reducing the chances of Democratic support). Republicans seemed quite happy to pass healthcare legislation that took away benefits from 20 million Americans, compared to which, tax cuts for the rich seems inconsequential.
Not enough attention has been paid to the impact of ending deductibility of interest expenses. This will affect the optimal structure of corporate balance sheets. It could also hurt the debt-funed M&A business, as well as making corporate buybacks - which have driven EPS growth in recent years - more expenseive. From an economic perspective it makes a lot of sense, but it could be hard to implement.
Ending interest deductibility would have a big impact on real estate investors, which raises the question of whether the president would oppose it. Moreover, if existing debt is grandfathered (presumably it would have to be), then we could expect a rush of issuance ahead of new rules coming into effect.
As ever, proponents will claim that the tax cuts will pay for themselves through higher growth. This has two problems. First, it is not true. Second, there is a non-partisan process (dynamic scoring) that makes a realistic assessment of the growth impact on revenues.
It looks like the probability of tax reform passing is around 50:50, but we will learn more as the budget progresses over the coming couple of months.Disclaimer applicable to recommendation
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