$450 Billion Loophole To Cut Taxes

Tax Cut Talk Heats Up

The rally in stocks on Tuesday was said to have been caused by the tax cut talk. The S&P 500 rallied 0.99% and the Nasdaq rallied 1.36% as both inch closer to revoking the 2% selloff. I don’t know how much of the rally is about the tax cuts because the economic data and earnings have been strong. Stocks shouldn’t be down. There’s always an inflow of ETF buying ready to catch the dip as well. Either way, the chart below shows the market’s reaction to tax cuts being discussed. CNBC floated an article saying President Trump’s perceived controversies make it more likely a tax cut would pass because the GOP will need a victory to go into the 2018 election looking good. I don’t buy the argument that bad news is good news. Even if President Trump’s poll numbers were higher, the GOP still would need to do something to show the voters they are making progress. Presidents usually lose Congressional votes as the two-party system sways back and forth. It’s about who is less unpopular opposed to who is more liked.

While the discussion of the likelihood the tax cut is passed based on Trump’s popularity isn’t news, there was another topic floated on the tax cut issue which does effect potential policy. Setting this up, we must remember that the boarder adjusted tax cut isn’t getting done and the healthcare reform is unlikely. That means that there’s not much room to cut taxes as there won’t be an offset. The corporate tax rate will probably only be cut to 25% which is a 10% cut from the current 35% rate, but only a 2% decrease from the effective tax rate which is 27%. Corporations have seen their taxes as a percent of GDP decline despite the high tax rate so there’s not much room to cut. The other obvious issue is that the government is running large deficits, so cutting government revenue isn’t the fiscally responsible thing to do. The tax rates on individuals will likely fall slightly as well. The reason why I keep discussing this issue is because the repatriation tax holiday will help buybacks. Even with the chances of large tax cuts diminished, the repatriation tax cut is thought of as a way to bring back capital to America, so that cut should be large either way

We’ve established that the size of the cut will be diminished, meaning each dollar in the budget is more important than ever. This is why the latest development which could allow the GOP to cut taxes by $450 billion without offsets is critical. In the new proposal, the GOP wouldn’t account for expiring tax breaks. There would also be a change to a “current policy” baseline instead of a “current law” baseline. The GOP has resorted to accounting shenanigans to get a large tax cut after their initial plans backfired. On the one hand, not having spending cuts with a tax cut is appealing for Congressional voters. On the other hand, deficit hawks in the freedom caucus won’t be happy. That’s emblematic of the entire party as the conservatives care about cutting spending and the moderates care about not cutting benefits; the conservatives want a balanced budget and the moderates want to spend more money than the government takes in.

Economic News

Let’s switch our attention to the latest economic reports. The Chicago Fed National Activity index was released Monday. The July report came in at -0.01 which is effectively zero. When the index is positive, it means growth is above trend and when the index is negative it means growth is below trend. The index looks at production and income; employment, unemployment, and hours worked; personal consumption and housing; sales, orders, and inventories. There’s not much to say about this indicator other than July looks to be growing on track with the historical average. The chart below is the diffusion index. I put this in to shows how the economy isn’t near a recession. This supports my claims in the last article where I said the data shows the economy isn’t in the decline phase.

Another economic report this week was the Richmond Fed Manufacturing index. As you can see from the chart below, the index came in at 14 which was above expectations for 10. This is yet another example of positive manufacturing momentum in August. The index was at 14 in July as well which is why the dotted line is flat. Looking at the specifics of the report, the prices paid and prices received indexes both fell indicating the Fed’s expectation for increased inflation isn’t showing up yet. The individual metric with the largest gain was the number of employees index which went from 10 to 17. However, the expectation for the number of employees fell from 33 to 30. The worst individual metric in this report was the shipments index which fell from 13 to 8. The expectations for shipments fell from 50 to 45.  As you would expect with an index which was sequentially flat, there aren’t many underlying changes in the data. The takeaway from the report is manufacturing continues to be strong.

The final economic report we’ll look at is the Redbook year over year change in department stores, chain stores, and discounters same store sales. As you can see, in the week of August 19th, the same store sales growth accelerated to +3.2% year over year. That’s the fastest growth rate since late 2015. This shows that consumer spending is relatively solid. The economy is reaching the heights seen in 2015 before the weakness in 2016 took over. The year over year sales in August 2017 are up 2.8% so far. This is the end of the pivotal back to school season, so these numbers are important.

Conclusion

The stock market is waiting on Congress to raise the debt ceiling and cut taxes. Yet another month will go by without action on either. The reason the market can rally on the hope of something getting done is because S&P 500 earnings are strong. It’s not looking as great for the Russell 2000 which is only up 1% year to date because of this inaction.

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