Tax Reform Bill Released

Productivity Growth Returns

The biggest economic change in 2017, in my opinion, is the improvement in productivity. Growth in productivity is the key to economic expansion. Without productivity growth, we just have nominal growth driven by inflation. Productivity grew 3% on an annualized rate in Q3 which is the fastest growth rate since Q3 2014. In Q2 2017, productivity only grew 1.5%. The Q3 report beat expectations for 2.4% growth. On a year over year basis, productivity was up 1.5%. Manufacturing productivity fell 5% quarter over quarter which was the worst reading since Q1 2009. It might have been impacted by the weather. From 2007 to 2016 productivity grew 1.2% which was below the 2.1% growth average from 1947 to 2016. Hopefully, this is a new step in the right direction. Output increased 2.8% and unit labor cost was up 0.5%. The more productivity rises, the easier it will be for businesses to handle wage growth. The fact that productivity is accelerating shows that the labor market is tight.

Manufacturing ISM Report

The ISM report has been one of the most optimistic economic reports that we’ve reviewed this year. The manufacturing report took a step back on Wednesday as it fell to 58.7 from 60.8. That’s still not a bad report as it’s 0.7 point above the 2017 average and 1.9 points above the 12 month average. It’s consistent with 4.9% GDP growth which is clearly not going to be reached. The 2017 average is consistent with 4.4% growth which also won’t be reached. That’s why I say it’s one of the most optimistic reports. Every single measure besides costumers’ inventories and imports fell from last month. New orders fell 1.2 points to 63.4. The overall manufacturing economy is still growing, but it slowed. I think the best summary of this report is to say last month was over the top and this month is back to normal. The September numbers were juiced by the hurricanes. The fact that this month fell from a juiced number is to be expected.

Let’s look at some of the quotes from the report. A computers and electronic products company said "Hurricanes have caused shortages in the resin market, resulting in price increases, inventory constraints and increased lead times.” This could be useful in trying to figure out why there was weakness in the information tech sector of the ADP report. There’s still weather impacts causing problems for businesses. A plastics and rubber products company said "In plastics processing, Hurricane Harvey is the reason for every price increase being announced — and virtually all suppliers are announcing price increases." There are clearly still impacts from hurricane Harvey even though it was over 2 months ago. This shows that any bullish investor who scoffs at a bad economic report, claiming it’s weather related, has a valid point. I thought the effects would be gone by October, but it looks like there are still impacts to the supply chain.

Tax Reform

The GOP finished its legislation on tax reform on Thursday. The goal remains to pass it by Thanksgiving which is November 23^rd. There will likely be a vote in the next two weeks. With the legislation done, there will be a lot of jostling to see who supports it and who doesn’t. Afterwards, the bill will probably be changed a few times to get as many people on board. With this legislation unveiled, the PredictIt betting website has a 10% chance of a tax cut on individuals passing and a 34% chance of a corporate tax cut passing by the end of the year.

Let’s get into some of the details of the plan. The table below shows the changes for the single filers. The number of brackets is lowered from 7 to 4. Taxes are cut for everyone. The standard deduction is almost doubled as it goes from $6,350 to $12,000. The bill adds $1.51 trillion to the debt over 10 years. The rule under the reconciliation process is the bill can only add $1.5 trillion over 10 years. This means the GOP figured out how to get it to fit within the rules essentially. The best news that was revealed was that the corporate tax rate will be cut from 35% to 20% immediately. The talks of the tax cut going through over 3-5 years didn’t lead to anything.

Another key issue which has been hotly debated is the state and local tax deduction. The legislation allows people to deduct state and local property taxes up to $10,000, but not income or sales taxes. As you can see, that’s a middle ground option. There needed to be some compromise to make it work. If the deduction was completely eliminated, high tax state legislatures would have had an uproar. If the state and local tax deduction on income and sales was included, the math wouldn’t work.

The repatriation tax holiday has a 5% rate for illiquid assets and a 12% rate for liquid assets such as cash. There will be no changes to the 401(k) plans. This was another hotly debated issue as some favored a ceiling to the tax free funding of these retirement plans. The mortgage interest deduction limit was cut from homes worth $1 million or more to homes worth $500,000 or more. The estate tax threshold was nearly doubled from $5.6 million to $10 million and the tax is phased out over 6 years. Most itemized deductions are eliminated except the charitable giving and the home mortgage interest deduction which I just mentioned. Because of the halving of the maximum mortgage income deduction, the home builder stocks fell.

The most important question investors have is what this means for stocks. It’s difficult to tell because we don’t know if it will pass. That’s the most important focus because if it doesn’t then the details are irrelevant. My instinct is to expect the bill to have a tougher time in the Senate than the House. The key voters will once again be the moderates which are Susan Collins and Lisa Murkowski.