Goldman Sachs 

10 Questions on the Political Outlook

As the policy focus shifts from executive actions to legislative n debates, the pace of activity has slowed somewhat. This is most apparent in the debate over “repeal” of the Affordable Care Act (ACA), which has become bogged down by disagreement among Republicans on the appropriate “replacement”. The outlook for ACA repeal is still murky, but enactment in Q2 looks slightly more likely than not.

Since the issues are likely to move in sequence, delays on ACA imply delays on tax reform. The trouble Republican leaders have had on ACA legislation also bodes poorly for radical tax reforms; legislation that creates winners and losers, like tax reform, is hard to pass when near unanimous support among Republicans would be required.

That said, more incremental reform with a more modest tax cut than proposed by House Republicans or the White House remains our base case. “Dynamic scoring” will provide some room for congressional Republicans to cut rates while keeping tax legislation technically “revenue neutral.”

The border-adjusted tax (BAT) proposal is still on the table, but its prospects have faded substantially. We continue to see a 20% chance of some type of BAT. While opposition today appears overwhelming, the final decision is unlikely before late this year, when opinions might have changed.

The Trump Administration continues to take a hawkish tone on trade policy, including the possibility of “reciprocal” taxes and tariffs on trading partners. In the near term, we expect only incremental action, however, as the USTR nominee awaits confirmation and attention is focused on NAFTA renegotiation rather than the potentially thornier issues the administration might raise with China.

Infrastructure is still on the agenda, but for now remains an afterthought. Our expectation is that new infrastructure funding will be enacted this year or next, but that it is likely to take the form of tax incentives that might be included in tax reform legislation.

1. What has changed over the last month?

The most obvious development is simply the slowing pace of policy actions and expectations of further delays. Over the last month, market participants have shifted their focus away from the series of executive orders the President released shortly after inauguration and toward congressional debates on health care and tax reform. However, despite expectations that the President would release proposals on replacing the Affordable Care Act (ACA) and tax reform, the President has refrained from endorsing any particular proposals, and prospects for speedy resolution of either issue have faded. Regulatory activity, which does not require congressional consideration, continues but the absence of confirmed appointees in key positions suggests that tangible policy changes in some areas may wait until later this year or even next year.

2. Will Congress actually “repeal and replace” the Affordable Care Act?

Probably, but it will take longer than originally expected and much of the law is likely to be preserved in some form. We note that while most observers in Washington believe that a resolution is likely, few are able to identify how this will be achieved. Instead, many simply assume that Republicans will reach a consensus because they must; this has been a campaign commitment in the last four elections, leaving no option for failure. However, they face two challenges. First, some conservative Republicans object to continuation of tax credit-based subsidies currently provided under the ACA, even in revised form. Second, 20 Republican senators and 10 Republican governors represent states that expanded Medicaid eligibility under the ACA, and most object to wholesale repeal of that additional funding.

The primary strategy Republican leaders appear to be using to broaden support is to shift financial risk as well as decision-making to the states. This would result in slower growth in federal spending on health subsidies in currently open-ended programs like Medicaid. It could allow federal lawmakers to shift the responsibility for programmatic changes to state officials, which could make a political resolution easier. However, while
these changes could be sufficient to win support from most Republicans, they might fail to win over fiscal conservatives who remain concerned about the total cost of a replacement plan.
Winning support among conservatives for an ACA replacement plan looks more difficult. Republican leaders may simply present their lawmakers with an-all-or-nothing proposition: they can vote for an ACA replacement bill, including some form of refundable health insurance-related tax credit that they have reservations about, or they can vote against Obamacare repeal, running the risk that they will be seen as responsible for continuation of the status quo. White House involvement is likely to become increasingly important in this regard, as many of these lawmakers represent areas where President Trump won by large margins and where his views are likely to have greater influence. That said, the White House thus far appears to be taking a hands-off approach to the issue; President Trump outlined some broad principles in his recent speech to Congress—he endorsed tax credits for coverage and state flexibility under Medicaid—but has not yet weighed in on the details.


3. How long will ACA repeal and replace take?

We think there is a good chance that Congress will resolve the ACA debate in Q2 (Exhibit 1). Activity on the issue will intensify over the next few weeks; House committees may begin to vote on legislation as soon as the week of March 6. This could allow for passage by the full House by late March or early April, if plans remain on track. However, even on that timetable, the Senate is likely to take longer, and the odds that the Senate sends the President a bill prior to the congressional spring recess (April 10-21) seems fairly low. If so, final resolution could be pushed until May, in light of the upcoming debate on the confirmation of Supreme Court Justice nominee Neil Gorsuch and the April 28 expiration of federal spending authority, which will require new spending legislation to avoid a temporary government shutdown.

If Republican leaders cannot send the President an ACA bill by April or May, they will face two politically unpalatable options. First, they could continue to press for a solution, delaying consideration of tax reform for an indefinite period. This delay would occur because both proposals are expected to be considered under the “budget reconciliation” process. However, since only one tax bill and one spending bill can be considered under that process in each budget cycle—and ACA repeal legislation is expected to have tax and spending provisions—Republican leaders plan to consider the ACA bill in the FY2017 budget cycle, and to begin the FY2018 budget cycle, including instructions to pass tax reform, once the ACA bill has passed. A second option would be to postpone ACA legislation and move to tax reform, essentially reneging on a campaign commitment. We assume that, regardless of the outcome of the ACA debate, congressional Republicans will move on tax reform by mid-year, if not earlier.

4. What does this imply for tax reform?

In our view, the slow process on ACA repeal signals that tax reform is likely to take longer than initially expected and that the final tax legislation that Congress enacts is likely to be less radical than the early proposals from House Republicans and the Trump campaign. That said, while tax legislation looks likely to be delayed we expect it to move forward eventually.

Beyond the timetable, the ACA debate is a reminder that enacting ambitious structural reforms on a partisan basis is difficult, for two reasons. First, shared accountability allows lawmakers to take greater political risks. Over the last few decades, most of the major fiscal reforms were enacted under divided government, as this allows for shared responsibility: the Social Security amendments in 1983, the Tax Reform Act of 1986, and the various deficit reduction measures of the late 1980s and 1990s all come to mind. Of course, this is not always the case; the ACA passed along party lines in 2010.

Second, relying on only Republican votes results in a very thin vote margin, particularly in the Senate. Republicans in that chamber have 52 seats, and will need 51 votes (potentially including Vice President Pence’s tie-breaking vote) to pass ACA or tax legislation through the budget reconciliation process. Although this is often sufficient on issues where there are clearly defined differences between the parties, it makes it quite difficult to pass legislation where lawmakers have more idiosyncratic concerns, as is often the case in tax reform.


5. Will Congress enact tax reform or just a tax cut?

Our expectation is that the tax legislation will be a tax cut with elements of corporate tax reform, but that the changes will not be nearly as sweeping as what the House proposes. We expect that policy actions will raise the deficit by about $200bn next year. We expect the main driver of this increase to be tax legislation, despite insistence from many congressional Republicans that the tax bill would be revenue-neutral.

Our expectation is based on three considerations. First, the Trump administration does not appear to be as concerned about increasing the budget deficit; we note that in his recent address to Congress, President Trump called for a “massive” tax cut but did not actually refer to “tax reform” as congressional Republicans usually do. Second, certain aspects of tax reform, like border adjustment, are controversial enough that tax legislation might receive more support by omitting those provisions than by including them, despite the revenue they raise. Third, “dynamic scoring” and other changes to the way the budgetary effects of tax legislation are estimated will provide additional fiscal room to cut taxes. We note that the market also appears to have downgraded its view of tax reform, judging by the relative performance of a basket of high-tax stocks compiled by our equity strategists, which should benefit disproportionately from tax reform (Exhibit 2).

6. Is there room in the federal budget for what President Trump is proposing?

Only if Congress is willing to increase the budget deficit. The Congressional Budget Office (CBO) projects federal outlays will total $53 trillion over the next ten years, against an estimated $43 trillion in receipts (22% and 18% of GDP, respectively, on average). In this context, accommodating roughly $3 trillion in tax cuts under the House blueprint or more than the $5 trillion the President proposed during the campaign is at least conceivable. However, in practice this even more difficult than the already large figures suggest, for three reasons.

First, the politics around the budget were stretched before tax cuts came onto the agenda. Congressional Republicans have had to work hard in recent years to pass their annual outline for fiscal policy, known as a budget resolution, due to competing demands in the party. Some fiscal conservatives have indicated opposition to a budget resolution that does not achieve a balanced budget by the end of the 10-year projection Congress uses. By contrast, some centrists object to the spending cuts used to reach that goal. Adding a tax cut to the mix will arguably make reaching consensus even harder.

Second, there are fewer areas than in the past where spending cuts can be plausibly proposed. President Trump has indicated that he opposes cuts to Medicare and Social Security, and he has proposed a $54 billion/year higher level of defense spending. The most recent congressional budget resolution also claimed around $2 trillion over ten years in reduced spending resulting from repeal of ACA subsidies, while leaving the tax hikes and spending cuts used to pay for them intact. While it is likely that ACA legislation will reduce subsidies slightly, we expect this to result in only a fraction of the savings previously assumed. Third, there are limits to how much “dynamic scoring” can make room for tax cuts under congressional rules.

7. But doesn’t “dynamic scoring” allow for a large tax cut?

Dynamic scoring alone would make room for only a modest tax cut. The abbreviated “skinny budget” the President is expected to release in mid-March is reported to rely on optimistic growth expectations to boost revenues and lower the reported budget deficit. A higher assumed growth rate would indeed create substantial fiscal space; for example, an assumption of 3% growth each year after 2019 would add $4.5 trillion to revenues over the next ten years, which would roughly cover most of the cost of the proposed tax cut and new spending President Trump seems to envision.

While the President’s Budget in prior years has often taken a slightly more optimistic view on growth, the assumed growth rate has no bearing on the congressional debate, which will rely on estimates from the Joint Committee on Taxation (JCT) and the CBO, both non-partisan entities that rely on technical staff to estimate the fiscal effects of legislation. Under rules established in 2015, JCT must incorporate the economic effects
of tax legislation into its official estimates. While Republican leaders might influence the process—for example, by specifying which of its various models JCT should rely on dynamic scoring will be based on objective analysis.

The most relevant recent example of dynamic scoring is the JCT’s estimate of the Tax Reform Act of 2014, a comprehensive, revenue-neutral tax reform proposal introduced by then-Chairman of the Ways and Means Committee Dave Camp. JCT estimated that it produced economic benefits sufficient to boost tax receipts by $50 billion to $700 billion over ten years. In light of the likelihood that upcoming tax legislation is likely to
provide greater incentives for business investment than the Camp bill, it might be estimated to produce slightly better dynamic effects. However, dynamic scoring is unlikely to result in offsetting revenues of more than $1 trillion over ten years, and will probably result in considerably less. Since each percentage point reduction in the corporate tax rate reduces projected federal receipts by about $120 billion over ten years, this would be sufficient to reduce the corporate tax rate into the high 20’s, but it would take additional offsets (or an acceptance of larger deficits) to go beyond that.

8. Is the border adjusted tax dead?

Not quite but its prospects have clearly faded. The House Republican blueprint on tax reform proposes shifting the corporate tax system to a “destination-based cash flow tax” (DBCFT). The “destination-based” aspect refers to the idea that US corporate tax will be applied based on where goods and services are consumed, not produced; border adjustment—disallowing the deductibility of imports and ignoring revenues related to exports—is used to achieve this, as is the move to a territorial tax system. The “cash flow” aspect refers to the proposal to repeal the deductibility of interest expense and other tax preferences but to allow the full expensing of capital investment. Together, these moves are intended to shift the US corporate tax from an income base to a consumption base.

However, many analysts including ourselves have questioned a premise of the proposal, which is that exchange rates would adjust to offset the tax increase on imports and subsidy for exports. This aspect of the proposal is critical, since one of its main political selling points is that would raise over $1 trillion over ten years without affecting the after-tax incomes of US corporations. It would be unique in that regard, since all other “revenue raisers” that Congress has considered to offset the cost of tax cuts would generally lower the after-tax incomes of some companies or industries.

Our sense is that the border-adjusted tax (BAT), as it has come to be known, faces a serious uphill challenge but that the debate is not quite over. The challenges are clear, with several Republican senators publicly opposing the BAT and an increasing number of Republican members of the House also raising concerns. However, the issue is likely to continue to be debated at least until the House Ways and Means Committee releases
legislation, likely in May or June. The Trump Administration also appears to have mixed views on this and, while he has not taken an official position, the President’s most recent comments have suggested continued openness for the general concept if not the specifics. This raises the possibility that the President could ultimately support other changes to the treatment of imports if the BAT is omitted from tax reform.

9. Where does this suggest that trade policy is headed?

We expect trade frictions to increase, but this could be a gradual process. A notable aspect of the President’s recent address to Congress was his discussion of trade, where he noted that “many other countries make us pay very high tariffs and taxes but when foreign companies ship their products into America, we charge them almost nothing” and announced that he would seek changes. This is not the first time that the
President has discussed taxes and tariffs as essentially interchangeable, raising the possibility that if a policy like the BAT were omitted from tax reform, protective tariffs might receive more serious consideration.

Indeed, the President’s recently released Trade Policy Agenda for 2017 highlights two themes we have discussed recently: a delinking of trade policy from foreign policy, and the concept of “reciprocity.” On the former, the Administration “reject[s] the notion that the United States can strengthen its geopolitical position by adopting trade measures that make American workers, farmers, ranchers, and businesses less competitive in global markets.” On the latter, the release states that “It is time for a more aggressive approach. The Trump Administration will use all possible leverage—including, if necessary, applying the principle of reciprocity to countries that refuse to open their markets…” We have previously found that the US would need to raise tariff rates by 2.5pp to 5pp to equal the rates applied on US exports; taken literally, this suggests that the President might support a tariff of that size.

However, we continue to expect actions in the near-term to be targeted and incremental, for two reasons. First, the pace of Senate confirmations has been fairly slow, with Secretary of Commerce Wilbur Ross just recently confirmed and the US Trade Representative nominee Robert Lighthizer potentially still several weeks away from confirmation. Without a full trade team, the Administration is apt to move slowly. Second, the near-term focus appears to be NAFTA renegotiation, which has yet to formally take place and will take several months at a minimum to conclude. The changes the administration appears to be seeking—changes in rules of origin, for example—are likely to be more incremental and easier to resolve than many of the issues in the US-China relationship. The upshot is that while the Trump administration has made clear that it will pursue a more “protective” trade policy, the first steps appear likely to be incremental.

10. What ever happened to infrastructure?

It is still on the list of priorities, just not at the top. When Republican lawmakers list the priorities for the year, the first two are always the same: ACA repeal and tax reform.
Infrastructure and financial regulatory reform generally come in third or fourth, both in terms of chronological order as well as political importance. On one hand, this is an encouraging position given the seemingly low market expectations at the moment regarding infrastructure funding (Exhibit 3). On the other hand, this puts the issue later on the calendar than two issues that are likely to take the remainder of the year to resolve, and possibly part of next year as well.


Our expectation regarding an infrastructure program has remained largely unchanged over the last couple of months: we expect that Congress will ultimately enact a package of tax incentives for public-private partnerships, similar to the tax credit plan that President Trump proposed during the campaign, which would provide a tax credit worth roughly 14 cents for every dollar of private debt and equity capital invested. More detail on infrastructure plans might be forthcoming in the President’s budget release in mid-March.

Although there has been some discussion of direct federal spending as well, we are skeptical that the Republican majority in Congress would approve it. Direct spending would be even less likely if Republican lawmakers ultimately opt to include infrastructure incentives in tax reform, as might be necessary if there is insufficient bipartisan support for standalone legislation.

The US Economic and Financial Outlook :

Marketing communication : This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication.

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