Considering the Long and Short-Term Effects of Policy

October 6, 2017

As we move into the last quarter of this year, investor attention has turned once again to fiscal policy. Specifically, the debate in Canada over proposed changes to how private corporations are taxed is now being juxtaposed against the potential for sweeping tax reform in the United States. If the White House is successful in pushing through significant tax cuts, this will have both positive and negative consequences for Canada.

The economic implications from lower US taxes are fairly easy to analyze.  In Trump’s 9-page outline, there would be a reduction in the corporate tax rate to 20 percent from 35 percent.  The top rate on personal income would be lowered to 35% and companies would be able to write off capital investments immediately, rather than amortizing them over time. In addition, the plan would allow companies with foreign profits held abroad to bring them back in a one-time move at a favourable tax rate. There are some important offsets, such as the elimination of personal exemptions (which would supposedly hurt families with children) and it also eliminates deductions for state and local taxes. There would, however, be an elimination of the estate tax  and the so-called ‘generation-skipping’ transfer tax. These, of course, are just proposals and what ends up being passed through Congress could look a lot different, but let’s assume the essential features make it through, albeit with different tax rates than suggested.

This should provide at least a short-term boost to the US economy, both on the consumer side and in business investment. This does not necessarily mean that the stock market will get an equal boost, since tax cut expectations have been baked into the market since the start of the year, creating most of the gains we have seen.

 

 

Not all of the effects from a successful tax reform bill will be positive though. Perhaps one of the easiest components of the proposal to pass will be foreign profit repatriation. Once companies are allowed to pack up their  assorted currencies and head back to the USA, this will most likely cause the US dollar to jump. This is because firms will want to exchange their foreign currency for US dollars and given the amount of profits we are talking about, supply-demand will mean the price of a US dollar should increase.  In turn, US exports become less competitive and unless America’s trading partners are posting even stronger economic growth, the US trade deficit will widen and subtract from real GDP growth.  This isn’t a risk for this year, but certainly 2018 could see some of this drag appear.

 

 

The other thing we have to watch is the Federal Reserve’s reaction to tax cuts. Right now we are in the middle of a planned increase in interest rates and the Fed has started to pare back its balance sheet.  If it thinks US growth will be even stronger thanks to tax reform (outside of the export issue I talked about), then it may want to raise rates further or faster. That could put more pressure on the bond market, causing yields to rise. As with the dollar’s effect, it would be reasonable to expect the economy to slow.

Then we have Canada. Yes, stronger US growth and a lower Canadian dollar would normally be good news for us. The TSX alone should get a lift from a fall in our currency, although some commodity prices would suffer. The bigger issue is what happens over the long-term now that the US gains a relative tax advantage against Canadian individuals and small businesses?

While it is unlikely Canadians will be in a rush to pack up and apply for residence status in the US, many are already thinking about it. Decades ago, Britain saw the negative effects of having an excessively high tax regime and the exodus of high-earning individuals got dubbed the ‘brain drain’. For Canada, it is not just the potential exodus, but what happens if small businesses leave too. This segment has been the largest contributor to job creation, so longer-term this could result in weaker trend growth and, ironically, higher fiscal deficits. This might affect the relative performance of Canadian equities as well. For now, we just have to wait and see what Ottawa and Washington give us.

 

Upcoming events

Canada:  Housing starts, building permits, new home prices,

US:  FOMC minutes, producer prices, monthly budget statement, consumer prices, retail sales, University of Michigan consumer sentiment

 

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