MARKET COMMENTARY

Tax Cuts and the Outlook for US Government Debt

03.13.2018 - Jeffrey S. MacDonald, CFA

While the Trump administration and Republican-led congress struggled to pass legislation early on in an effort to move their agenda forward, a number of recent efforts have proven successful and potentially changed the future outlook for budget deficits and government debt in the United States.  

Tax reform passed in the fourth quarter of last year was arguably the administration’s biggest win so far. With tax cuts introduced for both corporations and individuals, the boost to economic growth has the potential to be meaningful, especially in the near term. But with an estimated $1.5 trillion in tax cuts over 10 years on top of a 2018 federal budget that includes $300 billion in new spending and another $200 billion in proposed infrastructure projects, this type of fiscal stimulus doesn’t come cheap.

In our view, this combination of factors does not present the financial markets with an immediate threat, and in fact could actually extend the current economic cycle and market rally. Piling debt on the US Federal balance sheet is not a recent phenomenon, nor is it limited to the current administration. In fact, US debt has been growing significantly over time, with debt as a percentage of GDP doubling over the past 10 years.

Is the Glass Half Empty or Half Full?

The challenge for investors and the broader economy likely resides in the outlook for the intermediate to long term. The rationale behind the stimulus is that while it will create up-front budget deficits as revenues drop and spending increases, the boost to longer-term growth and productivity will grow the tax base in future years to a level able to support this additional borrowing.

The Glass Is Half Empty

While the Trump administration has made the argument that tax reform will essentially pay for itself, analysis conducted by several independent agencies suggests that the administration’s financial assumptions overestimate tax reform’s ability to enhance government revenues and underestimate the costs. In their view, the numbers just don’t add up.

We tend to agree. One of the most glaring problems is that politically sensitive “entitlement” programs like Social Security, Medicare and Medicaid represent roughly two-thirds of the federal budget—and trimming those expenses will be difficult at best. We also question the likelihood of an increase in tax revenues that is significant enough to completely fill the budget gap.

In addition, interest rates are already increasing and are expected to continue rising. Higher interest rates could make it more expensive for the US government to pay down its debt. While debt service costs currently represent less than 10% of all federal spending, they are one of the fastest-growing expense items and are poised to accelerate. Furthermore, as the US Treasury is forced to issue more debt to finance its deficit spending, it could be met with fading demand as the Federal Reserve winds down its bond purchasing program and shrinks its $4.5 trillion balance sheet. 

Finally, recently escalated rhetoric around US import tariffs and NAFTA negotiations has the potential to reduce cross-border trade, which could have negative consequences for US GDP growth and demand for US dollar assets.

The Glass Is Half Full

On the other hand, the good news for the government’s fiscal outlook is that the economy continues to expand, and corporate fundamentals remain strong. Tax reform not only reduced corporate taxes to a flat rate of 21%, but also allowed the immediate full deduction of capital expenditures, which could add a near-term boost to investment and generate potential gains in productivity. Finally, a lower tax rate should also improve companies’ ability to service existing debt, which has been on the rise recently, in the wake of record borrowing.

It is also worth noting that while rates are rising in the US, they remain low by historical standards, and relatively cheap financing is still available. Corporate fundamentals remain strong and credit markets continue to function well with spreads still attractive for borrowers. Wages have also shown early signs of improvement, which could boost consumer spending.

An additional short-term boost to growth here in the US could result from the tax treatment of corporate earnings currently held overseas. By implementing a one-time tax on earnings held overseas the incentive to hoard cash offshore is removed and companies are free to bring that money back to the US. If that capital is reinvested in ways that improve corporate productivity and drive the economy forward—capital improvements, salary increases, acquisitions, etc.—the long-term outlook for the US economy and government fiscal situation improves.

We view the use of this repatriated cash with a bit of a skeptical eye. In recent years, companies have not been using their cash to make the types of capital improvements that drive productivity gains and real economic growth without much of a lift from inflation. Instead, they have largely taken advantage of low rates to borrow cheaply and used the proceeds to pay shareholder dividends and to repurchase company stock.

If companies continue along this path with the infusion of cash provided by tax reform, we could experience inflation without economic growth—generally a bad thing for the economy and government revenues.

The Threat Is Real, But Not Imminent

The government’s budget challenges are an important issue for investors to keep an eye on. Any immediate threat to financial markets is eased by strong economic underpinnings and healthy growth in corporate earnings. But the longer-term implications could depend largely on the ability of US legislators to keep government costs contained, and the willingness of corporate leaders to steer away from their recent focus on financial engineering and reinvest in ways that contribute to real economic growth.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of March 14, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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