Authored by Trey Reik, Senior Portfolio Manager, Sprott Asset Management USA, Inc.
The Tax Cuts and Jobs Act of 2017 has become a microcosm of contemporary American politics. Bravado and obligatory motion have dulled senses and marginalized rational analysis. The tax bill in its current form has morphed into movement for movement’s sake, largely devoid of coherent economic policy. As Obamacare has demonstrated, this brand of legislative action can inflict damaging unintended consequences and become the legislative albatross for an entire political party. Given heightened market expectations for tax reform, Republicans may have just sowed their undoing, leaving financial markets ripe for disappointment in 2018.
Few policy objectives hold more economic promise than simplifying the U.S. tax code. Legitimate efforts to address the bleak fiscal future for the U.S., such as the 2010 Simpson-Bowles National Commission on Fiscal Responsibility and Reform, always cite domestic tax reform as a critical component of sustained federal solvency. No matter how noble a goal tax reform may be, necessary tradeoffs in the ultra-polarized U.S. political climate make comprehensive tax reform virtually impossible in any environment short of outright crisis
Absent such an involuntary and total reset, tax cuts as a discrete policy tool are geared to offer the most utility in economic conditions such as recession, high unemployment, strong population growth and a balanced foreign trading environment (facilitating overseas deficit financing). Ironically, the present-day U.S. economy is characterized by virtually opposite conditions: unemployment is historically low at 4.1%; U.S. output is in its ninth year of expansion; population growth has declined from its historical 2%-rate to roughly 0.5%; and the U.S. capital account is already severely strained.
But having seen his other major policy initiatives whither on the vine, Trump is eager for this tax bill to pass, as he tweets, “It will be the BIGGEST TAX CUT and TAX REFORM in the HISTORY of our country!”
Despite President Trump’s banner proclamation of a massive tax cut for the middle class, our analysis suggests the bill’s schizophrenic jiggering essentially amounts to a glorified corporate tax cut. By leveling the (global) taxation playing field for U.S. corporations (while ignoring steep VAT burdens making statutory obligations for overseas corporations significantly higher than even the top U.S. nominal 35% corporate rate), and facilitating repatriation of “trapped” overseas profits, the legislation purports to foster U.S. economic growth, stimulate domestic capital investment and invigorate U.S. jobs markets.
Of course, this glowing appraisal is shared by few economists and strategists outside the Trump administration. Most independent assessments, such as the Joint Committee on Taxation (Congress’ nonpartisan scorekeeper) estimate the tax bill may increase GDP between 0.5% and 1.0% cumulatively over a 10-year period while boosting the federal budget deficit by $1.0 to $1.5 trillion, a tradeoff hardly worth its steep price.
We believe the corporate focus of Trump tax cuts is misguided for two reasons. First, lowering corporate tax rates will only exacerbate the economic stratification already plaguing the U.S. economy. As shown in Figure 1 below, corporate profits as a percentage of GDP hover near all-time highs precisely as wages as a percentage of GDP have dwindled toward historic lows.
Figure 1: Corporate Profits Hover Near All-Time Highs (1963-2017)
Source: Meridian Macro; Data from 1963-Q3 2017.
Given how far the economic pendulum has swung in favor of capital-over-labor in recent years, is this really the right time to pursue economic growth through tax cuts on record corporate profits? We would suggest $1.5 trillion in direct federal funding for education, job training, R&D and infrastructure programs would be a vastly more productive use of national resources than incurring the like-sized deficit implicit in the Trump corporate tax cut.
Second, there is precious little supporting evidence that reducing corporate tax rates and offering a tax holiday on overseas profits will actually stimulate either incremental capex or increased hiring. One particularly poignant rebuke of the Trump administration’s tax-cut reasoning occurred at a gathering of the Wall Street Journal CEO Council on 11/16/17. With White House Economic Council Director Gary Cohn seated on stage, a WSJ editor asked a room of 100-or-so CEOs for a show of hands, “If the tax reform bill goes through, do you plan to increase your company’s capital investment?” When virtually no hands were raised, Cohn nervously blurted out, “Why aren’t the other hands up?” This awkward scene quickly went viral as a vivid demonstration of how out of sync the Trump tax plan is from common corporate priorities.
During the past eight years, zero interest-rate policy (ZIRP) and related productivity declines have decimated corporate capex in favor of debt-fueled share repurchase. As shown in Figure 2 below, from the equity market lows of Q1 2009 through the first half of 2017, the corporate sector had repurchased 18% of total U.S. equity market capitalization, while institutional investors had liquidated 7% of total equity market cap. Figure 3 below, demonstrates these repurchases were funded almost entirely through the issuance of low-coupon debt in a ZIRP world. Given the fact that corporate spreads remain near all-time lows and liquidity remains abundant, we are skeptical that a reduction in corporate tax rates will have a meaningful impact on capex or hiring plans.
Figure 2: Corporations Are Biggest Purchasers of U.S. Equities Since 2009
Source: Thomson Reuters; Credit Suisse; Data from Q1 2009 - Q2 2017.
Figure 3: Corporate Buybacks Funded by Low-Coupon Debt (2006 - 2017)
Source: Meridian Macro; Trailing 12-Months of S&P 500 Share Buybacks versus U.S. Corporate Debt Growth; Data from 2006 - Q3 2017.
With respect to repatriation provisions of the 2017 Tax Act, we are similarly skeptical such a tax holiday will catalyze any significant corporate behavior outside share repurchases, shareholder dividends, and executive bonuses. After all, the vast majority of American corporations’ $2.6 trillion overseas cash hoard is already invested in dollar-denominated instruments (so no need to disturb), the reduced tax obligation was deemed (not voluntary) and the prevalence of interest rate swaps has long facilitated easy domestic monetization of these balances should any compelling corporate opportunity have presented itself in prior years (it did not).
Historically, tax holidays on overseas profits have hardly inspired imaginative corporate governance. By way of example, the Senate Permanent Subcommittee on Investigations published on 10/11/11 an in-depth analysis of the 2004 repatriation tax holiday. In return for reducing the tax rate on repatriated funds from a maximum 35% to roughly 5%, the 2004 legislation had specified that repatriated funds should be earmarked for activities such as hiring workers or conducting research and prohibited using the money for executive compensation or buying back stock. Nonetheless, the IRS reports that the 2004 tax bill motivated 843 companies to bring back $312 billion. The 15 companies returning the most overseas profits in the 2004 episode proceeded to cut a net 20,931 jobs between 2004 and 2007, slightly decreased their spending on R&D, accelerated spending on stock buybacks, and, most preciously, granted their top five executives average pay increases of 27% from 2004 to 2005 and an additional 30% between 2005 to 2006.
All-in-all, the Tax Cuts and Jobs Act of 2017 seems to us to be the wrong policy, for the wrong reasons, at the wrong time. Contrary to President Trump’s depiction of a Christmas present for the middle class, we expect tens-of-millions of Americans to be angered by the bill’s capricious sacrifice of longstanding and coveted deductions for mortgage interest and state-and-local taxes on income and real estate. We believe President Trump’s signature on the Tax Act will likely mark an inflection point for U.S. financial markets, as awkward realities of a deeply flawed bill displace general investor optimism over tax cuts. Finally, growing recognition that the 2017 tax bill will contribute an additional $1.5 trillion to the ever-deteriorating U.S. fiscal position should further pressure the U.S. dollar, already suffering through its worst annual performance since 2003. In our opinion, gold markets are likely to take notice.
This content may not be reproduced in any form, or referred to in any other publication, without acknowledgment that it was produced by Sprott Asset Management LP and a reference to www.sprott.com. The opinions, estimates and projections (“information”) contained within this report are solely those of Sprott Asset Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. SAM LP is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. SAM LP and/or its affiliates may collectively beneficially own/control 1% or more of any class of the equity securities of the issuers mentioned in this report. SAM LP and/or its affiliates may hold short position in any class of the equity securities of the issuers mentioned in this report. During the preceding 12 months, SAM LP and/or its affiliates may have received remuneration other than normal course investment advisory or trade execution services from the issuers mentioned in this report.
SAM LP is the investment manager to the Sprott Physical Bullion Trusts (the “Trusts”). Important information about the Trusts, including the investment objectives and strategies, purchase options, applicable management fees, and expenses, is contained in the prospectus. Please read the document carefully before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication does not constitute an offer to sell or solicitation to purchase securities of the Trusts.
The risks associated with investing in a Trust depend on the securities and assets in which the Trust invests, based upon the Trust’s particular objectives. There is no assurance that any Trust will achieve its investment objective, and its net asset value, yield and investment return will fluctuate from time to time with market conditions. There is no guarantee that the full amount of your original investment in a Trust will be returned to you. The Trusts are not insured by the Canada Deposit Insurance Corporation or any other government deposit insurer. Please read a Trust’s prospectus before investing.
The information contained herein does not constitute an offer or solicitation to anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada should contact their financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction.
The information provided is general in nature and is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering or tax, legal, accounting or professional advice. Readers should consult with their own accountants and/or lawyers for advice on their specific circumstances before taking any action.
You are now leaving Sprott.com and entering a linked website. Sprott has partnered with ALPS in offering Sprott ETFs. For fact sheets, marketing materials, prospectuses, performance, expense information and other details about the ETFs, you will be directed to the ALPS/Sprott website at SprottETFs.com.Continue to Sprott Exchange Traded Funds
You are now leaving Sprott.com and entering a linked website. Sprott Asset Management is a sub-advisor for several mutual funds on behalf of Ninepoint Partners. For details on these funds, you will be directed to the Ninepoint Partners website at ninepoint.com.Continue to Ninepoint Partners