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A Detailed Look at What to Expect From Tax Reform

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A Detailed Look at What to Expect From Tax Reform

Convex Capital Management introduces its Roadmap for 2017 series, which will provide investors a guide through an uncertain 2017. We begin the series by looking at tax reform. In the next several weeks we will focus on other upcoming issues, including trade and health care policy.

Tax Reform

Stock indices have risen sharply since the Presidential election on November 8th 2016, accompanied by rising interest rates, on the expectation of a significant fiscal push in 2017. The biggest piece of a potential fiscal package is a comprehensive overhaul of the U.S. tax code. The optimism on this front comes from the fact that tax reform is a policy area where priorities of President Trump and Congressional Republicans find the most overlap.

Given the focus on tax reform, we believe it is worthwhile taking a closer look at the policies presented by President Trump during his campaign and the proposal released by Congressional Republicans in July 2016 (called ‘A Better Way’). With Republicans controlling the Presidency, Senate and Congress, it would seem that tax reform should pass fairly quickly. However, we believe this may not be the case.

All pieces of legislation involve certain trade-offs, resulting in winners and losers. Comprehensive tax reform will impact the entire economy, as opposed to just a slice of it (like healthcare reform), raising the stakes considerably. Tax reform, as presented in either of these blueprints, would be the largest overhaul of the tax code we have seen in recent U.S. history, with the potential to impact every single aspect of the economy, and even global trade.

In this paper, we provide snapshots of key elements within each plan to see how they differ from each other, and from current law. We discuss the potential impact of various provisions on individuals, businesses and the macro economy. The paper also looks at the costs of the two proposals, including provisions that cost money and those that raise revenue, which will give us an idea of where negotiations may get stuck. We use the non-partisan Tax Foundation’s analysis of the Trump Plan and Better Way throughout this paper.

We start with ordinary income tax rates and capital gains and dividend tax rates, an area where the two proposals see the most alignment.

Individual income tax rates

Exhibit 1 shows individual income tax brackets under current law, the Trump Plan and Better Way. Both proposals cut the number of tax brackets from seven to three, with the top rate reduced from 39.6% to 33%. The Trump plan creates new thresholds for its three brackets while Better Way aligns thresholds with the current law.

While both plans give all taxpayers a cut, Exhibit 2 shows their impact at different levels of taxable income.

Effective tax rates, i.e. income tax divided by taxable income, see the maximum drop in the middle of the distribution, with the Trump Plan giving much larger tax cuts. For example, under current law the effective tax rate at a taxable income level of $100,000 would be 19.3%, whereas this would drop to 15.3% and 18.5% under the Trump Plan and Better Way, respectively.

Capital gains and dividend rates

The Trump Plan and the Better Way plan retain the current slab of three rates on long-term capital gains and dividends. However, as Exhibit 3 shows, the two plans simplify things considerably since they have only three ordinary income tax brackets. Both plans get rid of the additional tax that is currently levied on net investment income larger than $200,000 for a single person and $250,000 for couples.

The Better Way plan actually has the same capital gains and dividend tax rates as the marginal tax bracket, but it also allows a 50% deduction – which essentially means the rates are halved. The impact of this can be seen in Exhibit 4. Investors who fall under the top tax bracket currently (of 39.6%) pay 20% plus the net investment income tax, if applicable. Under the Trump Plan, investors in the top bracket (of 33%) will see just a 20% rate whereas under Better Way, they would see a fairly large drop in their capital gains and dividends taxes, down to 16.5%.

Both proposals also completely eliminate the alternative minimum tax, gift taxes and the current estate tax of 40% on estates valued in excess of $5.45 million. However, the Trump Plan would not permit a step-up in basis for estates over $10 million, essentially taxing all of the estate’s appreciation (current law allows a step-up in basis).

It is very likely that a Republican Congress and the administration will quickly find common ground as far as reducing the number of ordinary income tax brackets are concerned. However, it is an open question whether Senate Democrats would go along with lowering taxes for those in the top bracket, but they may do so as part of a deal to reduce tax rates more broadly.

In any case, taxpayers are likely to see a significant increase in take- home pay if tax reform passes, resulting in a boost to the economy if that translates into more spending. However, the significant reduction in tax rates results in revenue loss for the government and both plans seek to make this up by broadening the base, i.e. have more people pay taxes by limiting deductions and credits.

Standard deductions, exemptions and credits

As Exhibit 5 shows, the Trump Plan increases the standard deduction from $6,300 to a whopping $15,000, while Better Way raises it to $12,000. Both proposals make up for this by completely eliminating personal exemptions. The Trump Plan also eliminates the current child tax credit of $1,000 (per child), while Better Way raises it to $1,500. The Trump Plan instead allows for deduction of childcare expenses for low-income families.

You can see how current law favors families of larger size in Exhibit 6. A family of five (including three children) receives up to $3,000 in child tax credits under current law. Since President Trump’s plan eliminates personal exemptions, the overall tax adjustment for the family is actually lower than the current tax structure. The Better Way proposal also lowers overall adjustments for families but it does increase the child tax credit, which will mitigate the political cost.

It is likely that all the various parties will probably reach an agreement in this area so as to start clawing back some of the revenue that would be lost by lowering overall tax rates and prevent the deficit from rising sharply.

Itemized deductions

Under current tax law, itemized deductions are a critical means by which taxpayers, mostly higher-income households, deduct their taxable income, especially since there is no limit to the amount of deductions.

While a majority of households chose to take the standard deduction, 30.1% of households opt for itemization. For households over $75,000, the majority chose to take itemized deductions (93.5% of households with incomes larger than 200,000 opt to itemize). This is obviously an area that is ripe for revenue claw-back and both plans target it. At the same time, this is where negotiations on tax reform can start to get really difficult.

As Exhibit 7 highlights, the Trump Plan introduces caps on deductions at a certain level, whereas the Better Way proposal takes it a step further by eliminating most itemized deductions, keeping only charitable contributions and mortgage interest. The Trump Plan is unclear whether these would be allowed, and whether excess deductions will be allowed to carry forward to the following year(s).

While the Better Way provision of completely eliminating itemized deductions appears to be a simpler approach than the Trump Plan, the hurdles are immense. Small business owners, who typically pay for their health insurance, will not be able to deduct these expenses. High-income residents of high tax states like New York and New Jersey will not be able to deduct their state and local taxes, and Congressional members from these states are likely to lobby hard against this. Households will also not be able to deduct their real- estate taxes under this plan, which could impact the real-estate market. The National Association of Realtors and other powerful real-estate lobbies would be expected to strongly oppose this piece of tax reform.

Business taxes

This is perhaps the most discussed piece of reform, and on the face of it, where the Trump Plan and Better Way have a lot of overlap. Nevertheless, we will see why things may not be quite as simple as it may seem.

Unincorporated business tax

We start with taxation of unincorporated businesses, such as Sole Proprietorships, Partnerships and S Corporations. These are currently taxed at the individual level, at ordinary income tax rates. Both the Trump Plan and Better Way propose to do away with this structure and have these business owners pay a flat tax – 15% with the Trump Plan and 25% with Better Way.

One can immediately see where the difficulty lies. What is to stop individuals in higher income tax brackets from redefining their wages as business income, a potential abuse that would be larger under the Trump plan. Neither plan is clear on how they would go about overhauling the treatment of unincorporated business income, especially with respect to dealing with potential abuses.

Corporate tax

The current corporate tax rate is 35%, but it does allow companies to deduct interest and amortize the cost of asset acquisitions. This is in addition to several other deductions and credits, including the Section 199 deduction, which is a tax break for domestic manufacturers.

That the corporate tax in the United States is on the higher side relative to other developed countries of the world is a well- acknowledged fact. Yet, Congress and prior administrations have not been able to come to an agreement on how to go about lowering it without significantly reducing tax revenue. Many companies have avoided paying the high tax by transferring funds to a subsidiary in a country where the tax rate is far lower. This has been a notable policy issue for some time, and the new administration and Congress believe they have a plan to eliminate such loopholes.

As Exhibit 8 shows, the Trump Plan slashes the corporate tax rate down to 15%, while the Better Way plan pulls the rate down to 20%. In a bid to boost domestic manufacturing, both proposals allow businesses to deduct all of their acquisition costs. This is a significant departure from current law, which allows companies to amortize the cost of acquisitions over a period of years – the Trump plan preserves this as an option for businesses.

However, neither proposal will allow simultaneous deductions for interest expense, or else a company could potentially take a loan to acquire assets and deduct their cost as well as interest on the loan (existing loans would be grandfathered in).

Businesses that rely heavily on debt versus equity financing will be hurt, as well as several private equity deals. Allowing businesses to expense all of their acquisition costs, while removing the deductibility of interest expenses, could result in U.S. companies relying less on borrowing. This would have enormous implications for the corporate bond market and the overall economy.

On the face of it, the new proposals would be a good move since a lower tax rate and full deductibility would lower the cost of capital for businesses, over the long-term. The problem is that corporate America has issued a record amount of debt over the past several years, taking advantage of record low interest rates. Yet, most of the debt has gone toward buybacks, dividends or mergers and acquisitions, as opposed to investment spending. With the Trump administration and Congress looking to boost the economy, the question is how quickly businesses can change their model of operation with respect to financing new investments.

Lowering the corporate tax rate by such a large degree would obviously put a signifcant dent in fiscal revenue. In a bid to claw back some revenue, both plans eleminate the domestic production activities deduction and all other business credits, except for the Research and Development credit.

Both plans also enact a deemed repatriation of currently deferred foreign-source income, at a rate of 10 percent for the Trump Plan and 8.75 percent for Better Way, so as to bring these funds back in to the United States and drive investment spending. The Better Way proposal also moves to a fully territorial tax system, essentially exempting U.S. businesses from taxes on their foreign-source income. This would be a very generous provision for the technology, pharmaceutical and energy sectors. However, since these companies already have a significant amount of cash on-hand, it is very likely that any benefit will be driven towards more dividends, buybacks, debt repayments as well as mergers and acquisitions, rather than into physical investments.

This is where the similarities between the two plans end.

In addition to reducing the corporate tax rate, President Trump would like to further incentivize domestic manufacturers by imposing a tariff on imports from countries like Mexico and China, with whom the U.S. has a substantial trade deficit. As we will discuss in a future paper on trade policy, imposing tariffs (without proving dumping) would be violation of NAFTA and WTO rules and likely to result in a trade war that no country would benefit from. This is an area that would come under the purview of the executive branch directly, as opposed to Congress, and the Commerce department would have to institute arbitrary tariffs on specific goods or all goods originating from a specific country.

The Better Way plan seeks a more gray area with respect to encouraging exports over imports by instituting a border adjustment tax (BAT). We discuss the BAT more in-depth in the following section, since such a tax would have enormous implications for the U.S. economy.

Border adjustment tax

Under current law, all U.S. companies can deduct the cost of goods sold, irrespective of where they were produced. If a BAT were implemented, as in the Better Way plan, businesses would be banned from deducting the cost of imports that go into products they sell domestically. At the same time, they will be able to deduct export revenue, thus removing these from the tax base. Since the U.S. imports more than it exports, the provision would raise revenue, essentially by taxing the trade deficit. It would also align with President Trump’s stated priority of revitalizing the U.S. manufacturing sector.

A BAT is not exactly a tariff since it applies an existing tax to all imports and exports – a border adjusted tax – and so it is unclear whether it would run afoul of WTO rules. Proponents have likened it to a value added tax (VAT) that several other countries implement. Technically, a VAT would not allow businesses to deduct payroll but the Better Way plan maintains this.

We have written separately on how a BAT would work by looking at stylized examples. Suffice to say, this would be a major attempt to change how the U.S. economy works.

Take a retail company like Walmart, which depends primarily on imports for sales and eventually profit. Under a BAT, the company would pay a 20% tax (the new corporate tax rate under the Better Way) on the cost of the imported product and an additional 20% tax on its profit. They would not be allowed to deduct the import cost like they are able to today. Even a company like Toyota, which is the third largest automaker in the U.S. and employs close to 40,000 people (directly), would see a hit to their bottom line since they import about 1.2 million vehicles into the U.S. annually, half of its 2.4 million sales.

In the short run, retailers are likely to pass higher prices on to their consumers, cut jobs and/or lose money, all of which would impose a severe political cost as well. At the same time, exporters will benefit considerably since export revenue will be exempt from taxes, effectively subsidizing them. One can begin to see why under such a scenario, importers would lose out and exporters would gain, thus incentivizing the latter.

Supporters of the BAT, along with several economists, argue that the above situation will not occur since foreign currencies will depreciate against the dollar if the U.S. implements such a tax. In theory, foreign currencies will depreciate 20% against the U.S. dollar to balance out the effect of the 20% BAT.

Also, the U.S. will not be implementing a BAT in a vacuum, and America’s trading partners may not want to see such a large depreciation in their currencies. Their respective Central Banks may very well intervene to prevent this from happening, especially in emerging countries that also have to worry about inflation. Mexico’s central bank already intervened in early January to halt the slide in the peso, lifting the currency off its record lows against the dollar. A country like China, which is trying to manage its own economic transition, may not be keen on seeing even more disruption to its export industry. This could result in retaliatory measures that may hurt several U.S. sectors. For example, the food and agriculture industry relies heavily on export markets like China. Other countries could also challenge the measure at the WTO. Europe is already preparing the groundwork for such a challenge, which would be the biggest case in WTO history.

A BAT could cause significant churn and disruption in the domestic economy, especially since the U.S. is mostly reliant on personal consumption for economic growth. Retail companies, including Walmart, Target, Home Depot and Nike (amongst the nation’s largest importers), fear large tax increases under this plan. Members of the National Retail Federation have warned that a BAT could be as high as five times their profits (net margins in the industry are lower than 5%).

The largest importers have already begun an intense lobbying effort to kill the BAT proposal, calling it a “consumer tax”. At the same time, exporters such as Dow Chemical, Boeing and Caterpillar have formed the “American Made” coalition to promote the measure. With such heavyweights lined up for and against the measure, it is an open question as to whether the provision will pass. President Trump has also questioned the measure previously, deeming it “too complicated”, and in a recent meeting with retail chief executives (including those from Target, J.C. Penney and Gap), discussed tax reform without mentioning a BAT.

There are also significant challenges with respect to actually implementing a BAT, i.e. how to ensure all imports are taxed and how would exporters get a rebate. This would have an impact on how well it works in reality.

The cost of tax reform

The biggest hurdle that Congress will have to clear as they work toward tax reform is its impact on fiscal revenue. It is still too early to estimate the exact cost of tax reform, especially since proposed policies may see significant changes once they are officially introduced in Congress and are discussed. However, for the purpose of this analysis, we use the Tax Foundation’s estimates of revenue impact for the two plans. Our goal is to get a sense how the two proposals seek to offset the enormous cost of lowering tax rates on individuals and businesses.

Individual Income Taxes

Exhibit 9 illustrates the revenue impact, over ten-years, of different provisions on the individual side of tax reform for both plans, as estimated by the Tax Foundation. For both proposals, the largest hit to revenue on the individual side comes from consolidating tax brackets (from seven to three, as we saw earlier). Under the Trump plan, simplifying brackets costs almost $1.5 trillion, while the number is close to $2 trillion for Better Way. Additionally on the negative side are the costs of cutting capital gains, dividends and net investment income taxes, as well as eliminating the alternative minimum tax (AMT), estate and gift taxes. All of these, combined with the costs of increasing the standard deduction and making changes to child care expensing/credits, result in more than $3 trillion of costs – which both plans will have to offset by raising revenue.

As the graphic shows, the Trump Plan’s approach to raising revenue, mostly by capping itemized deductions, offsets just about 25% of the costs. The Better Way plan goes further, by completely eliminating itemized deductions, but still covers only about 75% of costs on the other side.

Given the various interests that would be aligned against limits on itemized deductions, or its elimination, the provision is likely to see intense opposition. Of course, lawmakers could ultimately choose to shelve this piece, but that would mean raising the deficit, which fiscal conservatives in Congress are deeply opposed to.

Corporate Taxes

The corporate side of tax reform is even more imbalanced than the individual side, for both plans. Exhibit 10 shows that the Trump Plan’s provisions to lower the corporate tax rate to 15%, lower the rate on pass-through income and allowing businesses to chose between full expensing or interest deductibility costs almost $4 trillion over the next decade. The only offsetting revenue comes from eliminating business credits and taxing repatriated foreign-sourced income, barely covering a tenth of the costs.

As we discussed earlier, the Better Way proposal allows businesses to fully expense their acquisitions. However, this generous provision turns out to be the most expensive piece of the plan, lowering revenue over the next decade by more than $2 trillion. Combined with the costs of lowering corporate and pass-through income tax rates, it adds up to more than $4.5 trillion over the next ten-years. The proposal does claw back a significant portion of this, up to $3 trillion, by disallowing interest deductions, imposing the border adjustment tax and eliminating business credits. Yet, that still leaves a fiscal hole of $1.5 trillion.

We can see in Exhibit 10 that the BAT provision is expected to raise more than $1 trillion over the next ten years, and hence it is vital to Congressional members who do not want tax reform to explode the deficit. However, as we discussed in the prior section, there are several heavyweight businesses lined up against the BAT and it remains to be seen whether the provision will actually make it into the final bill. Without it, Congress will have to look elsewhere for revenue that offsets the cost of reducing tax rates, or ultimately chose to abandon a revenue-neutral package altogether.

Overall cost

Even if we assume that Congress can agree on and pass all the provisions that offset some of the costs of tax reform, both plans leave a considerable fiscal gap. The Trump plan reduces revenue by almost $6 trillion over the next decade, while Better Way reduces it by more than $2.4 trillion.

However, proponents of tax reform argue that reducing taxes will result in more economic activity and broaden the tax base. They make the plausible case that tax reform will cost substantially less than the estimates above, which do not account for higher economic growth that will come about as a result.

The Tax Foundation estimates costs on a static basis, which excludes the impact of reform on the economy, as well as on a dynamic basis, which accounts for it. Their economists use a “dynamic scoring” model that is designed to isolate and measure the effects of tax changes on the cost of capital and the cost of labor. After the costs are calculated, the model then simulates the effects of tax changes on GDP, investment, jobs and federal revenue.

The model is essentially based on the neoclassical view of the economy, that the willingness of people to deploy capital and to work more are the two main drivers of economic growth. Taxes are an important factor that people take into account before making new capital investments, as well as where they decide to locate these investments. Taxes also affect people’s decisions to work and how much they work.

Comprehensive tax reform, as described in the Trump Plan or Better Way, would potentially create a larger economy, with more people working and paying taxes, in addition to higher wages. This would result in more tax revenue than that estimated when scoring on a static basis. Similarly, lowering corporate taxes and allowing businesses to fully expense investments could result in more economic growth as they can make more productivity enhancing investments. This would also broaden the corporate tax base. As a result, on a dynamic basis, the cost of tax reform reduces considerably.

Exhibit 11 compares the overall cost of the Trump Plan and Better Way under static and dynamic scoring. With dynamic scoring, the Trump Plan reduces federal revenue by just under $4 trillion over the next decade, compared to $6 trillion when scored on a static basis. The Better Way Plan reduces revenue by less than $200 billion when you consider the macroeconomic impact of tax reform, versus close to $2.5 trillion under static scoring.

So dynamic scoring is another key piece of the puzzle as tax reform moves forward, since it shows lower costs by accounting for the positive impact of lower taxes on individuals and businesses.

Economic Impact

The Tax Foundation’s model projects that larger incentives for labor and investment under the Trump Plan would increase the size of the economy by an additional 8.2% over the next decade, and create 2.2 million more full-time jobs. This growth is over and above the baseline real GDP growth of almost 20% over the next ten years (as projected by the Congressional Budget Office under current law). In other words, the Trump Plan is expected to raise average annual real GDP growth from 1.9% to 2.5% over the next decade.

The Better Way plan is projected to increase the long-run size of the economy by an additional 9.1% over the next ten years, including 1.7 million more full-time jobs. This is equivalent to increasing average annual real GDP growth from 1.9% to 2.6% over the next decade.

An important caveat here is that the Tax Foundation’s model does not account for how trade would be affected by tariffs or a BAT, or any other polices like healthcare or immigration, either of which could have a significant impact on the economy. The model also does not take into account the impact of interest rates on the fiscal situation or the broader economy. For example, if economic growth picks up as a result of tax reform, the Federal Reserve may respond by raising interest rates at a faster pace to avoid a risk of overheating. So it is probably best to think of the dynamic scoring model estimates as one possible scenario, as opposed to a forecast.

Tax reform and monetary policy

The current proposals for tax reform have been compared to those implemented under the Ronald Reagan and George W. Bush administrations. President Reagan passed the Economic Recovery Act in August 1981, and President Bush passed the Economic Growth and Tax Relief Reconciliation Act in June 2001, a plan that sunset at the end of 2010. Both bills were introduced to provide relief to taxpayers amid economic slowdown. Ronald Reagan was elected in November 1980, in the midst of the 1980-1982 recession. While the economic situation was not quite as dire when George W. Bush took office in 2001, the Internet stock bubble had just burst and the country entered into a recession soon after. Tax reform did not prevent a recession from occurring under either administration. In fact, Federal Reserve policies helped lead to a recession in both cases.

In a bid to curb inflation, Paul Volcker’s Federal Reserve continuously raised the federal funds rate between 1979 and 1981, hitting a high of 20 percent in June 1981. Inflation peaked at 14.6% in March 1981, before falling to 2.4% in 1983 thanks to tight monetary policy. However, higher interest rates drove the economy into a recession that stretched from July 1981 through November 1982. The unemployment rate peaked at 10.8% in November 1982 and about 2.7 million jobs were lost during the recession. Lower tax revenues and a recession also ballooned the fiscal deficit from -2.6% of GDP in 1980 to -5.7% of GDP in 1983. Much of the 1981 tax cuts were eventually reversed in 1982, as concern grew over the deficit.

Alan Greenspan’s Federal Reserve raised the federal funds rate at six successive meetings in 1999 and 2000, to a decade-long high of 6.5%. Their objective was to prevent the economy from overheating amid the Internet stock bubble. The Federal Reserve eventually reversed course and started to lower rates in 2001, but were unable to prevent the economy from entering into a recession between March 2001 and November 2001. The economic slowdown continued through to 2003, and the economy lost about 2.6 million jobs between March 2001 and May 2003. The fiscal balance went from a 2.3% surplus in 2000 to a -3.3% deficit in 2003, due to the recession and lower tax revenue.

The current economic environment looks very different. The last few years have seen a slowly tightening labor market amid steady, though lackluster, economic growth. The labor force is also aging, meaning there are fewer workers. So any fiscal push may eventually lead to higher wage growth and inflation, which means the canary in the coalmine here is the Federal Reserve.

The Federal Reserve has only recently embarked on a path of rate hikes, after leaving them at the zero level for seven years. Core inflation, as measured by the consumer price index excluding food and energy, stood at 2.2% at the end of 2016, which is higher than the Federal Reserve’s target. It is not hard to envision the Federal Reserve playing catch up and raising rates at a faster clip in a bid to prevent the economy from overheating, especially if a massive fiscal push generates persistently higher inflation. However, as in the early 1980s and 2000s, there is the risk that this could lead the economy into a recession.

Conclusion

The key objective behind comprehensive tax reform is to incentivize individuals and businesses by lowering tax rates. The proposals we discussed in this paper would simplify individual tax brackets and reduce the corporate tax rate, while eliminating many deductions and credits. However, tax reform as stated in these blueprints would also change how U.S. businesses operate and incentivize certain sectors of the economy over others. The proposals would have an enormous impact on every single aspect of the largest economy in the world, and certain provisions like the border adjustment tax would even impact global trade.

Any final tax reform package may look quite different from the two plans we considered in this paper. However, our goal was to provide a snapshot of the key provisions in each proposal, as well as the trade-offs that will have to be made as Congress tries to write a revenue-neutral tax bill. The fiscal deficit already stands at -3.2% of GDP, while federal debt (at 105% of GDP) is at its highest level since the late 1940s. Several members of Congress will be against driving these deeper into a hole with tax cuts that are imbalanced.

Consensus can probably be reached swiftly in areas that involve cutting taxes, whether individual or corporate, but the real test is whether Congress can reach an agreement on offsetting revenue, i.e. coming up with a “pay-for” in Congressional parlance. This is enormously challenging for legislators even under the best of circumstances. There is always some constituency or group that is lined up against proposed tax increases or spending cuts. In the case of tax reform, the lobbying effort will be immense, with powerful groups lined up for and against almost every single provision. As we discussed earlier in the case of a potential border adjustment tax, there is already a backlash from domestic corporations that are amongst the U.S.’s largest importers.

Passing any sort of tax reform legislation has never been an easy task. The Reagan and Bush tax cuts were made temporary to facilitate passage through Congress, not to mention the fact that they were done in the midst of economic downturns. The current proposals intend to make significant long-term changes to the U.S. tax code, which means passage will be even more difficult.

Another key issue is that Republicans in Congress are currently relying on a careful sequence of legislation for 2017, with tax reform coming only at the very end, so Congress will have to pass a repeal and replace of the Affordable Care Act (ACA) before they even get to debating a tax bill. Conditioning tax reforms on ACA repeal and replace, which will be just as hard to do, reduces the likelihood of comprehensive tax reform.

Financial markets appear to be pricing in a tax reform package that puts more money in individuals pockets and significantly lowers the cost of doing business in the U.S. Yet, they do appear to be ignoring some of the trade-offs that will have to be made in order to raise revenue, let alone provisions that could cause significant economic churn. It is also an open question as to whether tax reform will even get through Congress, especially given the sequence of events that will have to occur before a final bill ends up on the President’s desk for his signature.

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