December 22, 2016
U.S. Tax cuts/reforms: How big a deal?
Introduction
President-elect Donald Trump’s surprise electoral victory and Republican control of both houses of Congress have raised
expectations that tax cuts/reforms will be one of the first items on the legislative agenda.
While Trump and many Congressional Republicans do not see eye to eye on such matters as trade and foreign policy,
they are in a broad agreement that taxes must be cut and the tax system reformed. The main point of contention is
whether tax cuts should be combined with reductions in government spending. Congressional Republicans, led by Paul
Ryan in the House and Mitch McConnell in the Senate, are in favour of reducing spending; while Trump campaigned on
the promise that entitlements would not be touched and that defence and infrastructure spending would be increased.
In our opinion, this difference should not prevent Trump and the Congressional Republicans from agreeing on a new tax
plan early in Trump’s mandate. For starters, the Republican leadership believes that its control of both the executive and
legislative branches of government has opened a window of opportunity that might not present itself again anytime soon.
The last time this occurred was during the presidency of George W. Bush (2003-2007). Before that, it was during the
presidency of Herbert Hoover (1929-1931).
Comparing tax proposals: Trump vs. Congressional Republicans
Under Trump’s plan, the corporate tax rate would be slashed from 35% to 15% and the top individual tax rate would drop
from 39.6% to 33%. The capital gains tax would be trimmed from 23.8% to 20% and the 40% estate tax (which applies to
estates worth more than $10.9 million) would be repealed.
The Congressional Republican plan, which has been championed by Paul Ryan, shares many similarities with Trump’s
plan. Both favour cutting the top individual tax rate to 33%, lowering the capital gains tax, and eliminating the estate tax.
They differ on the business tax which Ryan has proposed lowering to 20% instead of 15%.
Debt: the main point of contention between Trump and Congressional Republicans
The official position of the Congressional Republicans is that tax cuts must be combined with countervailing spending cuts
to avoid growing the debt. In contrast, Trump has made little mention of the need to reduce government spending. On the
contrary, he went in the opposite direction, calling for new infrastructure spending, more money for defence and no cuts in
pensions and healthcare for the elderly.
The Committee for a Responsible Federal Budget has estimated that, if fully enacted, Trump’s campaign pledges would
increase the national debt from its current ratio of 77% of GDP to 105% by 2026. Trump is already assuming the
presidency with the highest level of public debt since Harry Truman took office after World War II.
Luckily for Trump, the public is for the moment much less concerned than before about rising debt levels. A recent Pew
survey found that just over half of Americans considered the budget deficit a top priority, down from 72% in 2013.1 This
complacency is reinforced by the fact that, thanks to very low interest rates, the United States is making the lowest debt
payments as a percentage of GDP since the mid-70s, even though debt levels are much higher today. However, the
recent spike in bond yields could change the situation and once again turn debt into a high-profile political issue.
1
“Budget deficit slips as public priority,” Pew Research, January 21, 2016
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The odds are in favour of Republicans agreeing on a tax plan
Despite this seemingly wide difference of opinion over debt, we feel Congressional Republicans and President-elect
Trump will reach a compromise sooner rather than later for the following reasons:

Republicans feel that their control of both the executive and legislative branches of government represents a rare
opportunity that should not be wasted.

It is important to note that, historically, presidents have had the most success implementing parts of their agenda
in the first year or two of taking office. After that, the odds of passing major bills into law tends to drop
significantly. This is because a new administration’s honeymoon with voters tends to go sour over time, and this
quite often translates into losses for the governing party in the Congressional mid-term elections.

Trump has long maintained that his policy positions were open to negotiation. Further, unlike Obama, who had to
grapple with a Republican-controlled congress in the last few years of his mandate, Trump will have the much
easier task of negotiating with his own party.

Trump will not hesitate to use the presidency as a pulpit from which to lobby his political base to pressure
Republicans to support his policies.

The Congressional Republicans’ public support for making tax cuts revenue neutral is, upon closer inspection,
less iron-clad than first thought. For example, they support the use of a concept called dynamic scoring which
assumes tax cuts partly end up paying for themselves through the added economic growth they generate. Critics
of dynamic scoring consider it little more than a ploy to create overly optimistic long-term debt projections in order
to justify significant tax cuts.

The large deficits run up by both Ronald Reagan and George W. Bush shows that Republican aversion to public
spending and debt tends to be more pronounced when a Democrat sits in the Oval Office.
The 2011 Budget Control Act
Back in 2011, House and Senate Republicans negotiated an increase in the debt ceiling with the Obama administration in
return for cuts in defence spending (excluding war spending) and discretionary domestic spending (excluding entitlement
spending, such as pensions and healthcare). The deal allowed the U.S. Treasury to borrow the funds needed to pay all
U.S. bills and other legal obligations approved over the years by lawmakers from both parties.
The latest debt ceiling will be reached officially on March 15. But the Treasury will be able to buy the government a few
extra months to deal with the issue by using accounting procedures that will let it continue to pay bills without exceeding
the legal borrowing limit. It is also highly unlikely that Republicans will be as hard on Trump as they were on
Obama (e.g., they threatened to shut down government in 2011).
Democrats have long complained that the Budget Control Act hurt funding for vital programs such as education, while
Republicans have criticized its impact on defence spending. Trump has vowed to do away with the caps on defence
spending put in place by the Act. This suggests there is bipartisan support to dilute the Act if not repeal it entirely.
Will the tax plan end up being geared more towards the working class?
One of the biggest contradictions in Trump’s tax plan is that his political base consists largely of working class voters,
whereas those who stand to benefit most from his current tax plan are the very rich. Indeed, the Tax Policy Center has
estimated that the top 0.1% of the population (those earning over $3.7 million) would receive an average tax cut of 14%.
This compares to a reduction of only 1.8% for those earning between $48,000 and $83,000.
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However, in a recent public appearance, Steven Mnuchin, Trump’s nominee for Treasury Secretary, stated that
the main beneficiaries of the plan would be the working class, not the rich: “There will be a big tax cut for the
middle class, but any tax cuts we have for the upper class will be offset by less deductions that pay for it.”2
He cited placing a cap on tax deductions for mortgage debt interest as an example of one loophole that would be
narrowed. To date, no other details have been provided regarding what other deductions would be narrowed or
eliminated.
How Much Tax Do Corporations Actually Pay?
Officially, the corporate income tax rate in the United States stands at 35% (rising to 39% when state taxes are included).
In actual fact, however, many corporations pay far less thanks to a variety of accounting procedures that range from
keeping foreign income offshore to deductions for debt-interest payments. Standard & Poor’s estimates the effective rate
paid by companies to be 29%.3 Below is a listing of the effective tax rates—including federal, state and local taxes—for
the top 50 companies in the S&P 500 index. Domestically focussed firms tend to pay higher tax rates because they have
less opportunity than companies with large international operations to stash foreign profits overseas.
Source: “Trump and Congress both want tax cuts. The question is which ones,” The New York Times, November 12, 2016
Repatriation tax
Whereas many countries require corporations to pay taxes only on domestic profits, the United States extends its tax
reach to all global income. However, companies need to pay taxes on income earned abroad only when they bring profits
home. This has incentivized U.S. companies to keep an estimated $2.6 trillion in cash overseas to avoid taxation.4
Trump has proposed that firms pay a one-time tax of 10% to repatriate their cash from abroad.
The question is whether these repatriated fund would be mostly redirected into capital investments or used to finance
increased share buybacks/dividend payouts. Most of the $600 billion brought back from abroad during a 2004 tax holiday
2
“Trump's Treasury pick says he wants to slash taxes across the board,” CNBC, November 30, 2016
“Winners and losers from the Trump stock market rally,” The Economist, December 10, 2016
4
“Republican plans to cut corporate taxes may have unpleasant side-effects,” The Economist, December 14, 2016
3
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went towards the latter.5 Wilbur Ross, Trump’s pick for Commerce Secretary, wants to combine repatriation
incentives and corporate tax breaks in exchange for increased levels of capital investments.6
Congressional Republicans pushing for a major overhaul of the tax system
In addition to tax cuts, Congressional Republicans are pushing for a radical overhaul of the corporate tax system.
This includes two major proposals:

Eliminating the deduction for debt interest, which critics say encourages over-indebtedness. A deduction would be
granted instead for capital investments.

Taxing products based on where they are consumed rather than where they are produced. In practical terms, this
means imports to the United States would be taxed, but U.S. exports would not. This would mark a major shift
from the current system, which is aimed at collecting taxes on companies’ global income. Proponents of this
overhaul say it would eliminate the incentives for companies to hoard money overseas.7
While this plan would be a major boon to exporters, importers would take a big hit. It also raises the question of whether
other countries would consider this new tax system a form of protectionism.
How easy will it be for Trump and the Republican Party to pass a tax bill?
For the first time since 2007, Republicans will soon have control of both the executive and legislative branches
of government. The Republicans will hold 51 seats in the Senate against 48 for the Democrats. As for the House,
the Republicans will have 239 seats against 219 for the Democrats. While this constitutes a slim majority, particularly in
the Senate, it still leaves Republicans well positioned to pass major legislation that enjoys broad support within the party.
For legislation to become law, it must be approved by the two houses of Congress and signed by the President.
Traditionally, the minority party in the Senate has resorted to filibustering in order to obstruct legislation.
This is a process whereby the opponents of a measure require the other side to obtain a supermajority of
60 votes to pass a bill in the Senate. However, spending and taxation bills (via a process called reconciliation)
cannot be filibustered.
It is important to note, though, that using reconciliation to get a spending bill passed in the Senate via a simple majority
vote entails a drawback. If the bill significantly increases the federal deficit more than 10 years down the road, it expires.
This is known as the “Byrd Rule”. Under this scenario, Trump’s tax cuts would have to be renewed in a decade’s time or
they would expire.
Conclusion
We feel that the President-elect and Congressional Republicans will work out a deal to cut taxes and implement
significant tax reforms early in Trump’s mandate. The reasons for this are twofold:

Both Trump and Congressional Republicans are broadly in support of lower taxes and tax reform.

The widespread view among Republicans is that their control of all the federal branches of government is a rare
opportunity that cannot be wasted.
However, the tax cuts ultimately agreed upon will differ from Trump’s initial proposals in two ways: They are likely be
smaller in size and geared more towards the working class, though the very rich will still benefit tremendously as well. It is
important to note that even if Trump’s original plan for a $5.7 trillion tax cut was reduced by half, this would still constitute
a significant reduction in taxes. This agreement should also include a one-time 10% tax on corporate funds transferred to
the country from abroad.
5
“Winners and losers from the Trump stock market rally,” The Economist, December 10, 2016
“Legendary corporate dealmaker faces battle as Trump’s trade tsar,” The Financial Times, November 24, 2016
7
“House Republicans’ plan for a tax revolution: QuickTake Q&A,” Bloomberg, December 14, 2016
6
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The contradiction between the Congressional Republicans’ supposedly strong opposition to increasing debt levels and
their support for significant tax cuts will be papered over by their embrace of the concept of dynamic scoring, which
assumes tax cuts partly pay for themselves by stimulating economic growth. This will allow Republicans to claim that the
tax cuts/reforms in question will not raise debt levels substantially. Critics of dynamic scoring see it as little more than a
ploy to project overly positive long-term debt projections in order to justify large tax cuts.
Further, the final tax plan could also include elements of Republican proposals to overhaul the corporate tax system, such
as eliminating the tax deduction for interest on debt and taxing products/services based on place of consumption rather
than place of production. This means imports would be taxed, while exports would not. The risk is that many countries
would consider this new tax system a form of protectionism, and retaliate with countervailing measures.
All in all, we feel the tax cuts/reforms being proposed by Trump and the Congressional Republicans have the potential to
be a very big deal.
Angelo Katsoras
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ECONOMICS AND STRATEGY
Montreal Office
514-879-2529
Stéfane Marion
Marc Pinsonneault
Chief Economist & Strategist
Senior Economist
Kyle Dahms
Economist
[email protected]
[email protected]
[email protected]
Paul-André Pinsonnault
Matthieu Arseneau
Senior Fixed Income Economist
Senior Economist
[email protected]
[email protected]
Toronto Office
416-869-8598
Krishen Rangasamy
Angelo Katsoras
Warren Lovely
Senior Economist
Geopolitical Analyst
MD, Public Sector Research and Strategy
[email protected]
[email protected]
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