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US | Economy

Crucial Month Ahead for US Fiscal Trifecta

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US tax and spending negotiations is likely to deliver plenty of drama in the month ahead. The last of the COVID-19 related legislation, a US$3+ trillion Biden “social infrastructure” bill, is being finalised. There is a debt ceiling vote required to allow the US to keep borrowing. And then there is a bill to fund the government’s fiscal year 2022 initiatives. All of these require action in September/October, and the divided Congress is likely to erupt the fireworks as the deadlines loom.

 

The administration and Congressional Democrats have already scaled back the scope of several proposed tax hikes affecting corporate income, capital gains and carried interest, with more changes likely. However, prediction markets place the probability of passage of some form of sweeping tax legislation at 70%.

 

Equities most impacted by potential tax changes have rebounded, perhaps relieved by the absence of a corporate minimum tax in House legislation. Statutory corporate tax rates would rise just 5.5 percentage points after a 14-percentage–point cut at end 2017 (and likely even less on an effective basis). Individual income taxes – including a lower threshold for the top tax rate – carry a larger share of the revenue grab.

 

Partisan conflict could turn the annual debt ceiling ritual into one of the more troubling episodes. However, unlike 2011, Democrats control both houses of Congress, and could likely pass a debt ceiling increase by folding it into their reconciliation legislation with a simple majority.

 

The proposed gross fiscal expansion of US$3.5 trillion over 10 years is modest compared to the nearly US$5 trillion in emergency spending measures during the past two years. However, as markets now look to even modest tax increases, government support for the economy may not come “cost free” for investors.

 

US equity returns have been rapid year-to-year with the S&P 500 advancing over 20% following a similar gain in 2020. The rally has been strongly supported by what is likely to be 45% EPS gain this year.

 

In 14 cases during the past seven decades, US equities fell in the years featuring tax increases only once. Citi analysts would not alter the equity and bond allocations around US tax issues alone. Higher spending on US infrastructure and alternative energy may reinvigorate the performance of related shares.

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