US Tax Reform Achieved, but at a Cost

President Donald Trump secured the biggest win of his presidency on Wednesday as the Republicans passed the most sweeping US tax overhaul in three decades. The Republican leadership believes that the tax changes will help to simplify a complex tax code, provide relief to most tax payers and foster US international competitiveness.

• Citi analysts believe that while the tax reform may provide a transitory lift to US real GDP growth, it will result in larger deficits and debt. They also anticipate that the tax reform will be accompanied by spending cuts which will produce a fiscal drag that offsets the stimulus. In 2018, the Administration and the Republican leadership will likely focus on welfare reform which may reduce spending on healthcare and public assistance, as well as scale back the size and scope of discretionary outlays for government agencies. Citi analysts continue to expect three Fed rate hikes in 2018.
• On balance, Citi estimates that the fiscal stimulus from the tax reform plus spending on infrastructure, defence and security will add a cumulative additional 1.5 percentage point to GDP growth over 2018-2022. The annual federal budget deficit as a share of GDP is likely to expand from 3.5% in 2017 to 5.2% by 2022. Deficits are unlikely to improve until 2026 if legislators do not consider deep spending cuts to achieve budget surpluses. Public debt as a share of GDP may increase from 76% in 2017 to 89% by 2022 and then to 96% by 2027.

Rein in Expectations

• For US companies, a key component in the tax overhaul is the cut in the corporate tax rate from 35% to 21%. This potentially brings the US corporate tax rate broadly in line with the average rate in the developed world. While Citi analysts calculate that a 1% tax rate decline theoretically adds nearly $2 to earnings per share, they caution that investors may want to rein in their expectations for a large boost in earnings and share prices.
• For one, given the strength in the S&P500 and particularly in domestically-oriented industries’ stock prices in the earlier weeks, the impact of the tax reform is probably largely priced in. Many companies are also likely to use some of the tax savings for price discounts and/or more market expenditures. Hence, the full benefit of the tax cuts may not be reflected in earnings. Changes in interest expense deductibility, capital expense write-offs could also dilute the impact of the lower corporate tax rate although Citi analysts also note that many US companies’ effective tax rate is already lower than 35%. As such, Citi analysts suggest that investors remain selective within US equities, especially since investor sentiment has been climbing higher. They favor the Financials and Energy sectors within the US, given positive business fundamentals, earnings momentum and valuations.
• On the currency front, Citi continues to believe that the dollar has peaked. Real growth rates in Europe, Japan and the Emerging Markets are picking up and converging with the US, reducing the cyclical support by the US dollar. The swelling US federal budget deficit and debt over the medium term may also weigh on investor sentiment towards the dollar.