The Problem With Tax Cuts

There are multiple substantial fiscal and monetary issues right now that investors have to try to consider. On the fiscal side, there's the debt ceiling, the 2018 federal budget and the Trump tax plan. On the monetary side, there's the upward trajectory and its continued telegraphing by the Fed, as well as the added consideration of reducing the size of the Fed's balance sheet, which I discussed last week. 

Assessing each of these issues individually is challenging enough, but having to consider multiple variables at once requires a good understanding of the macroeconomic environment and how it relates to each issue. 

I last addressed the problem for tax cuts amid a dearth of demand last December. 

Now that the promised agenda looks likely to be pursued legislatively, I'll consider the issue from the other principal vantage point -- availability of capital. 

Just as lower federal income tax rates are an ineffective way to counteract a dearth of private-sector demand, it is also ineffective and perhaps even counterproductive if it is done when there is no dearth of private-sector capital available. 

Lowering tax rates with the intention of causing private-sector economic activity, and thus tax receipts, to increase assumes the current levels are high enough to stymie incentive for domestic capital investment. 

That means the rates are causing capital to flow out of the U.S. or that there is simply a dearth of capital available to invest in the U.S. 

On the outflow-of-capital issue, the response was supposed to be the adoption of a border adjusted tax that would reduce the relative attractiveness of investing outside of the U.S. That looks like it's been temporarily shelved, though. 

That leaves the primary tax policy being lower domestic personal and corporate tax rates. 

If there was a lack of private capital available for investing that was restraining investment, growth and thus tax receipts, this could, as a stand-alone move, provide a catalyst to reverse such. 

However, and this is profoundly important, there hasn't been a lack of available capital issue since the Fed lowered the fed funds target rate to 0-25 basis points in December 2008. 

That means lowering the tax rates won't increase the available investment capital and won't incentivize investment, which means it won't cause economic activity and tax receipts to increase. 

It's more probable that doing so will exacerbate the federal debt situation by causing tax receipts to decline. 

Also, because the tax cuts are predominantly focused on high earners, it won't cause consumption to increase. 

It will, however, provide capital to drive stock prices and multiples to earnings higher, and will as a result be positive for the stock market broadly and especially large companies and utilities as the beneficiaries seek to park their retained incomes in sectors least impacted by economic activity. 

That doesn't mean lowering tax rates is not a viable part of a broader restructuring of the tax code that could achieve the stated economic objectives of growth, job creation, increased tax receipts, relative increase in domestic investment and similar. 

It is intended to show conceptually, though, that each tax code change is not an incremental step that is independent of other changes. 

Lowering tax rates, without also including a border tax adjustment and/or an increased federal spending agenda targeted at directly increasing economic activity, will be counterproductive. 

At this point, I'm not sure how many around President Trump are aware of this. 

It may be that everyone knows this, but has decided that political pragmatism mandates pursuing tax changes incrementally. 

The most important point for investors is that the probable tax policy changes appear to be very positive for stocks and the stock market but less so for the economy, and negative for tax receipts. 

If lower tax rates are not adopted simultaneously, or close to it, with a domestic federal investment program of some kind, the negative impact of lower tax rates on tax receipts will make any domestic spending proposals not politically possible, perhaps even before the midterm elections. 

The situation is obviously very fluid right now. The best thing investors can do is to be watchful for signs of awareness of all of this from the president's team and members of Congress.

At the time of publication, Arnold had no positions in the stocks mentioned.