The Possibilities of Trump’s US

The Possibilities of Trump’s US

Drawing from his business background, Trump may treat the US as a "Trump Inc." Fortunately, President-elect Trump really likes debt. This is a good thing because—as it stands—his tax plan requires gobs of it. His administration will inherit a significant debt load, though, so this may limit his ability to execute some of his more ambitious fiscal plans.

To turn Trump Inc. into a successful operation, he will have to work through a balance sheet in disarray and an income statement in dire need of growth. Granted, it is not all bad news for the president-elect. The balance sheet reflects the effects of the Great Recession and the subsequent slow-growth environment. But it is still salvageable. The income statement could also be worse. The deficit has actually shrunk in recent years. In 2015 it was 34% lower than in 2014.

But there are significant reasons to be skeptical in the near term. Already running a deficit, Trump Inc. needs to cut costs and increase its income streams. Several solutions are under consideration. These include using a “border adjustable” tax rate and lowering the repatriation tax on cash held by US businesses overseas. But these ideas may not meet the cash flow stimulus required. The plan targets businesses, but the US tax burden rests mostly on individuals, not corporations. (See Table 1.)

The Income Statement

With 75% of Trump Inc.’s income coming from individual income taxes, altering the personal tax code will make for a huge change in government revenue (Table 1).

Much of this will depend on how “pass-through” income is treated. Pass-through income is business profit treated as personal income. It is presently treated as earnings and taxed at the corporate level. The House GOP tax plan calls for a 25% top marginal rate on pass-through income.

For its part, corporate taxes constitute about 10% of the overall tax base. Therefore, the proposal to lower the corporate tax rate would have relatively little impact on the budget deficit. The Tax Foundation (TF) estimates that the proposal to repatriate overseas cash at an 8%–10% tax rate would raise $200 billion in taxes over a 10-year period. This could possibly provide a lift to business investment, but repatriation would do relatively little to boost revenue.

But the driver of tax revenue may change if some of the recommendations from the House GOP plan are implemented. The mechanism of transferring (at least some of) the tax burden would be a so-called “destination based” tax.

This works through the use of a tax that is “border adjusted” to make everything sold in the US effectively have the same tax rate. Consumption would be taxed, rather than taxing based on whether it was US produced. Given the level of US imports versus US exports, this could raise revenues for Trump Inc. as much as $1.2 trillion over the next 10 years—according to the Tax Policy Center (TPC).

Not a trivial sum, but this tax will more than likely be deemed illegal under World Trade Organization rules. This is because it effectively acts like a tariff.

US Income Statement (Table 1)

Source: Bureau of the Fiscal Service 
US Department of the Treasury
(In billions of dollars)
2015
Revenue:
Individual income tax and tax withholdings
2,545.20
Corporation income taxes
339.8
Excise taxes
101.7
Unemployment taxes
49.1
Customs duties
33.6
Estate and gift taxes
19.1
Other taxes and receipts
202.9
Miscellaneous earned revenues
42.6
Total Revenue
3,334.00
Net Cost of Government Operations:
Total net cost
3,858.80
Unmatched transactions and balances
5.1
Net operating (cost)/revenue
-519.7

Initially, the combination of personal and corporate tax breaks will have a relatively small effect on the income side. The TPC estimates about an $11 billion revenue loss in 2016. However, this reduction becomes more pronounced in subsequent years. 2018 will be the lowest year, with a loss of more than $339 billion.

Over 10 years, the income loss is estimated at $2.5 trillion by the TPC and almost $4 trillion by the TF. Even the lower of the two figures is astounding.

There is also a cost side to an income statement, and here there is little concrete information. Trump Inc.’s latest business plan would be spending neutral. Normally, this would be a good thing. Trump Inc. would grow, and spending the same amount would allow the bottom line to grow over time.

However, given the deep cuts to revenue, the lack of spending cuts will cause the deficit to grow. Without offsetting spending cuts, the health of the income statement is likely to deteriorate—or at best not improve much—over the next decade.

The Balance Sheet

The US’ balance sheet (Table 2) is already in need of repair. This is where the income statement losses of Trump Inc. become an issue. Primarily, the balance sheet problems are due to the lack of cost cutting combined with tax cuts.

 Why? The tax cuts reduce revenues and increase the deficit. This means the debt load and interest payments on the debt become increasingly more painful. Furthermore, the additional debt overhang weighs heavily on long-term US growth.

US Balance Sheet (Table 2)

Source: Bureau of the Fiscal Service 
US Department of the Treasury
(In billions of dollars)
2015
Assets:

Cash and other monetary assets 
305.1
Accounts and taxes receivable, net 
117.8
Loans receivable, net
1,216.00
Inventories and related property, net
320.6
Property, plant, and equipment, net 
893.9
Debt and equity securities
104.4
Investments in government-sponsored enterprises
106.3
Other assets
165.7
Total assets
3,229.80
Liabilities:

Accounts payable
68.3
Federal debt securities held by the public and accrued interest
13,172.50
Federal employee and veteran benefits payable 
6,719.30
Environmental and disposal liabilities
411.6
Benefits due and payable
213.9
Insurance and guarantee program liabilities
177.5
Loan guarantee liabilities
36.3
Other liabilities
652.3
Total liabilities
21,451.70
Contingencies and Commitments

Net position:

Funds from Dedicated Collections
3,247.70
Funds other than those from Dedicated Collections
-21,469.60
Total net position
-18,221.90

With the income statement continuing to run in the negative, the chance of repairing the balance sheet over time is slim.

But the balance sheet is also deceiving. Debt held by the public does not measure the entirety of the national debt. This is because the government owes itself about 20% of the debt outstanding. It also obscures the “off-balance sheet” liabilities of Social Security and Medicare—which at about $41 trillion, demand attention (Table 4).

On the asset side, there is no accounting for the federal government’s land holdings and associated mineral rights. In other words, not all assets or liabilities are captured on the standard balance sheet of the US.

President-Elect Trump’s US Turn-Around Team?

Running deficits and growing an economy are two wildly different things. The fact that the tax changes are expected to cause persistent deficits does not preclude significant economic growth. For instance, the TF predicts the US economy will add 6.9% to 8.0% in GDP more than it would have otherwise.

As the TF points out, the Congressional Budget Office predicts the US economy will grow 19.2% from 2016 to 2025 without changes. Adding the two together, the US economy will be about 26% larger in 2025 than it is today. That is about a 2.5% year-over-year growth rate during the period. That’s an improvement from the current 1.75%.

The other parts of Trump Inc.’s turnaround plan may not go over as well. Trade policies, immigration, and infrastructure could negate some of the purported tax benefits. Deregulation of certain industries—including the financial and energy sectors—could spur pockets of growth, but these would accrue over a longer time horizon. The US plan may succeed if the potentially harmful pieces of it are dropped or de-emphasized.

Potential Outcomes

US FINANCIAL STATEMENT SNAPSHOT (Table 3)

Source: Bureau of the Fiscal Service 
US Department of the Treasury
(In billions of dollars)
FINANCIAL MEASURES
2015
2014
Net Cost
($3,858.80)
($3,837.00)
 Tax and Other Revenue:
$3,334.00
$3,066.10
 Unmatched Transactions & Balances
$5.10
($20.40)
Net Operating Cost
($519.70)
($791.30)
Assets:


 Cash & Other Monetary Assets
$305.10
$264.90
 Loans Receivable, Net
$1,216.00
$1,125.70
 Inventories & Related Property, Net
$320.60
$318.40
 Property, Plant & Equipment, Net
$893.90
$878.30
 Other
$494.20
$478.00
Total Assets
$3,229.80
$3,065.30
Liabilities:


 Federal Debt Held by the Public & Accrued Interest
($13,172.50)
($12,833.60)
 Federal Employee & Veterans Benefits Payable
($6,719.30)
($6,672.60)
 Other
($1,559.90)
($1,259.80)
Total Liabilities
($21,451.70)
($20,766.00)
Net Position (Assets minus Liabilities)
($18,221.90)
($17,700.70)

This is where any analysis becomes muddled to the point of speculation. But we can venture a few broad generalizations and caveats to provide context.

Of note, without more substantial spending cuts than are currently being proposed, the projected GOP and president-elect plans will cause the budget deficit to expand regardless of the efficacy and how well they are implemented (See table 3). In part, this will be compensated by the GDP gains of 0.75% per year generated by the tax cuts, but the deficit will run at approximately twice that rate.

The best-case scenario would involve the proposed tax reform without the border adjustable tax rates. As stated, this tax is likely illegal. And the tax would be a trade-war starter if implemented. A lack of border adjustability taxation creates a problem on the revenue side, but revenues could be raised using a less combative, trade-oriented tactic.

Repatriation would accompany the creation of longer-term demand via either the individual tax cuts or a separate incentive. The tax cuts would be phased in slowly to encourage consumption or savings. This would generate a stable deficit environment.

Any infrastructure program would be set aside until a recession hit and job creation became necessary and needed. Deregulation will play a role in pushing GDP higher than the tax cuts alone, possibly adding 2%–3% over the time horizon. This would lead to a US economy in excess of 8% larger over 10 years than it would have been, and on a sustainable path.

In the base-case, the fiscal package is likely to be a muddling of the best and worst cases. Since border adjustability is a revenue-generating cornerstone of the GOP plan, it is unlikely to be removed without significant spending cuts or a new method of raising tax revenue. Border adjustability is tempting because it is more tariff than tax driven, making it easier for GOP fiscal hawks to accept.

The tax regime will remain near where the GOP and President-elect Trump are now with significant cuts to both individuals and corporations. The debate around the pass-through income tax may escalate, but that is the only major point of contention there.

Spending cuts will be difficult to come by in any quantity, especially given the proposals to increase defense spending. Again, this will lead to gains in GDP (excluding the consequences of border adjustability, a stronger dollar, and any retaliation) of around 8%. But in this case, the gains come with a much larger debt-to-GDP ratio as the deficits from less receipts and more spending far outstrip gains in GDP.

The worst-case scenario would see smaller than expected tax cuts, border adjustability, and a large infrastructure package with little in spending cuts or other offsetting mechanisms. This would generate a smaller boost to growth, hurt trade relations, strengthen the US dollar, and stoke inflation for only a minimal GDP growth. And it would still have negative ramifications for Trump Inc.’s balance sheet by raising the deficit and debt levels.

In the End

The base-case is the most likely to come to fruition. There will be growth, but the near-term growth could be stifled and reversed in the long term without substantial spending cuts. That said, there is the potential to breathe life into an economy restrained by debt, demographics, and regulatory burden.

SUSTAINABILITY MEASURES-OFF-BALANCE SHEET (Table 4)

Social Insurance Net Expenditures:
2015
 Social Security
($13,440)
 Medicare
($27,940)
 Other
($108)
Total Social Insurance Net Expenditures
($41,487)

Adding 0.75% annually to growth over a decade does not sound impressive, but it is a 43% boost over the current potential GDP growth rate of around 1.75%. It comes, however, at the cost of a higher deficit and further increase in the US debt level. Tax reform and deregulation are positive for growth in the near term, but trade wars and debt are not. Avoiding one and minimizing the other will likely determine whether Trump Inc.’s turnaround succeeds or fails.

Investment Implications

The investment implications rest on the delivery of the fiscal package. Deemed repatriation should be a positive for equities due to the increased sustainability of dividends and buybacks. Tax reform is a similar story with a step function change in earnings estimates. Deregulation will primarily affect the expense lines of certain industries, including energy and finance, boosting earnings.

Inflation expectations will likely cause more volatility and a possibly higher interest rate environment. But a strong dollar and Fed tightening policy should counteract at least some of the pressures. Commodities may benefit from fiscal demand, but the strong dollar will counteract this to a degree.

A breakdown in trade relations would be unquestionably bad for business and would interrupt supply chains. This would cause ripple effects across industries.

It is unclear how interest rates would react, whether a flight to safety would prevail or a reactionary selloff from sovereign holders would dominate.

Notwithstanding a trade war, a well-executed Trump plan should be a long-term positive for equities and a mixed bag for fixed income and commodities. Asset allocation will remain paramount in this environment. Fixed income continues to play a vital role in fulfilling long-term objectives and providing diversification from other asset classes, while real asset exposures should provide inflation protection for a portfolio. Equities could benefit from the potential success of a Trump Inc. turnaround.