- Tax and trade initiatives most critical
- Lower recession risks, higher earnings, rising wages possible
- Inflation impacts monetary policy and exchange rates
Tax reform, fiscal stimulus, and trade policy are key economic initiatives of the new administration. Among the proposals floated are significant reductions in corporate and personal tax rates, a one-time “tax holiday” for corporations that repatriate funds currently held offshore (an amount estimated at more than $2 trillion), and increased government spending on defense and infrastructure. Our newly elected president also has threatened to institute punitive tariffs on nations such as China that, in his view, engage in unfair trade practices. Of these potential measures, tax reform would likely have the largest financial impact, and trade the most risk, since other nations could retaliate by placing tariffs on U.S. exports.
If done well, a plan that carefully balances tax reform and fiscal stimulus can reduce recession risks, boost longer-term growth, and increase wages. However, the magnitude of the proposed measures can also influence inflation and monetary policy as well as the U.S. dollar. Tighter monetary policies and a stronger dollar may potentially offset some of the beneficial aspects of lower taxes and rising wages. Ultimately, we believe the mix of policy initiatives successfully enacted will be the dominant factor driving equity and fixed income returns for the next few years.
The chart shows the summation of monetary policy, fiscal policy, and the dollar exchange rate. The objective is to set policy just right, so that economic growth, corporate earnings, and wages increase, without excessive inflation. Currently, these economic components are rising and are at levels historically associated with good equity market returns.
The tax proposals Mr. Trump initially articulated differ from the plan put forth by the House of Representatives. Mr. Trump wants to lower corporate and individual taxes substantially, which would reduce government revenues and increase the deficit, potentially by several trillion dollars. The House plan would lower taxes, but also reduce many deductions, broaden the number of individuals paying taxes, and try to be more deficit-neutral. How much Trump and Congress may compromise, and the resulting tax plan, is uncertain. If those devising new tax policies adhere to sound economic research, then tax changes should target areas that will drive productivity and capital formation, be implemented at timely periods as economic conditions warrant, and not add to the deficit on a sustained basis. It is not yet clear what the new tax regime will look like or when it will take effect.
While global trade produces winners and losers, there are many economic arguments for sustaining trade among nations. A large negative impact is felt by those whose jobs have gone abroad, but technology and lower wages/costs overseas have roughly equal effects on eliminating domestic manufacturing jobs. Levying tariffs, which usually raises the overall costs of goods and services while reducing their quality and/or supply, can lead to retaliation by trading partners. The right path for policymakers is to sustain the benefits of global trade while minimizing the harmful effects of poorly designed trade agreements.
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