“IN THIS WORLD NOTHING CAN BE SAID TO BE CERTAIN, EXCEPT DEATH AND TAXES.”
— BEN FRANKLIN
If Benjamin Franklin were alive today, I wonder if he might add to his list of life’s certainties. Since he is not here to do so, in his absence I will add one more to his list: Republican efforts to reduce tax rates of the “haves” – wealthy individuals and businesses – in order to prove that trickle-down economics is more than suspect economic theory.
Since the Tax Reform and Jobs Act of 2017 (“2017TRJA” or the “Bill”) became law, I have been asked numerous times what I think about it, what actions should be taken to minimize the Bill’s impact, and what effect the Bill might have on the financial and real estate markets. So, rather than keep you waiting and forcing you to read pages of fairly dense tax legislation history and trickle-down economics, here is the punch line. I think it’s extraordinarily ill-conceived, poorly timed, extremely risky, perfectly reflective of the political divisiveness that plagues our great country, and is not likely to provide all of the economic benefits we have been promised, at least in the long-run if history provides us with any guidance. Phew. I am glad to get that off my chest.
The Bill is a deficit-expanding ($1.5 trillion according to the Congressional Budget Office (“CBO”)), hodge-podge of modest and temporary tax cuts for the middle class, greater tax cuts for the rich (far less so for those in a few of the blue, coastal states), significant permanent cuts for businesses, heirs to large estates, perhaps a Mar-a-Lago member or three, and is a big economic and political “win” for a select group of Republican politicians and their supporters.
But let’s not kid ourselves. The deficits will need to be funded either by cuts in expenditures, increased borrowing, or both. If military spending is not going to be cut – and it won’t be so long as the Republicans control the Executive and Legislative Branches – the only place to find the funds needed to offset the drop in tax revenues is entitlements: Medicare, Social Security, food stamps, housing assistance, and the like. It isn’t rocket science. These are going to have to be cut, unless Uncle Sam has some sort of Nixonian slush fund that I am unaware of.
So, what will be the ultimate economic result of 2017TRJA? Well, the rich will get richer, and the poor, poorer. However, this assumes that the financial markets behave themselves in the medium- and longer-run, and do not ultimately decline as a result of the Bill. And there’s the rub. The longer-term impacts of the Bill are very uncertain, adding uncertainty to what has been solid, if uninspiring economic growth, and well performing markets. And while I cannot be absolutely sure how things will ultimately pan out, history provides some very cautionary tales of what often happens following these sort of Republican-led tax cuts based on flawed, trickle-down economic theory.
This Bill is Not a Win, but Tribalism at its Worst
If there is one thing that this sweeping tax legislation proves, it is that our nation of consensus and compromise has disintegrated into pure tribalism. The Bill passed the Senate by a whopping 51-49 vote. Not a single Senate Democrat voted for the Bill. In the House, the results were not much different, with the final vote of 227 in favor and 205 against (two did not vote), again, essentially along party lines, as not one House Democrat voted for the Bill. Not one. Such a result is unique in the history of tax legislation. Usually at least a handful of Congress members cross party lines when voting for tax legislation. Not this time.
Meantime, the non-partisan CBO estimates that the Bill will add approximately $1.5 trillion to our deficit over the next ten years, even after the Bill’s projected macroeconomic benefits and the already estimated $10 trillion in debt the CBO projects will be needed to fund baseline GDP growth and federal government activities over this time frame. Perhaps due to these sobering projections and the Bill’s complexity (promises to simplify the tax code remain election cycle rhetoric from both parties), 2017TRJA is not exactly winning popularity contests, with only 32% of the American people supporting it. Imagine that. Not a single member of the opposing party voted in favor of the Bill and over two-thirds of Americans do not support it. And yet it passed.
Now, don’t get me wrong. When companies like Apple and Google have to structure their global operations using a “Double Irish with a Dutch Sandwich” (I did not make that up) involving a combination of Dutch and Irish subsidiaries to shift profits to low (or no) tax jurisdictions, you know there is something amiss with our Tax Code. When numerous U.S. based companies (e.g., Medtronic, Chiquita Brands, AON) invert and change their place of domicile from the U.S. to places like Ireland or the Cayman Islands, in order to reduce their tax burdens, you would be hard pressed to find someone who didn’t think that our tax code was in need of reform.
But when you have a Bill that substantially increases budget deficits, barely passed, received not one vote from the opposing party, has not even a third of Americans supporting it, such a Bill is not a “win” some have characterized it. We should also keep in mind that Congress had to make many of the tax cuts (for individuals and estates) “temporary” in order to reduce the number of votes needed to get the Bill passed. Under arcane Senate budget reconciliation rules, legislation can be passed with a simple majority only if it doesn’t drive up the deficit ten years after passage. By making many of the individual and estate tax cuts “temporary,” they could pass the Bill without any Democrat support. Otherwise, the Bill would have needed 60 votes and would not have passed. Welcome to a new era of political gymnastics.
Unfortunately, the 2017TRJA is a rousing victory for tribalism, as it is clear that “winning” has nothing to do with consensus, unity, simplicity, or popular support. It is literally among the least favorable pieces of legislation in our nation’s history, and only contributes to or reflects the present state of divisiveness that characterizes the country.
Why Pass this Bill Now? What are the Risks?
If just because of its breadth and complexity, the speed with which it was drafted, negotiated, and passed (the 400+ page Bill was drafted and passed in a matter of weeks, and neither chamber of Congress held a single public hearing, another historic first), and the lack of any pressing economic impetus, the Bill presents immeasurable risks to our economy. Some additional context is crucial.
Well before any drafts of tax reform bills had even appeared on the House or Senate floors, the economy and financial markets were doing quite well. The country is in its ninth year of economic growth (second longest stretch of growth in some 150 years), equity markets have experienced quite a winning streak (the Dow Jones has not had a down year since 2009, the NASDAQ was up some 275% from its 2009 lows through last November’s election, and total equity returns have been positive for 23 consecutive months, the longest streak in history), inflation is tame (around 2.5%), interest rates low (the 10-year Treasury sits at around 2.41%, while 30-year mortgage rates approximate 3.75%), the unemployment rate has declined from double-digits to 4.1% (essentially full employment), real estate prices (both residential and commercial) have essentially recovered all of the losses from the Great Recession, and household wealth has followed suit. Overall American household wealth (nearly $100 trillion) is at record highs.
Meanwhile, corporate profits have never been higher (second quarter 2017 corporate profits were 9.5% of GDP, versus a long-term average of 6.6%), and non-financial U.S. companies have some $2.5 trillion in cash. Corporate liquidity has never been greater. While much of that cash might be overseas, modest tweaks to what were impractical tax rules surrounding repatriation could have addressed this particular tax issue.
The only economic data points that were and are of concern are the expanding gap in wealth inequality and stagnant hourly wages received by a typical worker. The wealth gap between the “haves” and “have-nots” in the U.S. has never been higher. The richest one percent of American families control some 40% of the country’s entire wealth. Jeff Bezos (Amazon CEO), Bill Gates (former Microsoft CEO), and Warren Buffett (Berkshire Hathaway CEO) collectively own more wealth than the entire poorest half of the U.S. population. Those are not typos. And these folks need more? This sort of wealth inequality exceeds that which existed in France before the bad hair day Marie Antoinette experienced one October in 1793.
Part of the problem is that employee wages have increased a whopping 0.2% per year since the 1970’s, adjusted for inflation, principally due to the three A’s (automation, Amazon, and artificial intelligence), globalization (and lower global wages), and declines in the power of unions. Does anyone think these trends will miraculously change due to tax reform? Really?
In 2012, the non-partisan Congressional Research Service issued a report, analyzing the economic impact of changes in tax rates between 1945 and 2010 (the “Report”). The Report concluded that top tax rates and changes have no discernible impact on economic growth, saving, investment, or productivity, but did increase income inequality. Therefore, it is more than reasonable to predict that the 2017TRJA will be no different. For example, assuming that the temporary individual tax cuts are not renewed in 2025, individuals would actually end up paying over $80 billion more in taxes than they do right now, unlike corporations, whose tax cuts under the 2017TRJA are permanent.
And if you still have your doubts, perhaps history can provide some worthwhile, if ominous, clues as to what to expect from this latest trickle-down tax reform effort.
Those Who Fail to Learn from History are Doomed to Repeat it, so Let’s Talk a Little History
This Bill is the most significant piece of tax legislation since the 1980’s, when we had two substantial tax bills, the Economic Recovery Tax Act of 1981 (“1981ERTA”), the largest tax cut in history, and the Tax Reform Act of 1986 (“1986TRA”). Both of these bills passed while Ronald Reagan was President, the Democrats controlled the House (all eight years), and Republicans controlled the Senate (Republicans actually controlled the Senate for the first six years of Reagan’s presidency, from 1980 to 1986, while the Democrats did so for the final two years of Reagan’s second term as President). Reagan came into office in 1980, following a forgetful 1970’s (oil embargo, OPEC, hostage crisis, high unemployment, sky high interest rates), when our national debt was around $900 billion. Between 1970 and 1979, the Dow Jones Industrial Average gained a measly 4.8%, well below inflation. The economy was in desperate need of a jump start. There is no comparison between 1980 and 2017.
As a result, the 1981ERTA had a lot of support from Democrats, who controlled the House, and was designed to kick start the economy and reverse demonstrably negative trends. Unfortunately, such was not the case, and in 1982 a double-dip recession occurred, high interest rates returned, and the national debt tripled, to around $2.6 trillion as a result of fiscal deficits. So, the largest tax cut in American history up to that point did not seemingly improve things at all. The one industry that benefitted substantially from 1981ERTA was real estate, as passive losses from real estate partnerships could now be deducted dollar for dollar from other income, real estate could be depreciated on an accelerated schedule, and rates, both ordinary and capital, were significantly reduced. In response, investments in real estate partnerships quintupled between 1981 and 1985.
Fast forward to 1986, and again, President Reagan was able to muster enough support from Democrats, and pass additional and significant tax reform. More than 30 Senate Democrats voted in favor of the 1986TRA and only 12 Democratic Senators voted against the final bill. The 1986TRA repealed many of the real estate related benefits. Passive losses were no longer deductible, other than against passive income. Accelerated depreciation was eliminated and periods over which real estate could be depreciated were essentially doubled.
There are two other Republican-led (Presidents Warren Harding and Calvin Coolidge) tax cuts that warrant discussion, though we need a bit of a time machine (hot tub optional) for this one, the Revenue Acts of 1924 and 1926 (collectively, the “Revenue Acts”), which reduced personal tax rates on highest incomes, reduced inheritance taxes, and eliminated other taxes. In fact, tax cuts were the order of the day…or actually that entire decade. Both chambers of Congress were firmly controlled by Republicans, and following the end of World War I, Republicans went to great lengths to reduce taxes across the board, especially for (I hope you are sitting down)…the wealthy. The top individual income tax rate was reduced from 73% to 25% via the Revenue Acts.
And last, but certainly not least, were the two Bush tax cuts of 2001 (the Economic Growth and Tax Relief Reconciliation Act of 2001) and 2003 (the Jobs and Growth Tax Relief Reconciliation Act of 2003) (collectively, the “Bush Tax Cuts”), the most recent efforts for Republicans to put their trickle-down economic theory to the empirical test prior to 2017TRJA. The Bush Tax Cuts reduced both ordinary and capital gains tax rates across the board, by definition disproportionately cutting taxes for the wealthiest taxpayers, although taxes on all taxpayers were reduced.
So, How Did all the Republican-led Trickle-Down Tax Plans Work Out?
Well, we know what happened between the Revenue Acts of 1924 and 1926, and…1929. If not, pick up a copy of The Great Gatsby at your local bookstore (Amazon, I mean), and take a look. Speculative frenzy in the stock markets and excessive leverage ruled the day, until it all came crashing down in October of 1929, ushering in the Great Depression. The era of reducing taxes came to a screeching halt. Trickle-down economics had failed its first test. Badly.
Between 1930 and 1980, tax rates generally increased, in order to fund deficits caused the Great Depression, spending tied to World War II, and efforts to redistribute wealth, when such efforts were not met with such hostility by conservatives. By 1980, the highest individual income tax rate was 70%, having reached a high in 1945 of… 94%. The 1981ERTA reduced the top marginal tax rate to 50%, and the 1986TRA reduced the top rate yet again, to 28%. However, contrary to the assurances that these tax cuts would pay for themselves, such was not the case. The budget deficit tripled, and total federal government debt grew from 33.3% of GDP in 1980 to nearly 52% in 1988. And you may remember one particular October in 1987, when the stock market suffered its largest loss ever (in percentage terms), when the Dow Jones dropped 22.6% in a single day.
Moreover, the 1980’s and early 1990’s saw record number of bank failures and unprecedented losses in the banking industry. Between 1980 and 1994 more than 1,600 federally insured banks were closed (or received FDIC bailouts), far more than in any other period since the advent of federal deposit insurance in the 1930’s. A lack of oversight, deregulation, increased competition, other local and macroeconomic factors, and good old malfeasance played roles, but there is no doubt whatsoever that Republican-led tax reforms shoulder some of the blame.
While the Bush Tax Cuts stimulated economic growth between 2002 and 2006, when equity and real estate markets performed extremely well (perhaps too well) before they imploded in 2007 and 2008, in the most significant economic crisis since the Great Depression. Interestingly enough, the Heritage Foundation, a conservative think tank in D.C., predicted that the Bush Tax Cuts would completely eliminate U.S. national debt by 2010. Oops. And in one other noteworthy tidbit, several Democrats crossed the party aisle and voted for both bills, although the votes were mostly along party lines.
So, Will History Repeat Itself?
So, will history repeat itself, or merely “rhyme,” to quote Mark Twain? In short, I don’t know. Prognostications are tricky, and even with some 100 years of tax history, data points are still relatively few and far between. Moreover, distinguishing between the correlation of Republican-led, trickle -down tax legislation and economic downturns versus causation is important, and without greater research and data points, one must be careful about drawing firm conclusions about relationships between the two.
What I can say without hesitation is that trickle-down economics has no empirical support, and If Newton’s Third Law on Motion (every action…) applies to markets, 2017TRJA makes me extremely uneasy. What is clear is that tax cuts over the past 40 years have mostly benefitted the wealthiest taxpayers, while the middle class and the poor have not been helped nearly as much. Even State-led efforts to implement trickle-down policies have failed. Deep-red Kansas and their recently failed trickle-down experiment would be exhibit one in this regard. Will this time be different?
Regardless of whether history ends up repeating itself, or merely rhyming, the risks of a significant market correction are substantial and heightened as a result of 2017TRJA, the elevated state of the markets (the equity markets are hitting new all-time highs, as I type), the penchant for investors to become excessively exuberant in bull markets, the significant corporate liquidity that already exists, and the increased investment incentives that 2017TRJA compels. Look no further than Bitcoin, Blockchain, the FANG stocks, along with numerous other assets (high-yield debt, Tesla, Nvidia), whose valuations seem to be disconnected from underlying fundamentals. I certainly don’t think it is coincidence that the markets have so strongly rallied when 2017TRJA’s passage became a certainty, and I am very fearful that the investors and the markets will overshoot, incented excessively by untimely and poorly conceived tax reform.
Why Doesn’t Trickle-Down Economics Seem to Work Empirically?
This is an interesting and important question, since trickle-down economics seems intuitively reasonable. Cut taxes and investment in equipment and personnel, along with higher wages, should follow. Easy peasy. And yet, it seems to have zero empirical support. Why?
Different theories have been expressed, but one is that wealthy individual investors simply take their tax windfalls, and invest them in passive investments (e.g., equities, bonds, real estate), which do not create jobs or real economic growth, at least in any meaningful or timely way. For those of you with reasonable resources, ask yourselves what you would do with extra cash? I imagine you would either pay down debt or simply invest it passively, which would create a nano-trickle at best.
And companies? They will likely use most of the newfound cash to increase dividends and repurchase shares. While several companies (e.g., Wells Fargo, American Airlines, Time Warner, among many others) have announced modest employee bonuses ($1,000) and additional capital investment plans with great fanfare, I see these actions more about public relations than anything else. Bonuses are one thing, while permanent employee raises and new hires are something else altogether. Moreover, companies already have plenty of liquidity for capital investments, so the 2017TRJA might move the needle somewhat in the short-run, but beyond that, I have my doubts. We shall see.
How Long Will it be Until We Know Whether 2017TRJA is Successful or Deja Vous All Over Again?
Ahhh, the million, or should I say, trillion-dollar question. For better or worse, we will not know for certain for three to five years, if history provides any clues. But with some of the speculative excesses I am seeing in certain corners of the markets, we might have a sense of 2017TRJA’s longer-term impacts more quickly. In the short-run, it has definitely given the markets additional adrenaline. But my concern is that this short-term impact is like a performance-enhancing drug. Eventually the benefits wear off, often with deleterious consequences and side effects.
Certainly, President Trump and Other Republicans are Students of History. Right?
Finally, how could I not mention President Trump in this discussion? In an unscripted interview with the NY Times last week, President Trump was asked whether he had read 2017TRJA, he replied, “I know the details of taxes better than anybody…better than the greatest CPA…” Since I am most definitely not nearly the “greatest CPA,” you can take comfort in knowing that our President knows all there is to know when it comes to tax law, and even though it sounds like he did not read the Bill, perhaps his assurances are comfort enough.
Finally, I would add that I do not have a red button sitting on my desk that controls nuclear weaponry. I do have such a button sitting on my desk that I got from Staples, but when I push it, it just says, “that was easy.” I assume that all Congressional Republicans must have similar buttons on their desks given the speed with which the 2017TRJA was passed. In any event, I hope this latest grand experiment with trickle-down economics is different. But history and a little common sense tell us it likely won’t be.
Thank you for reading, and I look forward to any comments or feedback you might have.
 Prior to the 2017TRJA, the U.S. employed a “worldwide” tax system, designed to tax the profits of U.S. companies no matter where they were earned. However, any taxes due on foreign-based profits (generally the difference between the U.S. tax rate and the relevant foreign rate) were deferred, and only due when the profits were “repatriated,” or returned to our shores. In order to avoid payment of such taxes, U.S. companies simply failed to repatriate them. The 2017TRJA converts the U.S. to a “territorial” tax system, where the U.S. will only tax income earned here. Foreign-based profits will now only be taxed by foreign governments. Obviously, this change amounts to a very substantial piece of the corporate tax cuts part of the 2017TRJA.
 “Taxes and the Economy: An Economic Analysis of the Top Tax Rates Since 1945,” Thomas L. Hungerford, September 14, 2012.
 Between 2012 and 2017, Kansas’s Republican Governor, Sam Brownback, conducted a real-life experiment in trickle-down economics. He and the GOP-controlled legislature sharply reduced the state’s (already-low) tax rates, eliminated state income tax for most owner-operated businesses and sharply reduced vital government services. The results were nothing short of disastrous resulting in large budget deficits, a ratings downgrade, and large cuts in government services. In June of 2017, the Kansas Legislature voted to roll back many of Governor Brownback’s trickle-down policies.