GOP Works On Spending & Tax Plans

Spending Plan To Be Extended Temporarily

The GOP is working to get the temporary spending plan passed before the deadline on December 8th. Trump discussed the possibility of the government shutting down, but that’s unlikely. The government is great at kicking the can down the road which is what this plan does as the extension lasts until December 22nd. After the extension, the goal for Republicans is to have a separate spending bill for defense because they don’t think the military can constantly rely on temporary plans. However, the Democrats don’t like that because as I’ve discussed before they want equal spending increases for defense and non-defense spending. Passing a separate defense bill is just a new strategy to get more defense spending. The House is figuring out a way to get it done without Democratic support. However, the Senate needs 8 votes to avoid a filibuster by the Democrats. That’s why the GOP is planning to fund the expiring Children’s Health Insurance Program to get Democrats on board. We’ll discuss this in more detail in a couple weeks. For now, it looks likely that the extension will be passed.

The Tax Bill Will Cost A Lot

Getting back into the tax bill, I’ve ignored the deficit issues this plan has because whether it will pass and what is in the bill are far more important to near term stock prices. The more tax cuts, the more stimulative it will be for the economy. However, as the plan gets closer to passing, we need to focus on the effects on the budget because it will start to weigh on the economy. This could be the last big tax cut the country can ever afford with the way the debt is trending. On a dynamic basis, the debt to GDP ratio will rise to 96% if the tax plan is passed instead of the current path of 91% by 2027. This doesn’t include the gimmicks in the bill which have taxes going up at the end of the 10 year period, to make it more palatable for the budget. This reinforces the point I made which is that the government won’t ever be able to cut taxes again unless it reins in spending. The current plan doesn’t even cut taxes for the full term. It’s like trying to fit a size small shirt on someone who is 6 feet tall.

The table below gives us the totals without the $585 billion in gimmicks the Senate bill has. There are $515 billion in arbitrary sunsets in the plan such as tax increases in 2026, ending the individual tax cuts in 2025, and ending the bonus depreciation for expenses in 2022. The plan also expands the tax deduction for pass through businesses and keeps part of the state and local deduction. Finally, in 2017 and 2018, the income floor for the medical expense deduction is reduced from 10% of income to 7.5% of income. Some of these plans which are ended in the initial plan will likely be extended, meaning the true cost is higher than the headline estimates.

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The chart below gives a visual explanation as to how much the deficits will increase over the next few years with and without the tax plan. This shows how stark the situation is. The deficits were on pace to increase before this tax cut; this just makes the situation worse. The original plan for the GOP this year was to solve the healthcare spending problem to fund the tax cuts. However, the GOP failed to do that, so the government faces a world of pain. This is without a recession which would hit deficits in the short run and the long run because it usually takes unemployment and wage growth a while to recover. There might even be 2 recessions within the next 10 years since we’re currently at the end of the business cycle.

Whenever a new plan is released, the first thing investors do is look how it has historically effected markets. Every event and policy are different, but before you do in-depth analysis, it’s good to have a framework to have a basis for your initial opinions. The chart below shows the dollar sold off when the Reagan tax cut and the Bush tax cut were passed. Similar to the last two times, the dollar has already started selling off before the plan is enacted. The dollar also rallied a few years prior to the tax cuts in all three instances. It will be interesting to see if the heightened deficits over the next 10 years lead to the value of the dollar falling further. I’ve been bearish on the dollar because the ECB is tapering its bond buying program. It’s effectively more of a hawkish move than the Fed modestly unwinding its balance sheet. The Fed is ahead of the ECB on rate hikes and the unwind, but the ECB is catching up.

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Ending Recency Bias

There are many bears who claim investors who started in the past 8 years have never seen a bear market. While that’s true, there’s another side to this debate. As you can see from the table below, the previous decade was the worst decade for stocks in the past 110 years. Therefore, any investors who started between 2000-2009 are likely too bearish because in their formative years, they experienced large shocks to the system. There aren’t always massive crashes at the end of bull markets. Some investors who lived through the last crash are waiting for another 50% decline to buy stocks again. That might not happen for decades. The 1910-1919 decade was similar to last decade. The following decade was one of the best as there was 14.37% compound annual returns on large cap stocks. Therefore, this current bull market has a mixture of investors who think another crash is coming and investors who think stocks never fall. That balances the sentiment of the market. The longer this bull market goes, the more likely there will be a crash at the end of it. Because I could see this rally going for another 18-24 months, there might be a large bear market afterwards. That depends on the size of the negative catalyst. The 2014-2015 energy collapse wasn’t even large enough to catalyze a recession.