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Trump tax cuts spike markets, risks shrugged off

December 4, 2017

The financial world has heralded the Senate tax cut vote. But as the Trump administration embarks on the biggest tax reform in the US in 30 years, some accuse it of ignoring systemic economic risk.

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Essen und Trinken Sektflasche Korkenknallen
Image: Fotolia/Mikael Damkier

European stock markets have strongly gained on Monday, while the US dollar climbed against the euro on the back of renewed hopes Donald Trump's tax-cutting plans will soon pass to the president to be signed into law.

The US Senate on December 2 approved the nearly $1.5 trillion (€1.26 trillion) taxation bill by a vote of 51-49.

A similar package was approved by the Republican-led House of Representatives in November and a final version will be negotiated by the two chambers before being sent to President Donald Trump to be signed into law, he hopes before the end of the year.

Nothing to fear

Republicans claim that the cuts can be funded through growth, with US investment bank Goldman Sachs seeing US tax cuts boosting growth 0.3 percentage points in 2018-19.

The Tax Foundation, a nonpartisan, conservative-leaning think tank, has argued that lowering the top income tax rate would lead to increased job opportunities. The Tax Policy Center, meanwhile, has said if Trump's plan come into law the average family in America would see its overall tax rate reduced by about 2 percent. It didn't specify for what period.

A study by Deutsche Bank has concluded that if Trump's proposed cuts are enacted the federal deficit would rise from the current estimated 3.2 percent of gross domestic product (GDP) to 3.5 percent in the initial years of the Trump administration.

That would represent a $100 billion revenue reduction to the US Treasury, a relative drop in the ocean. it said.

Bloomberg News noted that Trump's plan to allow manufacturing companies to immediately expense their capital investments could lead to a large increase in corporate spending.

"Trump's bill makes the economic playing field even more tilted toward the most fortunate," William Gale, co-director of the Tax Policy Center. said
"Trump's bill makes the economic playing field even more tilted toward the most fortunate," William Gale, co-director of the Tax Policy Center. saidImage: picture-alliance/newscom

Or everything to fear?

In the short-term a fear is that the markets have already squeezed as much value as they can out of the proposals and that any backtracking — which may happen over the next two or three weeks given the GOP's narrow majority in the Senate — will impact stock prices negatively.

"The reaction of investors is unpredictable in light of positive market moves ahead of the vote and suggestions that corporate tax cuts are to some extent already priced in," Michael McCarthy, chief market strategist at CMC Markets, said in a daily commentary on Monday.

"While the reduction in tax rates is widely viewed as stimulatory, and therefore supportive of higher share prices, the stellar run and record levels of US share indices have some fearing a 'sell on the fact' reaction," McCarthy said.

In the longer-term, the GOP has historically claimed that reducing the top tax rate will create economic growth, a core tenet of supply-side economics. But that hasn't always happened.

Speaker of the US House Paul Ryan
Speaker of the US House Paul Ryan speaks as US Senate and House Republicans announce the new tax reform planImage: picture-alliance/CNP/R. Sachs

Debt

Critics claim the cuts will lead to far higher budget deficits over ten years, adding to the current $20 trillion national debt

The independent Tax Policy Center said that the Senate bill would add $1.2 trillion to the federal deficit over the next decade after accounting for increased economic growth.

The Bank for International Settlements' (BIS) quarterly health check warned the global economy resembles the era just before financial crash, when investors, seeking high returns, borrowed heavily to invest in risky assets, despite moves by central banks to tighten access to credit.

Risky behavior

Investors are ignoring warning signs that financial markets could be overheating and consumer debts are rising to unsustainable levels, the BIS said.

The BIS said attempts by the US Federal Reserve and the Bank of England to reduce risky behavior by raising interest rates had failed and unstable financial bubbles were continuing to grow.

"The vulnerabilities that have built around the globe during the long period of unusually low interest rates have not gone away," Claudio Borio, the head of the BIS, said.

"And so are frothy valuations,” he said. "What's more, the longer the risk-taking continues, the higher the underlying balance sheet exposures may become. Short-run calm comes at the expense of possible long-run turbulence," he said.

The BIS said the benign global economy, which is predicted by the International Monetary Fund to see growth accelerate next year to 3.7 percent from 3.6 percent this year, was encouraging investors to dismiss concerns about high debt levels and growing asset bubbles.

The GOP has historically claimed reducing the top tax rate will create economic growth, a core tenet of supply-side economics
The GOP has historically claimed reducing the top tax rate will create economic growth, a core tenet of supply-side economicsImage: AP

Demographics and social spending

"A long-term issue with respect to the US tax cuts is that the current formulations appear to cut federal government revenues whereas the pressures on social spending suggest that revenues need be a higher share of GDP," Linda Yueh, Adjunct Professor of Economics at the London Business School, told DW.

"This impact potentially has a longer term effect on the shape of the US state in that the budget deficit will continue to expand since the pressures on social spending derive from an ageing population."

Bush's administration proposed and Congress enacted a set of supply-side-focused tax cuts in 2001 and 2003 that some blamed for the Great Recession.

Inequality

The centerpiece of the Republican tax plan is a massive corporate tax cut, from 35 percent to 20 percent, which is expected to disproportionately benefit the wealthy. 

In 2019, a person in the bottom 10 percent will get a $50 tax cut and a person in the top 1 percent gets a $34,000 tax cut.

"The bill is investing heavily in the wealthy and their children — by boosting the value of their stock portfolios, creating new loopholes for them to avoid tax on their labor income, and cutting taxes on massive inheritances," Lily Batchelder, a New York University professor, said.

The underlying notion is that tax cuts will generate growth by feeing businesses to increase investment. Higher retention of tax by higher earners will, the argument goes, increase incentives and drive growth, increasing jobs and also as an indirect knock-on effect, the tax base.

But the Congressional Research Service published a paper in 2012 that found no correlation between top tax rates and economic growth and others argue that the reforms will start to eat through the fat and into the muscle of the real economy.

A 2015 New York Times poll found 65 percent thought the growing gap between the rich and the poor in the US needed to be addressed
A 2015 New York Times poll found 65 percent thought the growing gap between the rich and the poor in the US needed to be addressed Image: Getty Images/S. Patt

The next crash?

Wolfgang Streeck, a professor at the Max Planck Institute for the Study of Societies in Cologne, told DW that the US-led world economy depends on a web of social relations that when broken undermine social cohesion and make it unworkable.

"Trust, loyalty, faith in institutions and in laws. Inequality is growing and alternatives to financialized capitalism are not there any more," he went on so that the rise of Donal Trump in this context was "not surprising."

"Steady growth, sound money and a modicum of social equity, spreading some of the benefits of capitalism to those without capital, were long considered prerequisites for a capitalist political economy to command the legitimacy it needs," Streeck argued.

"Unprecedented liquidity has failed to jumpstart the economy and inequality is reaching ever more astonishing heights, as what little growth there is has been appropriated by the top one per cent of income earners — the lion's share by a small fraction of them," he added. "Half a decade after the financial crisis and hardly anything has changed."

Noam Chomsky, Institute Professor Emeritus at the Massachusetts Institute of Technology (MIT), told DW that markets now have only a limited relation to the real economy.

"Their exuberance reflects the massive gifts to the very rich and corporate sector in what amounts to highway robbery by one of the most corrupt organizations to have run a developed society,"

"[I say] 'organization,' because I don’t think today’s Republicans can be regarded as a normal parliamentary party," Chomsky said.

"A better term perhaps is 'radical insurgency.' The financial institutions that are right now laboring to dismantle the limited regulatory apparatus know very well that it will probably lead to a crash, but so what?  Meanwhile they are enriching themselves beyond the dreams of avarice, and they are counting on the tacit government insurance policy to take care of them as usual when they crash the economy again," he went on.

Head shot of a man (Jo Harper) with grey hair and brown eyes
Jo Harper Journalist and author specializing in Poland