Less than a week after Bridgewater’s Ray Dalio flip-flopped in his support of Donald Trump, going from vocally praising the billionaire’s vision for the US, to becoming “increasingly concerned about the emerging policies of the Trump administration” because “there is significant risk that his populist policies could hurt the world economy (and worse),” it was Goldman’s turn to dramatically sour on Trump’s economic policies, and as the bank’s chief economist, who previously just like Dalio was ecstatic about the economic growth prospects under President Trump, warned in a Friday night note that “one month into the year, the balance of risks is somewhat less positive in our view.”
As the Goldman team writes, following the election, there was a burst in euphoria and “the positive shift in sentiment among investors, business, and consumers suggested that the probability of tax cuts and easier regulation was seen to be higher than the probability of meaningful restrictions to trade and immigration”, however three months later “the risks are less positively tilted than they appeared shortly after the election.”
Hatzius gave three reasons for why his outlook has soured so much:
- First, the recent difficulty congressional Republicans have had in moving forward on Obamacare repeal does not bode well for reaching a quick agreement on tax reform or infrastructure funding, and reinforces our view that a fiscal boost, if it happens, is mostly a 2018 story.
- Second, while bipartisan cooperation looked possible on some issues following the election, the political environment appears to be as polarized as ever, suggesting that issues that require bipartisan support may be difficult to address.
- Third, some of the recent administrative actions by the Trump Administration serve as a reminder that the president is likely to follow through on campaign promises on trade and immigration, some of which could be disruptive for financial markets and the real economy.
In short, everything we said was bound to happen in late November has now, again, become mainstream. So with that caveat in mind, what does Goldman believe will happen next: for now, much of the same as before, however in what is perhaps the most notable shift, Goldman – whose former president Gary Cohn now is in charge of Trump’s economic policies – now sees only a 20% chance the border adjustment tax will be included in tax reform. If so, sell the dollar (something Goldman’s FX team will most certainly not be happy about).
We continue to expect a fiscal expansion of around 1% of GDP, largely through tax cuts starting in 2018. We believe Congress will reduce the corporate tax rate to 25%, but do not expect “border adjustment” to be included in tax reform. We also expect an increase in the effective tariff rate on imports and a reduction in immigration flows.
If Goldman is right, expect little if any Trump policies to be implemented until mid to late 2081, and not only the various near-all time high “soft” economic indicators like consumer and business confidence to roll over steeply in the coming weeks as optimism fades, but more importantly, hard data to plunge, dragging the USD, yields and stocks along with it.
Donald Trump and former Goldman President, current Chief economic advisor, Gary Cohn
For those curious, Goldman’s full revised Q&A on Trump’s policy outook is below (highlights our).
Q: What are the main issues at play?
We look at the agenda in two ways. First, it is useful to separate the issues that, while important, are largely political or microeconomic priorities from the more fundamental economic policy issues that are likely to have greater macroeconomic and financial market consequences. In the first group, we would count issues like the repeal of the Affordable Care Act (ACA, or “Obamacare”) and the upcoming debate over the President’s nominee for the Supreme Court, Neil Gorsuch, as well as a number of the targeted regulatory changes that might affect specific industries—Congress is poised to overturn certain targeted environmental regulations, for example. The more time Congress and the Administration spend on these issues at the outset, the longer it will likely take to address the core economic issues that market participants are largely focused on.
Second, among those issues that have meaningful macroeconomic consequences, there are risks in both directions. Tax reform, which we expect to result in a net reduction in tax liabilities, is likely to boost growth in 2018 and 2019. Infrastructure funding could provide a slight additional boost, though its fate is less clear. However, immigration restrictions could lead to an overly tight labor market and a slowing in final demand, and trade restrictions could pose risks to corporate profits and ultimately to growth if trading partners retaliate.
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Q: How have those risks shifted since the election?
The risks are less positively tilted than they appeared shortly after the election. Sentiment among investors, business, and consumers improved in November and December and risk assets performed well (Exhibit 1). While an improvement in economic data may be behind some of this, our impression is that the market perceives a higher probability of meaningful tax reduction and regulatory reform, while assigning a lower probability to meaningful trade and immigration restrictions.
Exhibit 1: A post-election boost to sentiment
Source: University of Michigan. Conference Board. NFIB.
Our view has been that the risks are more balanced than market participants might have expected, and recent developments reinforce this view, we believe. First, the difficulty that the Republican majority has encountered in its effort to “repeal and replace” Obamacare does not bode well for quick enactment of tax reform, which would provide most of the fiscal boost that we expect, raising the possibility that tax legislation might not pass until late 2017 or possibly even early 2018, and that it is likely to be less ambitious than the plans put forth by House Republicans and President Trump during the campaign.
Second, while bipartisan cooperation looked possible on some issues following the election, the political environment appears to be as polarized as ever, suggesting that many issues that require bipartisan support are likely to face substantial obstacles. In our view this suggests a low probability of a major infrastructure program that involves new spending in addition to tax incentives, and could pose obstacles to legislation making incremental changes to financial, health, and/or energy regulation, for example. While we have not expected a sweeping overhaul of regulation in any of these areas to become law, recent developments lower the probability somewhat that even incremental changes could pass in the Senate.
Third, some of the recent administrative actions by the Trump Administration serve as a reminder that the president is likely to follow through on campaign promises on trade and immigration, some of which could be disruptive for financial markets and the real economy.
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Q: After such an eventful few weeks, when will the outlook become more certain?
It would be a mistake to simply extrapolate recent political and policy developments, whether more market-friendly moves like the recent announcements on regulatory reform, or actions that have been associated with a negative market reaction, like the executive actions on immigration. That said, we expect policy uncertainty to persist for a while, with a continued mix of news that financial markets interpret positively and negatively. Exhibit 2 shows the range and average of the economic policy uncertainty index at the start of the last three new administrations, indexed to the Election Day level, compared with the current reading. In each of these periods, a new president entered office with his party holding the majority in the House and Senate, as President Trump has this year. We note that the limited historical evidence provides little reason to expect uncertainty to decline significantly over the next few months; in fact, on average it has tended to be more elevated in the spring of the inaugural year than in January. This is in line with our expectation of the next few months, which we expect to produce significant policy developments, particularly regarding fiscal policy, trade, and regulation.
Exhibit 2: More policy uncertainty ahead?
Source: Policyuncertainty.com. Goldman Sachs Global Investment Research.
Q: Why are Republicans having such a hard time addressing Obamacare?
The original strategy of Republican congressional leaders was to repeal major aspects of the law using the budget reconciliation process, which allows certain fiscal legislation to pass with 51 votes in the Senate, i.e., only Republican support, and to follow this with separate legislation to establish a replacement program at some later point. The expectation was that the repeal would take effect with a delay, giving lawmakers perhaps two years, until after the midterm election in November 2018, before the new program would actually need to be implemented.
This was intended to serve two purposes. First, it allowed for quick passage of an Obamacare repeal bill using the reconciliation process without the inevitable delays associated with devising a replacement plan. An important consideration was that the budget resolution for a given fiscal year allows for only one reconciliation bill for spending and another for taxes. Since the ACA includes spending and tax provisions, repealing it would use up both reconciliation instructions, leaving no opportunity for tax reform. To address this, Congress is likely to pass two budget resolutions this year. The first, for FY2017, is the resolution that would have normally passed last year and passed a few weeks ago. This will allow the reconciliation process for the ACA legislation. Once that bill has passed, Congress is then likely to pass the FY2018 budget resolution, which will actually guide fiscal decisions over the coming year and lay the procedural groundwork for upcoming tax reform and, possibly, infrastructure legislation. The upshot is that procedural constraints dictate that one bill is passed before the other is considered, and the ACA repeal bill was expected to be the easier task and therefore came first.
The second reason for the repeal and replace strategy was that Republican leaders hope to gain bipartisan support for the “replacement” legislation, because it would give the program a greater political mandate than the ACA had—reducing the likelihood that Republicans alone are held accountable for any future problems—and because some of the desired changes are regulatory rather than fiscal in nature and thus cannot be made through the budget reconciliation process, necessitating separate legislation that would require 60 votes in the Senate.
However, several Republican senators have objected to this two-stage approach, instead calling for at least some aspects of the “replacement” plan to be included in repeal legislation. While individual lawmakers’ motivations likely differ, among the concerns raised have been the potential problems in the insurance market that prolonged uncertainty regarding the replacement plan would cause, and the possibility that no replacement would ultimately be enacted, leaving some current enrollees without coverage.
Q: So what will happen with Obamacare repeal?
In our view, Republican leaders have two basic options. First, they could attempt to pass a partial reform of the program—stopping short of a true replacement—through the reconciliation process, with the expectation that it could constitute a sufficient reform once combined with administrative and regulatory changes the Administration can make without Congress. On the legislative side this could include, for example, increasing state flexibility with regard to the Medicaid expansion, and revising the distribution of the refundable tax credits used to finance coverage in the private market, combined with funding for a high risk pool for higher cost enrollees. On the administrative side, this might include changes to required benefits and changes in the regulation of premiums.
A second option would be to pause the work on Obamacare repeal and to address it at a later date, during or after the tax reform debate. However, while this might allow Congress to focus on tax reform and other areas that might be of greater significance to financial markets, it would create political problems, as many Republican lawmakers continue to be very focused on repeal.
Q: What does all of this mean for tax reform?
In our view, the last few weeks demonstrate that tax reform will take a while to enact and will probably be scaled back relative to what House Republicans and President Trump have proposed. As with many other policy issues, much hinges on the Senate. The ongoing debate over Obamacare demonstrates how difficult finding a consensus among 51 Republicans can be when there are only 52 Republican senators. Near-unanimous decisions are generally hard to reach and without bipartisan support congressional Republicans are apt to proceed more carefully since they are likely to be held accountable for the results.
The two biggest questions in tax reform are whether to include a “border adjusted” corporate tax in the proposal, which raises enough revenue to allow for 10pp reduction in the tax rate but could also result in potentially substantial unintended consequences such as price inflation of imported goods, and whether the legislation should be revenue neutral or whether it should result in a net reduction in tax liabilities. As discussed below, we assume that border adjustment will not ultimately be adopted, and that tax reform will increase the deficit by slightly less than 1% of GDP.
Q: What’s the latest on border adjustment?
We recently lowered to 20% our subjective probability that a border-adjusted corporate tax similar to the House Republican Blueprint will become law. This was mainly due to recent comments from President Trump expressing a mixed view on the proposal. That said, there continue to be what we view as good arguments for and against its eventual enactment.
We expect the proposal to continue to enjoy support in the House, since it raises a substantial amount of tax revenue—over $100bn per year, enough to finance a roughly 10pp reduction in the statutory corporate tax rate—without, in theory, reducing the long-run after-tax profitability of any industry, if the value of the dollar ultimately rises to reflect the effect of the import tax and export subsidy. It could also potentially achieve a number of long-sought goals of corporate tax reform, particularly allowing for a territorial tax system without incentivizing offshoring or imposing cumbersome protections against profit shifting. From a political perspective, some proponents of the plan also emphasize its appeal as part of an “America First” theme, suggesting that it could offset the alleged advantage that border-adjusted value-added taxes in other countries provide their domestic industries. While the last argument is unlikely true if exchange rates adjust to these tax systems, it nevertheless increases its political appeal in some quarters.
However, there are stronger reasons in our view to believe that border adjustment will ultimately be excluded from this year’s tax legislation. In the House, some Republican lawmakers appear to have misgivings. This may not be that relevant in the near term, since House Republican leaders are likely to ensure that it remains in the initial version we expect to be introduced around May, and most House members will not get an opportunity to vote to change the bill, only to approve or reject the bill in whatever state it reaches the House floor. We would not expect enough House Republicans to object strongly enough to the border adjustment provision in particular that they would vote against the Republican tax reform bill as a whole.
However, these concerns could become much more important in the Senate, which differs from the House in three important respects. First, the margin in the Senate is much smaller, since Republican leaders there can afford to lose only 2 Republican votes assuming that no Democrats support the tax legislation and Vice President Pence casts a tiebreaking vote. Second, dozens if not hundreds of amendments are likely to be considered to the Senate’s tax reform legislation, both in the Senate Finance Committee and on the Senate floor, unlike in the House, where few members will have an opportunity to change the bill. This means that each Senator’s view on border adjustment is relevant. Third, while House Speaker Paul Ryan and Ways and Means Committee Chairman Kevin Brady appear to be strongly behind the border adjustment effort in the House bill, there does not appear to be an equivalent driving force in the Senate; in fact, Senate Finance Committee Chairman Orrin Hatch and Senate Majority Whip John Cornyn, among several other influential Republicans, have made comments suggesting they have reservations regarding the proposal.
Q: Why is the proposal so controversial?
As a general matter, opponents of a given proposal are usually more vocal than supporters, and it appears to be the case here as well, with the retail industry and other concerned parties lobbying much more aggressively than the companies and industries in favor, including some industrials and technology companies. More importantly, while the proposal itself is fairly straightforward, the effects are somewhat uncertain and hard to prove. While dollar appreciation should offset some of the effect of the tax in the short-run and perhaps most of the effect over time, from a political perspective it will be abundantly clear who is subjected to higher taxes but it will be less clear in retrospect whether the expected dollar appreciation has actually occurred, since the dollar will fluctuate for a variety of other reasons and is fairly strongat the moment. The fact that many observers believe that dollar adjustment will probably offset the effects of the policy over the long run may give insufficient comfort to lawmakers who face reelection in less than two years.
Perhaps the most important issue is WTO compliance, and the risk of negative repercussions from trade frictions after a border-adjusted tax is enacted. Economic theory suggests that the symmetrical nature of the border adjustment—taxation of imports and subsidization of exports—should ultimately allow an exchange rate adjustment that neutralizes the effect on trade flows. However, rather than seeing these two policies as largely offsetting, a WTO panel might consider these policies to be a prohibited import tariff and a prohibited export subsidy. If so, the maximum retaliation that might be authorized under the WTO could be significantly larger than the roughly $100 billion per year in tax revenues that border adjustment would raise, assuming a 20% rate and the current level of the trade deficit. Even if a WTO dispute settlement panel viewed the policy as largely offsetting, the deduction for domestic wages that the House blueprint allows—the main difference with a traditional value added tax—makes it likely in our view that the policy would ultimately be found to be WTO-noncompliant.
Q: If Congress does not enact border adjustment, what does that mean for tax reform?
Without border adjustment, reducing the corporate tax rate to 20% or 15% will be very difficult. We noted previously that Senate Republicans appear less enthusiastic about border adjustment than House Republicans. This would leave them with three potential options:
- Increase the deficit: President Trump’s proposal would lower the corporate rate without significant offsets, expanding the deficit instead. While one can imagine the political appeal of simply lowering the rates without raising taxes in other areas, we expect that it will be quite difficult to reach 51 votes in the Senate for tax legislation that is not roughly “revenue neutral” as defined by congressional Republicans (see below). There could be concerns among fiscal conservatives in the House as well, though that appears less likely to us to be the binding constraint.
- Base broadening: While traditional base broadening such as the limitation or elimination of various tax preferences has been less of a focus in the current debate—the House pays for most of its proposal with border adjustment, and President Trump’s plan does not raise much offsetting corporate tax revenue—various other tax reform proposals over the years have primarily relied on such changes to finance lower rates. There is a limit to how far this can go; former Ways and Means Chairman Camp’s comprehensive reform bill released in 2014 went as far as politically possible, in our view, and achieved a 7pp reduction in the statutory rate.
- Scale back the tax cut: Lawmakers might ultimately decide to scale back the size of the statutory rate reduction to avoid the first and second options.
While the situation is fluid, our expectation is that Congress will ultimately enact a meaningful reduction in the statutory corporate tax rate, potentially down to 25%, but not to 20% or 15%. This could be financed with limited base broadening, the proceeds from profit repatriation, and a redefinition “revenue neutral” as follows:
- Dynamic scoring is likely to be estimated to generate at least a few and potentially several hundred billion dollars over ten years in revenue, enough to finance perhaps a 5pp reduction in the statutory corporate rate.
- Technical factors could provide a few hundred billion of additional room for tax cuts, potentially financing another 3pp or 4pp of corporate rate reduction. The main issue in play here is the use of a “current policy” baseline, which assumes that temporary provisions will be extended rather than the traditional method of estimating against a “current law” baseline that assumes tax receipts increase when tax incentives expire.
- Deemed profit repatriation is likely to provide sufficient revenue for another 1pp of rate reduction.
- Base broadening measures, like incremental reductions in various corporate tax preferences, might provide sufficient revenue for another 1-2pp of rate reduction
Taken together this would provide sufficient room for a reduction in tax rates for around 10pp of rate reduction, or from 35% to 25%. While the rate could be slightly higher or lower, the range of possible outcomes does not seem very wide; without border adjustment, going much lower than 25% would require more base broadening or deficit expansion than we expect could pass the Senate; going much higher than 25% would result in a rate that is still among the highest in the OECD and we suspect some lawmakers might simply decide that, absent larger changes, tax reform is not worth the trouble.
Q: Beyond tax reform, what other risks are there regarding trade policy?
Announcements regarding China’s currency policy and unilateral tariffs on a number of products seem likely, in our view. In general, we expect the Trump Administration to be much more active in using existing “trade enforcement” tools than recent administrations. This is likely, in our view, for three reasons. First, the domestic political atmosphere regarding international trade has changed, with increased skepticism of trade agreements and greater opposition to “free trade” among Republican voters than was the case several years ago. Second, President Trump has emphasized the importance of negotiations in a variety of areas, and taking unilateral action might be viewed as an opening step in negotiations with trading partners over broader policy changes. Third, and most importantly, President Trump has been publicly critical of US trade policy for decades, made it a key aspect of his campaign, and we see little reason to believe that he will not follow through on these commitments in general terms, particularly given that the President has authority to impose tariffs.
It is not yet clear what President Trump will do on trade enforcement, but he has many options. In our view, the most likely options in the near term involve the announcement of a formal process to determine whether China is “manipulating” its currency, and the initiation of trade remedy cases on products that have significant domestic production but where imports constitute an important share of the domestic market, like steel, large appliances, machinery or possibly parts of the auto sector. While we are reasonably confident that there will be new restrictions put on some product categories, we are less certain regarding the likelihood of broader tariffs applied to all imports from a given country, or in general. The president has the authority under several laws to impose such tariffs if he chooses, and the Trump transition team was reportedly considering as much as a 10% tariff on imports in December, but our expectation is that near-term activity is likely to be limited to targeted actions with tariffs held out as an additional tool that might be used later.
Q: How much will immigration policy change?
President Trump has already announced two executive orders on immigration, and another regarding work-related immigration has been released to the press in draft form but not formally announced. Like many recent executive orders, it is general in nature and lacks detail, but it appears to place an emphasis on enforcement of existing restrictions on such workers, rather than quantitative limits. That said, we note that some categories of admission into the US rely on maximum annual limits, which are generally reached quite quickly. While immigration law also establishes minimums in several areas, it is likely that the administration could reduce legal immigration levels materially if it chose to do so. In the near-term, we expect the administration to focus primarily on stricter enforcement of laws related to temporary work visas, but additional actions to limit legal immigration seem likely to be announced over the coming months, in our view.
Congress looks unlikely to be nearly as active on immigration policy changes. In the near-term, the focus is likely to be on funding for President Trump’s proposed border “wall” with Mexico, which Republican leaders might attempt to address as part of upcoming legislation to extend federal spending authority past April 28, when the most recent extension expires. Beyond this, we are skeptical that a breakthrough on immigration reform will be reached, as legislation would take 60 votes in the Senate and an agreement on broader immigration reform looks very unlikely, in our view.
Q: What ever happened to the infrastructure program?
President Trump proposed during the campaign to generate $1 trillion in new infrastructure investment, but unlike other policy areas where the President has already taken executive action, infrastructure has gotten relatively little attention, for two reasons in our view. First, infrastructure is mainly a financing issue, and spending and tax changes must go through Congress. Second, while congressional Republicans are very focused on tax reform and Obamacare repeal, infrastructure appears to be a lower priority. Congressional Democrats are quite supportive of infrastructure spending, but have shown much less interest in tax incentives aimed at public-private partnerships, as the White House seems to envision.
Our expectation continues to be that a modest infrastructure package will be enacted—we have penciled in a figure of $25 billion per year—and that it is likely to consist mainly if not entirely of tax incentives. If so, the most likely avenue for enactment will be to include it in tax reform legislation, which we expect to pass late this year or in early 2018.
Q: What happens next?
The next major milestone will be the President’s State of the Union Address, scheduled for February 28. This is likely to be followed by the President’s submission of a preliminary budget to Congress sometime in March. We are unsure of what to expect out of the budget next month but, in light of the fact that the nominee for Director of the White House Office of Management and Budget (OMB) awaits confirmation along with several other Administration officials, we expect that the forthcoming budget will probably include minimal detail.
Exhibit 3: A long road to tax reform
Source: Goldman Sachs Global Investment Research
Around this same time, in late March or April, we expect the budget resolution for the coming fiscal year (FY 2018) to be released, though the timing could be delayed if Republican lawmakers are still trying to resolve the Obamacare issue. This will be an important event for two reasons. First, it will demonstrate how congressional Republicans propose to simultaneously eliminate the budget deficit by 2027 (the end of the 10-year budget window Congress uses), cut taxes meaningfully—the Tax Policy Center estimates that the House plan would reduce tax receipts by around $3 trillion over ten years—while preserving Medicare and Social Security spending, which President Trump indicated during the campaign he did not want to cut, and increase defense spending. By contrast, the most recent House-passed budget resolution proposed spending cuts of around $6 trillion (13%) over ten years to reach balance by the end of that period, with half of the savings coming from Medicare savings and the repeal of Obamacare benefits, no reduction in tax revenues, and a modest increase in defense spending. We expect that congressional Republicans will ultimately reach an agreement and pass a budget resolution because it is a necessary step to pass tax reform legislation later this year, but the process is likely to demonstrate the limits of how much fiscal stimulus is possible given other constraints.
Once the FY 2018 budget resolution has been approved by both chambers, the House Ways and Means Committee is likely to move forward on tax reform legislation. This is unlikely to occur before May. At this point, we expect to see the first concrete policy details of tax reform in the House and, as noted earlier, we expect that border adjustment will continue to be in the House proposal at this stage. House passage looks likely by July. The Senate is likely to be on a slower track; the Senate Finance Committee may not produce legislation until the second half of the year, potentially responding to the House product with a proposal of its own. Assuming substantial differences with the House on issues like border adjustment, the two chambers will probably resolve differences in a conference committee, which will agree on one final version subject to a single final vote between the two chambers, though other methods are possible. In Exhibit 3, we show this final step as occurring sometime between October and December, but there is a fair chance that final enactment of tax legislation could slip into early 2018.
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