President Trump is expected to announce a revised tax cut plan soon. In the meantime, it’s worth revisiting how the sausage gets made in Washington. By law, tax code changes must originate in the House of Representatives, and the Senate will have its say. A central focus will be on revising how the foreign earnings of U.S. firms will be taxed. Here, there are likely to be large economic disruptions even if Washington gets it right – and heaven help us if they get it wrong.

“I love rumors! Facts can be so misleading, but rumors, true or false, are often revealing.”

– Col. Hans Landa (Inglorious Basterds)

While it’s getting difficult for investors to tell fake news from the really fake news, there have been a number of interesting leaks reported to have come out of the current administration. One is that a certain someone was surprised to learn that a $1 trillion infrastructure spending program in fact costs $1 trillion. Now that may be false, but it gets to the heart of the situation. We are unlikely to see a major infrastructure spending program anytime soon. House members aren’t going to favor adding to the deficit, at least through higher spending.

Trump’s spending and tax cut proposals from the campaign were widely blasted as “budget-busting.” Last May, the non-partisan Committee for a Responsible Budget calculated that Trump’s plan would add $12.1 trillion to the national debt by 2026. Other estimates are smaller, but still very large. Treasury Secretary Mnuchin has suggested that tax cuts will be revenue neutral, which seems to strain credulity. One possibility is to allow dynamic scoring. Tax cuts should lift growth to some extent, and one could factor that into revenue projections. However, nobody believes that tax cuts can pay for themselves. In Paul Ryan’s Blueprint for American, tax cuts are offset by unspecified future cuts in spending, but if you don’t touch Social Security and Medicare, you want to increase defense spending, and can’t do anything about interest payments on the debt, there isn’t enough left to cut to get the budget to balance. Democrats fear that there will be cuts to entitlements, and calling it “reform” doesn’t change that.

Let’s review the expected mechanics on the Hill. A tax reform bill, preferred by some Republicans in the Senate, would require 60 votes to pass in the Senate, which means that Republicans would have to get eight Democrats on board (given the 52-48 mix). That’s not out of the question, especially if there is an emphasis on business tax cuts. Tax cuts could be done through budget reconciliation, which would require a simple majority in the Senate, but you can do only one extra thing per year through budget reconciliation and Republicans have their sights on the repeal and replacement (or possibly “repair”) of the Affordable Care Act. The budget resolution approved by both chambers of Congress last month (budget resolutions do not require presidential approval) was reported to “pave the way” for ACA repeal. Yet, if you actually look at the budget resolution, there’s no mention of the ACA. That could mean that Congress can shift its priorities, putting tax cuts ahead of the ACA repeal (makes sense since there is no replacement in mind), but there’s been no indication of that so far.

One area that clearly needs reform is how we tax U.S. firms’ foreign earnings. Just about everyone agrees that the current system is “badly flawed,” leading firms to keep large amounts of foreign earnings (seen at somewhere around $2.6 trillion) offshore. Fixing it would lead to a repatriation of capital, and some short-term rise in tax receipts, but that seems unlikely to boost business fixed investment (as firms are generally flush with cash and currently have relatively easy access to credit).

Reducing the corporate tax rate from 35% to 20% would likely reduce tax revenue by about $200 billion per year. Added revenue from a border adjustment tax (BAT) could offset about half of that loss, and reduce distortions in corporate behavior. However, there are costs and benefits to moving to such a plan. Exporters would not be taxed, but consumers and businesses would face higher costs. U.S. manufacturing is critically dependent on global supply chains and disruptions would likely be large. Moreover, exchange rate adjustments and global capital flows could be destabilizing. The Bank for International Settlements recently reported that daily US$ forex volumes average more than $4 trillion (far exceeding trade flows). Implementation of a BAT would likely violate current trade agreements. Last week, the European Union indicated that it would file a complaint with the World Trade Organization if we move to a BAT. It would be the largest such complaint by far. While U.S. exporters would not be taxed, they would likely have a harder time through retaliatory efforts taken by the countries to which they export. The uncertainty of all these changes and conflicts could itself be a negative for business investment.

When asking for directions in Maine, the usual response is “well, I wouldn’t start from here.” That is a good summary of U.S. tax policy. If you started from scratch, you could have an efficient tax system – but nobody wants to give up their specific tax breaks. One proposal would eliminate all deductions except for mortgages and charitable giving. Good luck with that. A BAT proposal would pit importers against exporters. Congress is already getting an earful from their constituents (and more importantly, their donors). Hence, the odds of meaningful tax reform remain relatively low despite single-party control.

Most economists are in favor of moving to a value-added tax (with some adjustments), but that isn’t even being discussed.

© Raymond James

© Raymond James

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