What We Think Tax Reform Will Look Like

Joshua Aguilar and Matt Dolgin contributed to this note

After reviewing the Trump administration’s comprehensive tax reform outline released April 26, we continue to believe that U.S. corporate tax reform is more likely than not to occur, and that the proposal that we’re incorporating into our valuation models approximates the compromises that Trump and the Republican party will eventually settle on. In a reflection of what has long been a characteristic of the president, the plan was skimpy on details but bold in ambition. The administration’s corporate proposals are limited to four points: a 15% tax rate, a move to a territorial tax system, a one-time, unspecified repatriation on overseas cash, and an elimination of "tax breaks" for unspecified "special interests." Our proposal calls for the following: a rate cut to 25%, an option for manufacturing firms to elect immediate capital expensing or retain interest deductibility, a deemed repatriation of 10% on overseas cash, and an elimination of all tax credits in the code, less the research and development credit.

We are unsurprised by these developments, with one exception. We did not anticipate the president’s proposal to include a move to a territorial tax system. The Republican House plan has always included this as part of its "Better Way" tax plan. Trump’s original plan, however, preserved the original worldwide tax system and went so far as to end deferral. As later drafts emerged on the campaign trail, however, this proposal was conspicuously missing. Tax experts were divided in interpretation of this apparent walk-back by then-candidate Trump. Nearly all agreed, however, that the apparent shift in position was due to the influence of his inner circle of economic advisors, many of whom are longtime Republican mainstays. Some observers have lauded this move as the United States is one of the few countries that operates on a worldwide corporate tax system. Only six OECD countries currently operate on such a system. As anticipated, however, the president’s current proposal excludes the House GOP’s border-adjustment tax, the largest offset to the proposed rate cuts floated by both camps.

When we developed our proposal, we aimed for one that reflected what we believed would be a reasonable set of compromises among proposed tax plans to make it through Congress and that would be close to revenue neutral on a dynamic basis. We also assumed in our base-case scenario that the administration would struggle to win Democratic votes, forcing Republicans to go through the budget reconciliation process to pass tax reform. We used dynamic scoring because the administration indicated it would do so. Both the administration and certain members of the Republican-controlled Congress have indicated they would be willing to go beyond the constraints of revenue neutrality, though. While the rules that would allow them to do so are constantly evolving, the bottom line is that we believe it would permit them to do so. Current rules, however, would require that any reform offered through the budget reconciliation process to sunset over a 10-year period.

As a practical matter, however, the Senate is only controlled by a slim 52-senator Republican majority and we believe that compromises will need to be made. Trump risks overplaying his hand with more moderate senators in the Republican majority--specifically, Sen. Susan Collins of Maine and Sen. Lisa Murkowski of Alaska. Both have shown a willingness to break from party lines, leaving Trump a slim margin to deliver on one of the signature promises of his campaign. Compounding the problem for the Trump is Sen. Rand Paul’s reputation as a budget hawk and insistence on fiscal discipline. Trump’s proposal to reduce the top rate for flow-through entities to 15%, in line with his proposed corporate rate--the so-called “Trump tax loophole”--would likely blow an unrecoverable hole in the budget. We believe Trump has learned from the growing pains of his first foray into legislative politics with the failure to help pass the AHCA.

Trump is often characterized as both ideological and as a competitive negotiator to the exclusion of other negotiation tactics. We disagree. We believe that Trump’s ambitious rate cut is consistent with his modus operandi of starting with an arguably far-fetched proposal and subsequently seeking a win-win solution. This is a consistent staple of his negotiation strategy as evident in his writings. Ultimately, we believe that Trump will acquiesce to a win-win solution to gain buy-in from skeptical corners of the Republican party and will ultimately pass a more moderate brand of tax reform. As such, we are leaving our proposal unchanged until we believe it is more likely than not an alternative should take its place. Admittedly, we believe the most likely area that we would change in our proposal is a move to a territorial corporate tax system. That said, as many companies that we currently cover permanently reinvest their foreign earnings and don’t pay U.S. taxes on those earnings, we don’t anticipate that this change in our proposal would have a material effect on our valuations.

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