The markets have made two assumptions—both questionableby James Kwak / February 28, 2017 / Leave a comment
The US stock market is giddy. The S&P 500 index has enjoyed a virtually uninterrupted climb of 10.9 per cent since Donald Trump’s election on 8th November. Economist Robert Shiller’s cyclically adjusted price-to-earnings ratio (a measure of the price of companies’ stocks relative to their profits) is at levels previously seen only in the technology bubble of 2000 and just before the crash of 1929. This is unlikely to last.
The “Trump bounce” seems to be based on two premises. The first is that corporate and individual tax cuts will make stocks more valuable. The second is that looser fiscal policy—lower taxes and higher spending—will increase economic growth and therefore businesses’ profits. Both of these assumptions are questionable.
Corporate tax cuts boost stock prices by increasing the profits that companies earn, even with no change in their fundamental business. Republicans in the House of Representatives want to reduce the top corporate tax rate from 35 per cent to 20 per cent. In addition, their plan would effectively lower the tax rate on profits that American corporations have earned and parked overseas, freeing up trillions of dollars to distribute to investors.
Individual tax cuts boost stock prices by making the same amount of corporate dividends or capital gains worth more to investors. The House Republicans’ plan would reduce the top tax rate on dividends from 23.8 per cent to 16.5 per cent. In other words, the after-tax value of $100 of dividends would jump from $76.20 to $83.50—an increase of 9.6 per cent, which should partially translate into higher stock prices.
However, there is reason to doubt that President Trump and his allies will be able to cut taxes so drastically. To pay for a lower tax rate, House Republicans have proposed border adjustment—lowering taxes on exports and increasing import tariffs. This plan is fiercely opposed by retailers, which source many of their goods overseas, and by those manufacturers that import the inputs for their factories. More generally, corporate tax reform always involves battles between different segments of the business world. With Democrats unwilling to give the president any victories—especially handouts for corporations and their shareholders—the defection of only a few Senate Republicans could torpedo or at least weaken corporate tax reform.
An individual tax cut is more likely to sail through…