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 Congress, since virtually all Republicans agree on letting the rich keep more of their money. But because of the Senate’s procedural rules, Republicans face a choice between compromising with Democrats— who are not eager to cut taxes on dividends and capital gains—or using the reconciliation process, which means that tax cuts must be paid for by spending reductions or phased out within ten years.
The second reason for the post-election bounce is the belief that Trump’s policies will stimulate the economy. The hope is that a Republican Congress that routinely blocked any attempt by President Barack Obama to spend money will suddenly open the coffers for President Trump, who has promised to create jobs by fixing the United States’ aging infrastructure. That, combined with individual tax cuts, will put more money in people’s pockets, increasing consumption and generating a virtuous cycle of growth.
But there are several problems with this story. First, the tax cuts proposed by both the president and the House Republicans are massively skewed toward the very wealthy, who tend not to buy more stuff when their taxes go down—because they can already afford anything they might want to consume. The last time the US slashed taxes for rich people, under President George W Bush in 2001 and 2003, the effect on economic growth was minimal at best.
Second, government-funded infrastructure programs are almost the last thing that most congressional Republicans are willing to sign off on; recall that exactly zero Republicans in the House and three in the Senate voted for the 2009 stimulus bill, when the economy was in far more dire straits. If any infrastructure bill is passed, it will probably take the form of tax credits or other incentives for privately projects, which are unlikely to come close to meeting America’s infrastructure needs. In addition, any spending on infrastructure will be offset by domestic spending cuts that Republicans have been hoping to enact for years.
More generally, for the economy to grow, either more people have to work or workers have to become more productive. After seven years of the current recovery, however, unemployment is relatively low and there are probably not that many more people who could be drawn back into the labor force. The president’s ideological crusade to curb immigration will only deter people of all skill levels from coming to the United States to work. And since corporations are already awash in capital, it’s hard to see how lower taxes or anything short of a massive infrastructure investment would have an appreciable impact on overall productivity levels.
It is never possible to state definitively that stock prices are too high. Current valuations, however, seem to assume that everything will go right (from the perspective of corporations and their shareholders), which is never a sure thing. At some point, bad news out of Washington—relating to tax reform, infrastructure spending, Federal Reserve interest rates, or anything else—will likely make investors think twice about the stock market’s record highs. The US economy remains generally healthy, limiting the chances of a messy ending. But a stock market correction would take what remains of the bloom off of Trump’s first months in office.
James Kwak’s new book is “Economism: Bad Economics and the Rise of Inequality”