• "Kee" Points with Jim Kee, Ph.D.


    • Hammering out the Tax Plan
    • How to Think About Corporate Cash
    • Important Point on the Federal Reserve

    Markets were down slightly last week as Senate Republicans outlined their version of a tax bill which proposed, among other things, a one year delay in cutting the corporate tax rate. They also proposed rethinking some tax breaks (charitable deductions, mortgage interest deductions, medical deductions). Other points of contention are state and local tax deductions. I think this highlights the inevitable conflicts between tax simplification, on one hand, and key tax deductions or incentives, on the other.



    Hammering out the Tax Plan

    Another trade-off is the loss of federal revenue to the US government. Individual income taxes currently account for about 80 percent of government revenues, corporate income taxes account for about 9 percent, and the rest comes from miscellaneous taxes. In general, capital is more responsive to tax changes than labor, and a large cut in the corporate rate would have the biggest bang-for-the-buck, particularly as it affects business investment spending. This includes reducing taxes on repatriated income, or income earned overseas. It also includes accelerated depreciation schedules, as immediate expensing of capital expenditures lowers tax burdens relative to depreciating them over time. That is because expensing lowers immediate taxable income more, while depreciating investments over a time schedule spreads the “tax shield” over future periods, thus making the present value of taxes paid higher under depreciation (versus expensing). Lowering the corporate rate permanently also has a bigger impact than a temporary reduction. For these reasons, we still believe that the highest probability of impactful reform will take place at the business level, where revenue losses are smaller and growth impacts are larger, than at the individual level (where revenue losses are greater and growth impacts are smaller). The higher the existing rate, the stronger the impact of tax cuts, and here again corporate rates are relatively higher than individual rates. That’s as simply as I can lay it out without 10 pages of detail!



    How to Think About Corporate Cash

    What should companies do with higher after-tax income and with earnings brought back (repatriated) from overseas? The way to think about it is in terms of wealth redistribution versus wealth creation. If companies are profitable, that is, if they are earning a return on their investments that is higher than the cost of those investment funds (called “the cost of capital”), then more wealth is created by reinvesting in the business, which includes spending on plant and equipment, building or leasing more space, and - increasingly in a high tech world - spending on research and development (R&D). These are actions that result in wealth creation. If profitable reinvestment opportunities aren’t available, then firms should give excess earnings back to investors, which takes the form of paying down debt, buying back shares, and paying out dividends. These are best thought of as wealth redistribution strategies. This is also where regulatory morass comes in to play, which is difficult to quantify but no less important than taxes. Streamlining the myriad layers of regulation and clearing up regulatory uncertainty would go a long way toward maximizing the growth impact (i.e. business investment spending) of any given tax cut, so the two - taxes and regulation - should be looked at in tandem, and I believe they currently are. Of course, regulatory safeguards with respect to workers and environmental impacts are important, but at issue here is accomplishing these laudable goals in as straightforward a way as possible.


    Clearing up uncertainty goes a long way toward inducing companies to reinvest for wealth creation, which is risky, versus returning cash to investors, which is not (really). The safest thing a company can do with cash is to sit on it, but that doesn’t help anybody. The next safest action is buying back shares, more so than increasing dividends, as a later decision to have to cut dividends is frowned upon by investors. General Electric’s recent decision to cut its dividend for the first time since the Great Recession and, before that, the Great Depression era, is an excellent case in point (the stock sold off almost 8%!). A corporate tax cut combined with regulatory reform or simplification results would be the ideal reform package.



    Important Point on the Federal Reserve

    Lastly, I have made the point in several webcasts that, overall, the Federal Reserve has done a pretty good job at maintaining price stability in the face of numerous crises over the past several decades. In his recent blog, “The Grumpy Economist,” University of Chicago economist John Cochrane made the point that Fed Chair Janet Yellen has continued this performance. True, she didn’t face any monumental events during her tenure, but Cochrane points out that she didn’t mess anything up either, and she maintained the basic Fed mandates of promoting maximum employment, stable prices, and moderate long-term rates. My expectation and hope is that, in future years hence, we will be able to say same the same thing about incoming Fed Chair Jerome Powell.


  • "Kee" Points with Jim Kee, Ph.D.


    • Economic Growth
    • Tax Reform
    • Other Notes


    Economic Growth

    Sometimes I think media discussions regarding government policies and economic growth have gone a little too far, implying that economic growth is determined by this or that tweaking of monetary or fiscal policies. Competition in the areas of production and exchange is what produces growth, and policies can facilitate this to a greater or lesser extent. “It is impossible to have a clear understanding of the growth process,” says UCLA economist Arnold Harberger, if there is a failure “to recognize that all economic growth takes place at the level of the productive enterprise.” Harberger has probably been more engaged with individual countries in helping them to foster growth than any living economist of the past 60 years. On the subject of how to create growth, his take is surprisingly modest: “in general, economic policies typically do not determine any element in the growth process. Rather, they operate to permit or impede these elements.” I think Harberger’s views are good to keep in mind when thinking about pending policy changes.


    Tax Reform

    The House Republican tax bill was released last week, and it offered more detail on what amounts to a pretty sweeping proposal to reform the US tax system. I won’t go into a line-by-line discussion here, but I will provide links below to several sources that do a good job of summarizing the bill. As for the impact on economic growth and on government deficits, the proposed tax cuts would increase both, although the magnitude of each is open to debate and will be 50 years from now.


    In general, capital is more responsive or “elastic” to tax changes than labor. Martin Feldstein alluded to this in his article in Monday’s Wall Street Journal, “Corporate Tax Reform is the Key to Growth.” And while I wouldn’t call Feldstein unbiased (he rarely advocates tax increases), he does point to the cut in the corporate tax rate from 35% to 20% as the most important reform in the bill. This assertion that the cut in the corporate tax rate is the most impactful with respect to growth is shared by other estimates I have seen, like those from the Tax Foundation’s econometric model (Nobel laureate Robert Mundell has also said the same). To be fair I will also point out that the Brookings Institution has argued that the proposed bill will benefit the wealthiest taxpayers, may hurt others, and will worsen an already bleak government debt and deficit picture.


    Here's the bill.


    Here’s a good “Old versus new” format summary from Forbes.



    Central Bank Change

    President Trump’s announcement that he would nominate Fed governor Jerome Powell to succeed current Chair Janet Yellen surprised almost no one, and I would reiterate that the key difference between the two will likely be Powell’s enthusiasm for bank deregulation. This needn’t be a repeal of the Dodd-Frank Banking act, but merely a roll-back of some of the massive regulatory sprawl that followed this piece of legislation after it was passed in 2010.

     

    Other Notes

    Brent crude oil is pushing $65 per barrel, a two-year high, over rising tensions in the Middle East (WSJ). This is quite consistent with what Amy Myers Jaffe had articulated a few weeks ago at a couple of STMM events in Houston. In Spain, direct rule from Madrid has been imposed by the Rajoy government (Mariano Rajoy, Spain’s Prime Minister) over Catalonia. Rajoy decided to call a December 21 vote to seat a new government in Catalonia (the independence movement there failed to achieve credibility, and its leaders were jailed).



    The link above will redirect you to an article or page on a third-party website. The link is directed to the specific article or interview noted, but the third-party website may include additional information, content, or links to additional pages or sites that STMM has not reviewed. STMM does not have control over the third-party website and while STMM has verified as of the date of this email that the link directs to the intended article or interview, this may change in the future. This article or interview sets forth the personal opinions of its author as of its publication date. This article is for general informational purposes only. It is not a recommendation to buy or sell securities or to adopt any investment position; nor is it a solicitation of an offer to buy or sell any securities or investment services. This article is not intended to constitute investment, legal or tax advice and should not be relied upon as such. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this reprint were or will be profitable. All material and information presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. 

  • "Kee" Points with Jim Kee, Ph.D.


    • US Policy
    • Amazon’s Second North American Headquarters
    • Quick take on the Global Economy


    US Policy

    This is potentially a big news week for the market, with the possibility of tax reform clarification on Wednesday, a potential statement on Trump’s preference for the Federal Reserve Chair on Thursday, and the October payroll report (jobs created) on Friday. The September jobs report (Bureau of Labor Statistics) indicated a decline of -33,000 jobs, largely attributed to Hurricanes Harvey and Irma (expectations were for 150,000+). Some of September’s decline is just due to the mechanics of how these surveys work, with those temporarily unable to work pushing the numbers down and then up. I think markets are just looking for some reassurance of that, with expectations in the 300,000 range for Friday’s report.


    A good payroll number would be consistent with recent economic releases, particularly Friday’s GDP report (from the Bureau of Economic Analysis), which showed that the economy grew at a 3% annualized rate in the third quarter. “Nowcasting” models are indicating similar growth for the fourth quarter as well. All of these are subject to revision as new data come in, but they all point to continued expansion in the US.


    As for President Trump’s choice of who will chair the Federal Reserve, I will reiterate that the only rationale for not reappointing Janet Yellen (from Trump’s point of view) would be a preference for someone more enthusiastic for bank deregulation. I think that’s what makes Fed Governor Jerome Powell the high probability candidate. And I suspect that any tax reform proposals this week will amount to more of a negotiation wish list than a hard and fast set of expected rates, brackets, exclusions, etc. In the words of Rob Arnott, “picking winners and losers is a bit of a dangerous game because the sausage factory (Congress) hasn’t even begun to weigh in on how to construct this thing.”



    Amazon’s Second North American Headquarters

    Dozens of cities across the US and Canada are vying to attract Amazon for the location of its second North American headquarters, although Moody’s analytics cites Austin and Atlanta as highest on the list. It’s a big deal, as Amazon intends to invest over $5 billion and employ 50,000 workers (Financial Times). Cited as must-haves by Amazon are a population of over 1 million, proximity to a major airport, and a good university system. Over 100 cities have submitted bids.



    Quick take on the Global Economy

    Looking globally, I mentioned that the global data has come in a bit stronger than was expected at the beginning of the year, although country-by-country there is a lot going on. Here are a few things to keep an eye on (from wading through a couple of weeks’ worth of Financial Times):


    Japan: Prime Minister Shinzo Abe won a decisive election which investors cheered as a continuation of stimulus and stability, with the Nikkei 225 stock index enjoying a record 15 consecutive days of gains.


    Europe: UK Prime Minister Theresa May expressed an interest in keeping a “deep and special” partnership with the European Union regarding Brexit, something much of Europe, including Germany, desires based upon what I would say is widespread recognition of interdependence and a limited stomach for disruption. In France, President Emmanuel Macron is proposing tax cuts in a follow through of his stance as a business-friendly government (Japan Times).

    India and China continue to expand, with government funds in India providing capital ($36 billion) to shore up banking system problems there. China’s President Xi Jinping closed the Communist party congress in Beijing and appears to have no immediate successor, while China’s highly esteemed central bank governor (People’s Bank of China) Zhou Xiaochuan confirmed his pending retirement. He expressed ongoing concern over credit/capital control policies there. Banking/financial systems in both China and India have a long way to go (growing pains?) with regard to matching the developed world, so I expect these stories to be an ongoing part of the news flow.


    Latin America too is growing, with each country there experiencing its own problems and political uncertainties. Mexico, for example, is dealing with the aftermath of a terrible earth quake, declining energy investments (mining sector) and uncertainty regarding potential changes (“updates”) to NAFTA (North American Free Trade Agreement).


    Finally, an interesting take on the destabilizing efforts in the cyber-security realm from both Russia and North Korea, for while Russia has a continued interest in and is integrated to the global financial system, North Korea does not.


  • "Kee" Points with Jim Kee, Ph.D.


    • Budgets and Taxes
    • Fed Appointment
    • The Fed and the Economy

     

    Budget


    Markets finished the week on a strong note as the Senate passed a budget bill on Thursday that was seen as a prerequisite to tax reform (Market Watch). I don’t think anyone thinks this budget for fiscal 2018 is anything but a vehicle to facilitate tax reform, but it does articulate the Senate GOP’s (Republican’s) political vision, i.e. maintaining spending in 2018 at 2017 levels, with nondefense spending cuts in future years and reduced Medicare spending over the next decade (TheHill.com). It is generally conceded that little of this will be enforceable without further legislation, which is why it is taken pretty lightly.


    Tax Reform


    Tax reform is important, and some progress towards simplification and permanence would be beneficial to the economy (i.e. market participants – you, me, business entities) and supported by both political parties. Whether that occurs with higher or lower rates, on the other hand, is where the political divide occurs. With respect to businesses, a reduction in the corporate tax rate and on income earned overseas seems most likely at this point, while there is less clarity on things like allowable tax deductions (including the interest deduction), depreciation schedules (versus expensing), and pass-through businesses. On the individual side, there will probably be fewer brackets (perhaps 3 or 4) but the income thresholds at which those take place are not yet known (but of course most important). There are hundreds of potential topics here (Estate taxes? Mortgage deductions? State income tax deduction? Etc.), but the above are getting the most attention from the administration (Whitehouse.gov).


    Appointing a Federal Reserve Chair


    Janet Yellen’s term as Fed Chair ends in February, and a there is a lot of media buzz surrounding the question of whether President Trump will re-appoint her, or whether he will choose some other candidate. Trump’s biggest issue with Yellen is probably her relative enthusiasm for banking regulation, particularly the Dodd-Frank Banking Act. Two potential candidates, John Taylor and Kevin Warsh, are considered to be a little more “hawkish” than Yellen, meaning they are more anxious to normalize rates and reduce the Fed’s balance sheet. But Fed Governer Jerome Powell, largely considered to be the front-runner (Greg Valliere), tends more towards Yellen and a gradualist (“dovish”) stance by the Fed but with a different regulatory bent (other potential candidates are former US Bancorp CEO Richard Davis; Columbia University’s Glenn Hubbard, former BB&T head John Allison, and Trump economic adviser Gary Cohn).


    The Fed and the Economy


    Looking to the importance of all of this, I always go back to the fundamental notion that wealth is created by production and exchange. Monetary policy and fiscal policy can facilitate specialization and exchange, but in and of themselves cannot create wealth. Many argue, and I am certainly in this camp, that the best the Central Bank can do is to, (1) ensure a stable-valued currency, which optimizes or best facilitates exchange, and (2) also serve as a lender of last resort in times of crisis in order to avoid banking/financial system collapse. In an interesting Wall Street Journal article last week, former Treasury Secretary George Shultz pointed out that the Fed’s view of what constitutes “normal” growth is also important. A Fed chief and Open Markets Committee group that feels 2% GDP growth is the new normal (rather than the longer-term average of 3%+) might be more aggressive in raising rates to slow the economy (for fear of inflation) than a group that believes 3% growth is doable. I thought that was an interesting point.


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