US Tax Reform Bill Could Add to Growth Next Year
The US tax reform bill contains significant incentives to capital expenditure, which should add to economic growth in 2018.
The US tax reform bill was passed by Congress on 20 December. The tax reform package is very complex and entails many moving parts. Hence, it is very difficult to estimate its effect on economic growth. In general, the net fiscal boost is limited as tax cuts are partly financed by abolishing various deductions and curbing spending in the budget. Nevertheless, some positive effects on private consumption are likely as individual taxes are on average being reduced. Whether the tax reform creates additional business investment that would otherwise not have been executed is questionable.
The tax reform brings, however, significant incentives to front-load capital expenditure, so some positive investment effects should be penciled in over the next two years. Many observers expect the tax reform to add roughly 0.3 percentage points to 2018 GDP growth, an estimate we feel comfortable with and which is already reflected in our set of forecasts (acceleration of GDP growth to 2.5 percent YoY in 2018, from 2.2 percent YoY in 2017).
Sweeping, Permanent Changes to Corporate Tax Code
The changes to the corporate tax code are the most relevant for markets. With a few exceptions, they are intended to be permanent. The main changes are:
- 21 percent tax rate: The corporate tax rate is permanently slashed to 21 percent from currently 35 percent, effective 1 January 2018.
- Expensing of new investments: The bill allows firms to immediately and fully expense new investments until the end of 2022. The provision is then gradually phased out between 2023 and 2026. This measure brings a significant incentive to front-load investments.
- Territorial tax system: Similar to other developed countries, the USA will move toward a territorial tax system, where international companies’ foreign income is tax exempt. However, a so-called "base erosion and anti-abuse tax" is introduced to discourage companies from shifting net income to low-tax destinations.
- Repatriation tax break: The tax bill levies a mandatory, reduced tax on all currently deferred foreign profits of US multinational companies, irrespective of whether they are actually repatriated or not. In the final bill, the applicable tax rate ended up higher than initially proposed, and was set at 15.5 percent for liquid assets and 8.0 percent for illiquid assets. The tax may be paid in installments over an eight-year period.
- Interest deductibility: The bill limits deductibility of interest expenses to 30 percent of EBITDA over the next five years. Starting in 2023, rules will become stricter to impose a deductibility limit of 30 percent of EBIT.
A Temporary Tax Cut for Individual Taxpayers
While the changes to the individual tax code are less relevant for markets, they are more in focus of the public debate and also have a larger impact on the budget, as they currently bring federal revenue that is around fives time the one corporate income taxes bring. Almost all major provisions sunset at the end of 2025 to conform to the strict rule ("Byrd rule") that tax reform must not add to the federal deficit beyond a 10-year time horizon.
- Tax rates, brackets and deductions: The tax burden of individuals is reduced by a combination of lower tax rates for most of the seven tax brackets and a higher standard deduction. Most controversially, the top marginal tax rate is cut to 37.0 percent from 39.6 percent. The bill also increases the child tax credit. The State and Local Tax (SALT) deductions for property taxes are maintained, but capped at USD 10,000. Meanwhile, the cap on mortgage interest deductions is lowered. The estate tax is not repealed as initially proposed by the House, but the burden is reduced by doubling the exemption. All of the aforementioned provisions sunset at the end of 2025.
- Health care: The bill repeals one of the centerpieces of the Affordable Care Act ("Obamacare"), namely the individual mandate. This measure is controversial, as it might destabilize health insurance marketplaces if healthy people increasingly chose to opt out.