An equity boom is under way in the US, reflecting market optimism about tax and regulatory improvements by the Donald Trump administration, accompanied by higher infrastructure spending.
What is at stake in US fiscal reform, and what are the global spillovers?
First, let’s look at the US growth context and long-standing growth concerns. The reality is that US potential growth (the long-term trend growth of output) has fallen from about 3% in the early 2000s to 2% now. A major factor has been declining productivity growth, reflecting marked falls in business dynamism. Reforms to lift tax and regulatory hurdles and restore business investment and productivity in the US have been long awaited. However, it will not be easy to gain consensus across corporate America, in Congress, as well as international support.
Corporate tax reform is a critical element, given that the system is highly flawed relative to competitors. Briefly, at 35%, the federal rate is the highest among industrial countries, and its inefficiency has significantly reduced its share of fiscal revenue. This is because the base is narrow, given its affliction with credits, deductions, and special preferences that distort decisions, encourage excessive borrowing, and deflect corporate investment to other destinations.
Thus, much more needs to be done than just reducing the tax rate. What is necessary is moving to a less distorted system that increases the competitiveness of the US economy and attracts investment. However, with declining productivity and growth across advanced and emerging market countries, and the search for business investment, the global implications of such reform will be significant.
Within the US, it helps that the House of Representatives has been preparing for corporate tax reform for years. Now, with a Republican majority in the Senate and a Republican president, those plans could finally move ahead—potentially making them the most significant since the Reagan corporate tax reform in 1986. Among its domestic challenges will be maintaining the support of congressional Republicans who favour a revenue-neutral tax reform, especially given the accompanying aim to raise infrastructure spending.
The shape of the corporate tax package could have four major components:
l A lower corporate tax rate. There is emerging consensus to halve the current rate. With corporate tax revenue currently equal to 2% of GDP (gross domestic product), the proposed rate cut would reduce revenue by about 1% of GDP, or $190 billion a year. Over time, the resulting increase in investment could boost growth and lower the revenue loss.
l Reducing distortions to investments and borrowing. Moving to a “cash-flow” corporate tax would enhance the incentive to invest and put debt and equity on equal footing. Companies would be able to deduct all investments in equipment and structures immediately, instead of spreading the cost over time, and they would lose the deduction for interest costs on new debts.
l A territorial system for taxing foreign subsidiaries. The US fully taxes repatriated profits (with a credit for tax paid in foreign jurisdictions). Adopting a territorial system (used by other industrial countries) would help increase investment in the US.
l Border tax adjustment. The border tax adjustment would give the international advantage of a value-added tax (VAT), by taxing imports and excluding export earnings from taxable income. In principle, the trade balance would not change, and the dollar would appreciate in value, raising tax revenue significantly (given the US has a large trade deficit) to help meet about half the cost of the cut in tax rate.
Not surprisingly, there is substantial opposition to the border tax adjustment, within corporate America (from large retail importers) and internationally. By doubting that the dollar will strengthen in practice sufficiently, those against the border adjustment see it as equivalent to levying an export subsidy and an import tax. This could spark disputes at the World Trade Organization (WTO) with the risk of countervailing action by trade partners.
The proponents of the border tax adjustment see it as the equivalent of many countries that levy VAT on imports and not on exports. They see it as effectively taxing all domestic consumption at an equal rate, thereby removing the incentive for firms to relocate profits or move profitable activities outside the country.
Together with the aim to raise infrastructure spending, the overall fiscal agenda would be expansionary, raising the deficit. In the short run, real output will likely rise, but with a consequent widening of the external current account deficit. Given that there is little remaining slack in the US economy, inflation pressures could rise quickly, and this would make the Federal Reserve raise interest rates faster.
Thus, broader structural reforms will be needed to fund all this within a smaller deficit envelope, and convince markets that the agenda will sustainably boost productivity over the medium term. We are not there yet with the other reforms. Indeed, the future path of interest rates has already steepened, with the Fed anticipating several interest rate hikes in 2017, with the likelihood of further dollar appreciation.
If implemented, the spillovers of such US fiscal reform on global trade and investment flows would be considerable. On the one hand, many countries will benefit from higher US growth, provided protectionism doesn’t rise. However, a rise in interest rates and in the US dollar could easily follow, putting pressure on weak points around the world and on corporate borrowing in emerging markets. And, as many advanced countries lose their low-tax comparative advantage, the incentive for business investment to return to the US would rise, along with its growth and tax implications, which would burden the other countries.
Anoop Singh is adjunct professor, Georgetown University, and former director, Asia-Pacific department, International Monetary Fund.