Our strategists Michael Zezas and Ariana Salvatore provide
context around U.S. House Republicans’ proposed tax bill and how
investors should view its potential market impact.
Read more insights from Morgan Stanley.
----- Transcript -----
Michael Zezas: Welcome to Thoughts on the
Market. I'm Michael Zezas, Global Head of Fixed Income Research
and Public Policy Strategy.
Ariana Salvatore: And I'm Ariana Salvatore,
Public Policy Strategist.
Michael Zezas: Today, we'll dig into Congress's
deliberations on taxes and fiscal spending.
It's Wednesday, May 14th at 10am in New York.
Michael Zezas: So, Ariana, there's been a lot of
news around the tax and spending plans that Congress is pursuing;
this fiscal package – and clients are really, really focused on
it. You're having a lot of those conversations right now. Why are
clients so focused on all of this?
Ariana Salvatore: So, clients have reasons to
focus on this tax policy bill across equities, fixed income, and
for macroeconomic impacts.
Starting with equities, there's a lot of the 2017 tax cut bill
that's coming up for expiration towards the end of this year. So,
this bill is Congress's chance to extend the expiring TCJA. And
add on some incremental tax cuts that President Trump floated on
the campaign trail. So, there's some really important sector
impacts on the specific legislation side. And then as far as the
deficit goes, that matters a lot for the economic ramifications
next year and for bond yields.
But Mike, to pivot this back to you, where do you think investor
expectations are for the outcome of this package?
Michael Zezas: So there's a lot of moving pieces
in this fiscal policy package, and I think what's happening here
is that investors can project a lot onto this. They can project a
lot of positivity and constructive outcomes for markets; and a
lot of negativity and negative outcomes for markets.
So, for example, if you are really focused on the deficit impact
of cutting taxes and whether or not there's enough spending cuts
to offset those tax extensions, then you could look at the array
of possible outcomes here and expect a major deficit expansion.
And that might make you less constructive on bonds because you
would expect yields to go higher as there was greater supply of
Treasuries needed to borrow that much to finance the tax cuts.
Again, not necessarily fully offset by spending cuts.
So, you could look at this and say, well, this will ultimately be
something where economic growth helps tax revenues. And you might
be looking at the benefits for companies and the feed through to
the equity markets and think really positively about it.
And we think the truth is probably somewhere in between. You’re
not going to get policy that really justifies either your highest
hopes or your greatest fears here.
Ariana Salvatore: So, it's really like a
Rorschach test for investors. When we think about our base case,
how do you think that's going to materialize? What on the
policy front are we watching for?
Michael Zezas: Yeah, so we have to consider the
starting point here, which is Congress is trying to address a
series of tax cuts that are set to expire at the end of the year.
And if they extend all of those tax cuts, then on a
year-over-year basis, you didn't really change any policy. So
that just on its own might not mean a meaningful deficit
increase.
Now, if Congress is able to extend greater tax cuts on top of
that; but it's going to offset those greater tax cuts with
spending cuts in revenue raises elsewhere, then again you might
end up with a net effect close to zero on a deficit basis.
And the way our economists look at this mix is that you might end
up with an effect from a stimulus perspective on the economy
that's something close to neutral as well. So, there's a lot of
policy changes happening beneath the surface. But in the
aggregate, it might not mean a heck of a lot for the economic
outlook for next year.
Now, that doesn't mean that there would be zero deficit increase
in the aggregate next year because this is just one policy that
is part of a larger set of government policies that make up the
total spending posture of the government. There's already
something in the range of $200-250 billion of deficit increase
that was already going to happen next year. Because of weaker
revenue growth on slower economic growth this year, and some
spending that would automatically have happened because of
inflation cost adjustments and higher interest on the debt. So,
long story short, the policy that's happening right now that we
think is going to be the endpoint for congressional deliberations
isn't something our economists see as meaningfully uplifting
growth for next year, and it probably increases the deficit – at
least somewhat next year.
Now we're thinking very short term here about what happens in
2026. But I think investors need to think around that timeline
because if you're thinking about what this means for getting
deficits smaller, multiple years ahead, or creating the type of
tax environment that might induce greater corporate investment
and greater economic growth years ahead – all those things are
possible. But they're very hypothetical and they're subject to
policy changes that could happen after the next Congress comes in
or the next president comes in.
So, Ariana, that's the overall look at our base case. But I think
it's important to understand here that there are multiple
different paths this legislation could follow. Can you explain
what are some of the sticking points? And, depending on how
they're resolved, how that might change the trajectory of what's
ultimately passed here?
Ariana Salvatore: There are a number of
disagreements that need to be resolved. In particular, one of the
biggest that we're focused on is on the SALT cap; so that's the
cap on State And Local Tax deductions that individuals can take.
That raised about a trillion dollars of revenue in the first
iteration of the Tax Cuts and Jobs Act in 2017.
Republicans generally are okay with making a modification to that
cap, maybe taking it a bit higher, or imposing some income
thresholds. But the SALT caucus, this small group of Republicans
in Congress, they're pushing for a full repeal or something
bigger than just a small dollar amount increase.
There's also a group of moderate Republicans pushing against any
sort of spending cuts to programs like Medicaid and SNAP; that's
the food stamps program. And then there's another cohort of House
Republicans that are seeking to preserve the Inflation Reduction
Act. Ultimately, these are all going to be continuous tension
points. They're going to have to settle on some pay fors, some
savings, and we think where that lands is effectively at a $90
billion or so deficit increase from just the tax policy changes
next year.
Now with tariff revenue excluded, that's probably closer to
[$]130 billion. But Mike, to your point, there are these
scheduled increases in outlays that also are going to have to be
considered for next year's deficit. So, you're looking at an
overall increase of about $310 billion.
Michael Zezas: Yeah, I think that's right and
the different ways those different dynamics could play out, I
think puts us in a range of a $200 billion expansion maybe on the
low end, and a $400 billion expansion on the high end. And these
are meaningful numbers. But I think important context for
investors is that these numbers might seem a lot smaller than
some of what's been reported in the press, and that's because the
press reports on the congressional budget office scoring, and
these are typically 10-year numbers.
So, you would multiply that one-year number by 10 at least
conceptually. And these are numbers relative to a reality in
which the tax cuts were allowed to expire. So, it's basically
counting up revenue that is being missed by not allowing the tax
cuts to expire. So, the context matters a lot here. And so we
have been encouraging investors to really kind of look through
the headlines, really kind of break down the context and really
kind of focus on the short term impacts because those are the
most reliable impacts and the ones to really anchor to; because
policy uncertainty beyond a year is substantially higher than
even the very high policy uncertainty we're experiencing right
now.
So, sticking with the theme of uncertainty, let's talk timing
here. Like we came into the year thinking this tax bill would be
resolved late in the year. Is that still the case or are you
thinking it might be a bit sooner?
Ariana Salvatore: I think that timing still
holds up. Right now, the reconciliation bill is supposed to
address the expiring debt ceiling. So, the real deadline for
getting the bill done is the X date or the date by which the
extraordinary measures are projected to be exhausted. That's the
date that we would potentially hit an actual default.
Of course, that date is somewhat of a moving target. It's highly
dependent on tax receipts from Treasury. But our estimate is that
it's somewhere around August or September. In the meantime,
there's a number of key catalysts that we're watching; namely, I
would say, other projections of the X date coming from Treasury,
as well as some of these markups when we start to get more bill
text and hear about how some of the disputes are being resolved.
As I mentioned, we had text earlier this week, but there's still
no quote fix for the SALT cap, and the house is still tentatively
pushing for its Memorial Day deadline. That's just six
legislative days away.
Michael Zezas: Got it. So, I think then that
means that we're starting to learn a lot more about how this bill
comes together. We will be learning even a lot more over the next
few months and while we set out our expectations that you're
going to have some fiscal policy expansion. But largely a broadly
unchanged posture for U.S. fiscal policy. We're going to have to
keep checking those regularly as we get new bits of information
coming out of Congress on probably a daily basis at this point.
Ariana Salvatore: That's right.
Michael Zezas: Great. Well, Ariana, thanks for
taking the time to talk.
Ariana Salvatore: Great speaking with you,
Michael.
Michael Zezas: Thank you for your time. If you
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