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Is it Time for a Tax Cut?

By Jim Pearce on September 8, 2017

With the stock market floundering last month in the wake of mounting problems at home and abroad, many analysts are clamoring for a tax cut to soothe the markets. That may provide temporary relief, but historical evidence suggests that the case for a tax cut helping stocks is tenuous at best.

Does this scenario sound familiar? A recently elected Republican president promises to reduce taxes to stimulate the U.S. economy. He feels pressured to come up with something big to deflect attention from rising tensions with Russia and knows he made many campaign promises he can’t keep, but this one is important to him.

That may sound a lot like 2017, but the year was 1980 and the President was Ronald Reagan. The following year, the Economic Recovery Tax Act of 1981 (ERTA) was enacted, which drastically cut personal income tax rates and reduced estate taxes for the wealthy.

Unfortunately, the following year the economy slipped back into recession as the federal deficit predictably swelled, resulting in passage of the Tax Equity and Fiscal Responsibility Act of 1981 (TEFRA), which raised taxes in an effort to balance the budget. The Dow Jones Industrial Average fell 17% from the enactment of ERTA to the month prior to the passage of TEFRA, but rallied sharply on the news that higher taxes, and a reduced federal deficit, were on the way.

Of course, there are significant differences between now and then that may render any comparison difficult. ERTA was passed in the midst of a recession in an attempt to boost spending, since Reagan was a believer in supply-side economics. The unemployment rate was in double-digits, as were mortgage rates which peaked above 18% the fall of 1981.

That meant most American had much bigger problems to worry about than avoiding the 70% income tax bracket. Getting (and keeping) a decent-paying job was a higher priority, as was being able to afford a house and fill the car with gas. In short, a tax cut in 1981 was the wrong solution to what was ailing the economy at the time.

Five years later another major tax bill would be passed, the Tax Reform Act of 1986, but by then the economy was in full recovery mode and the stock market had more than doubled in value since the passage of ERTA. The economy no longer required a patchwork of tax credits, shelters and other special interest accommodations necessary to incentivize investment and spending. In that regard, the 1986 initiative is often referred to as a tax simplification bill and not a tax cut since it was designed to be revenue neutral.

For the past 30 years the country has been abiding by the major principles set out in this act, with some tweaks along the way. But most of its basic tenets exist in their original form, with tax reform bills since then primarily addressing ancillary issues such as retirement account contribution limits and medical spending accounts.

The tax reform package now being contemplated by the Republican party is more similar to the 1986 act in that its primary aim appears to be simplification, by reducing the number of personal tax rates to three with a top marginal rate of 33%, a middle rate of 25% and a minimum rate of 12%. Capital gains and qualified dividends would be taxed at preferred rates of roughly half the top marginal rate paid by each taxpayer.

But where this bill is potentially quite different from that one is in its treatment of deductions. Trump would like to keep most of them while adding a few of his own, while his GOP counterparts in Congress would like to eliminate all of them but the home interest mortgage deduction and charitable contributions. Depending on exactly where those lines are drawn, the net impact on the federal deficit is estimated to be slightly to moderately inflationary, as was the 1981 tax cut.

That being the case, it is difficult to rationalize an argument for how this tax bill, as currently contemplated, will do much to help the economy or the stock market. To be sure, there will be winners and losers at the margins, but on balance it most likely would not stimulate economic growth.

However, the psychological impact of getting it passed could keep the “Trump bump” rally alive into 2018, at which time its impact on the federal deficit may have the opposite effect.

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