Singapore, 29 Dec 2017 – In a matter of months, the US House of Representatives and Senate have managed to construct and pass a sweeping tax bill, the Tax Cut and Jobs Act (TCJA). Our focus is what this legislation means for Asia (we examine the US domestic implications later in this piece). From a basic macroeconomic perspective, we don’t think the TCJA will have a major impact on the direction of the US dollar or rates. On the currency, there has been a lot of talk about how flows could be diverted to the US, thus strengthening the USD, but this line of reasoning ignores the fact that most US corporate earnings kept overseas are already in USD-denominated assets. Indeed, many companies that leave cash abroad have issued bonds in the US (Apple being the most notable example). As they repatriate, these companies will issue less bonds, leaving the overall supply or demand for USD-denominated assets largely unchanged. Of course, if growth soars and the US equity market becomes an even bigger draw than it already is, the currency would appreciate, but that scenario can be envisaged without a tax cut in any case. As for rates, we don’t think the growth and inflation implications are sufficiently large to warrant a repricing of the curves.
Beyond FX and rates, however, there are several other considerations. If the TCJA manages to boost US investment and income considerably, the world ought to benefit. But the studies we have seen so far suggest rather limited upside to US growth in the near or medium term. Indeed, projections made by independent studies suggest no reason for Asian exporters to ramp up production or capacity.
In an environment of rising protectionism and economic nationalism, the TCJA comes with some pitfalls for the rest of the world; we identify four channels of concern:
- FDI reorientation. Lower tax rates raise returns on capital, potentially diverting investment from the rest of the world to the US. We think this is a bigger risk for Europe and Latin America than Asia. MNCs that were, on the margin, considering offshoring some production may pause to take advantage of the lower domestic rates, but the factors of production that are Asia-oriented, especially those related to the electronics supply chain, are very unlikely to move back to the US, in our view. The labour cost advantages, economies of scale, and the component ecosystem is well-ingrained in Asia, with little risk of FDI diversion to the US.
- Profit repatriation. Attempts to bring back overseas savings are hardly new. In recent decades, many countries have provided incentives to individuals and companies to repatriate earnings. The track record of such initiatives is mixed; they tend to fizzle out after an initial spurt. Nonetheless, some companies will probably take advantage of the tax benefit and go ahead with repatriation. This in turn could reduce USD liquidity in foreign banks and financial centres. Again, given Asia’s strong balance of payments and reserves position, we don’t worry that this could have a seismic impact here. Some offshore financial centres and economies with sizable external funding needs (especially those in Latin America) however could struggle.
- Foreign companies doing business in the US may find various asymmetrical tax treatments eroding their competitiveness. Already, the EU has expressed concern that the tax bill may well be the first salvo in a trade war. Tax on intra-company cross-border transactions, preferential tax regime for foreign-derived fees (which the EU sees as an export subsidy), and some element of double taxation that discourages imports have been seen as adversarial to foreign businesses. Asian companies that do business in the US would be affected as well.
- Tax competition. Although even after the tax cuts, the effective tax paid by US companies would not be sharply lower than most peers, a tax incentive race may ensue, affecting the public-sector revenue base worldwide. Corporate tax rates are low in Asia, so instead of direct cuts, countries may offer non-tax incentives, which could make tax regimes opaque and distortion.
Future of the US
The starting issue is the durability of the tax legislation. Since the bill was voted along party lines, a change in control of the US Congress in the coming years could lead to efforts to push up the corporate tax rate, thus rendering the reform precarious. Making the personal income tax cuts temporary (with expiration set at 2025) will cause uncertainty in tax planning and eventual conflict to retain them down the road. Lack of uniformity in the treatment between wage and business income could create some tax arbitrage opportunities. The expectation was that a genuine reform will be pushed to reduce marginal tax rates while eliminating distorted exemptions and special provisions. Unfortunately, such efforts did not come to fruition.
A key open question that divides the proponents and opponents of the tax bill – will the cuts pay for themselves by boosting activity and income in the coming years? The Federal Reserve, after its December meeting, alluded to considering the tax cut in its latest forecasts, and yet did not see particular upside to growth. Independent budget agencies that provide inputs to Congress have not come across as enthusiastic about the growth implications of the bill either. The Penn Wharton Budget Model (PWBM) estimates GDP gain of about 0.1% per year from the measure.
What about debt? The Congressional Budget Office (CBO) sees widening fiscal deficits, reflecting aging-related demands on transfer payments, even without the tax cuts. Given the CBO’s cost estimates of the legislation, we reckon it expects the tax cut to worsen the fiscal deficit by 0.6% of GDP per year going forward. As per the projection made by PWBM, US debt will be about 10% of GDP higher over the next decade.
The proponents of the tax measures assert that the US is about to see a massive spurt in investment due to a sharp drop in the cost of doing business, which will boost activity, jobs, and income. As economic growth heads toward 3%, the fiscal position will eventually turn neutral, steadying debt.
We will retain some degree of skepticism about the growth and fiscal implications. The US economy is already in a sweet spot, buoyed by a synchronised uptick in global demand and still-modest inflation, so a sustained pick-up in investment and income ought to be expected in any case. Will the tax cuts add fuel to the momentum? We would expect that to transpire if there was widespread prevalence of poor profitability hindering investment, which could turn around after a tax cut. But profitability has been healthy and the cash position of businesses has been comfortable, which begs the question why would even more profits be a necessary condition for further investment. What is typically lost in the discussion over statutory tax rates is that US companies have been subject to the broadly same effective tax rate as their OECD counterparts, owing to various exemptions and incentives. Similarly, the tax rate on new investment has been broadly the same as it is in other developed economies. The weak investment environment of recent years reflects deeper cyclical and structural factors than rate differential, and hence the idea that investment will turn on this legislation may turn out to be a rather optimistic one.
If the tax measures were largely populist, aimed at middle and low-income Americans, we would perhaps also be optimistic about an improvement in inequality and some boost to consumption. But with the bulk of the tax cuts going to the wealthy, there will likely be only a modest rise in spending by US households, on aggregate.
Bottom line, as per non-partisan analysis, average growth may rise from 2.2% to 2.3% and public debt would rise from 105% to 115% of GDP over the next decade. The figures may turn out to be more favourable if the US can continue to leverage from a strong global economy. Of course, if policy turns more protectionist and if geopolitical risks are not contained, the baseline estimates will turn out to be rather rosy.
