In line with Donald Trump’s pre-election promises to slash US tax rates, the Trump administration came up yesterday with proposals to:
- Lower individual income tax rates by reducing the number of tax brackets from 7 to 3 for individuals, to be set at 10%, 25% and 25%.
- Substantially reduce corporate/business tax rates by slashing the top tax rate for all businesses from 35% to 15%.
- Impose a one-time tax on overseas profits of US multinational corporations.
The proposals received mixed responses. Our view is that:
- There was no detail as to how these tax cuts would be funded to achieve revenue neutrality and avoid an increase in US budget deficits and US national debt (as a percentage of US GDP). The Trump administration argues that the tax cuts would be self-financing via the additional economic growth (and hence additional tax revenues) that they would generate. This is a very dubious argument from an economic perspective and history has shown that US tax cuts not offset by other measures always lead to an increase in deficits and the national debt.
- A divided Congress is highly unlikely to approve such sizeable tax cuts as many Republicans are traditionally hostile towards higher budget deficits and an increase in the US debt ceiling. It is more likely that any tax cuts, if approved, would be much more limited in scale than those proposed by the Trump administration.
- Lower taxes and higher deficits will almost certainly lead to an increase in US long-term interest rates and the cost of US debt. Hence, any benefits US companies could receive from tax cuts would be offset by higher debt financing costs.
- US banks stand to benefit from tax cuts as they are amongst the US sectors that pay a relatively high average/effective corporate tax rate when taking tax breaks into account. Most US banks pay an average tax rate of 25%-28%. They also stand to benefit from higher interest rates that these tax cuts could trigger. However, we think that all these potential benefits are already discounted in US banks share prices, hence any disappointment regarding the actual magnitude of the tax cuts that Congress is willing to approve could lead to a pullback in US banks share prices, which, at current valuations, are no longer cheap. However, given that it might take at least until early 2018 for any tax cuts to be approved and implemented, the mere expectation of lower tax rates provides a floor to US banks share prices and makes them attractive as short term plays on stock market pullbacks.
