The view from behind the binnacle at Weatherhelm Capital Management is increasingly clouded by developments in Washington D.C. The recent failure of the Republican plan to “repeal and replace” the Affordable Care Act (a/k/a Obamacare) has for the moment, at least, been largely shrugged off by the equity markets. After opening down roughly one percent on the first trading day after the failure, markets have recovered to be largely unchanged. It is our view that the key factors supporting so called “Trump Bump” that has lifted the market, (i.e. expectations of tax reform and stimulative infrastructure spending) will now move to the top of the agenda. For reasons outlined in this missive, we feel that an infrastructure deal is possible, but significant tax reform is highly unlikely to occur in the scale and timeframe the market expects.
The genius of the founding fathers, and perhaps why our American Republic has stood the test of Civil and World Wars, social unrest, and a Great Depression, is that the system is designed to be relatively impervious to change. Think of turning a giant supertanker rather than a little sailboat.
A brief account of civics is in order: the Republicans currently hold a comfortable majority of seats in the House of Representatives, but just a slim majority of 52 seats in the U.S. Senate, where Vice President Mike Pence can also be counted on to break a tie. You have certainly heard of a “filibuster,” the procedure whereby a senator may prolong debate indefinitely, not allowing a bill she opposes to come to a vote. Cloture (closing of debate and causing an immediate vote) may only be obtained with a three-fifths majority, i.e. 60 votes.
The Republicans simply don’t have the votes and, as evidenced by the recent climate in the upper chamber around the Gorsuch Supreme Court confirmation, Democratic votes for Republican priorities are hard to come by. Therefore, to avoid filibuster, Republicans must use the budgetary “reconciliation” process, whereby only a simple majority of 51 votes is required, to pass their agenda.
Enter the Byrd Rule. This arcane gem of parliamentary procedure, named after the late Sen. Robert Byrd of West Virginia, sets forth what you can and can’t do with reconciliation. Those items which are considered “extraneous” to a reconciliation bill under the Byrd rule are subject to a senator raising a “point of order” or objection. The point of order strikes the offending provision from the bill unless its proponents can muster a 60 vote majority to waive the rule or unless an exception can be obtained (more on what it takes to get an exception in a minute).
The Byrd Rule defines various criteria to determine whether a provision is “extraneous” and therefore ineligible for reconciliation. Several criteria ask whether a provision, being passed as part of the budget reconciliation process, actually impacts the budget. This should not be an issue with either tax reform or infrastructure spending. Another criterion is whether the provision is within the scope of the committee which recommended the bill; this too should be surmountable given Republican majorities. Still another adds credence to the saying that Social Security is the “third rail” of American politics- under the Byrd Rule you can’t touch Social Security with reconciliation, and so we expect that the Republicans won’t even try.
So far so good, but the Achilles Heel of the entire Republican legislative agenda may be the criterion of the Byrd Rule which prohibits any provision that “would increase the deficit for a fiscal year beyond those covered by the reconciliation measure, unless the provision’s title, as a whole, remains budget neutral.”
In plain English, the Byrd Rule requires that any reconciliation bill must either be (i) revenue neutral over 10 years (i.e. not increase the deficit) or (ii) not increase the deficit from year 11 onward.
How might the Republicans spend $1 trillion on infrastructure, cut taxes, and not increase the deficit? Well, like any good and complicated rule there can be exceptions. “Section 313(b)(2) allows certain otherwise covered Senate-originated provisions to be excepted from the Byrd rule if the provisions are certified for exemption by the Senate Budget Committee chairman and ranking minority member…”
Okay, so maybe there’s hope, right? If the Republicans can just get one Democrat on board, the ranking (Democratic) member of the Senate Budget Committee to agree to an exception…
Let’s see… who is the ranking Democrat on the Senate Budget Committee?
You can’t make this stuff up!
Either the Republicans have to make all their grand plans revenue neutral or they have to get Bernie Sanders to certify an exception to the Byrd Rule. We think the latter may be possible around an infrastructure plan, after all this was one of Bernie’s key issues, but cutting taxes? Fat chance.
It is possible that the Republican conference could make their proposals revenue neutral with some combination of the following:
- Include a “sunset provision” making any tax cuts temporary (this is what the Bush-era tax cuts, which were also passed by reconciliation, did to get around the Byrd Rule- remember the 2013 “fiscal cliff” fight when they were set to expire?); and,
- Offset the revenue impact of a tax cut and/or infrastructure spending with by a one-time tax holiday on the repatriation of corporate profits being held offshore.
The problem with the “sunset” idea is that budget hawk members of the Freedom Caucus are not likely to support unfunded tax cuts, even if they are temporary. This was the rationale behind doing the Obamacare repeal first- so that projected “savings” could be used to pay for tax cuts. Without a deal on healthcare, a deal on unfunded tax cuts becomes much more difficult.
On the second notion, we don’t think there is enough money to be gained with a repatriation holiday to achieve any meaningful reduction in the corporate tax rate. It is reported that there are $2.1T in corporate profits being held offshore. http://www.reuters.com/article/us-usa-tax-offshore-idUSBREA3729V20140409 Let’s say there is a 10% tax holiday and every nickel comes back, that raises $210B. How much can they cut the corporate tax rate with that?
The CBO did a study back in 2013, estimating the impact on revenues if the corporate tax rate was lowered from 35% to 25% and concluded the cost would be $1.3T over ten years.
If the CBO was correct, the $210B raised by repatriation would only pay for a paltry 1.6% reduction in the corporate tax rate!
Trump has pledged a corporate tax rate of 15% (cost= $2.6T). The market consensus is probably that the rate drops to 20% (cost = $1.95T). A 1.6% drop in the corporate tax rate that sunsets in 10 years (cost $210B) is not, in our view, enough to keep the Trump Bump popping.
We can see the possibility, slight but non-zero, of a bi-partisan consensus developing around an infrastructure spending bill, Bernie might even certify an exception to the Byrd Rule to get this done. But as for deep, permanent, and meaningful tax reform- the centerpiece of the Trump’s Republican Agenda- requiring an exception to the Byrd Rule, we think it much more likely we’ll see Bernie’s Revenge.
As always, we appreciate your comments and thoughts, welcome an open discussion, and remain… steady at the helm.
Clark Kastner Steve Lulla Kristina Ickes