Trump’s Tax Plans in Shambles, Stock Market Correction Ahead?

April 7 2017

Ever since it became known that Donald Trump would be the next American president, stock market indexes (the S&P 500, Dow Jones and Nasdaq) took an advance on his future tax plans. The Dow Jones rose by more than 12% after Trump´s election, while the S&P 500 rose by 10%. However, this so-called “Trump-trade” (buying stocks in anticipation of a future tax reduction) seems to be turning against itself, since it is not as easy as expected to actually lower taxes.

Stock Market Valuations

The stock market is relatively efficient in the longer run, which simply means that stock market prices tend to move toward the fundamental value of publicly listed companies. The fundamental value of a company is the present value of all its future (net) cash flows.

Now, a common denominator of companies when it comes to negative cash flows (which in turn lower net cash flows) is corporate taxes. Corporate taxes lower the cash flows (the cash profits) that companies earn. If we would calculate the present value of all futures taxes that a large business pays out to the government, we would reach a billion-dollar-amount in many cases.

That means that whenever corporate taxes are lowered, the present value of the future profits of a company is suddenly much higher. An important expense disappears; more money is left for the shareholders.

The Tax Plans of Donald Trump

By far the most important element of the tax plans of DonaldTrump was a proposed lowering of the corporate tax rate to 15% (currently at 35%). If suddenly an additional 20% is left of all corporate earnings, than that implies an enormous improvement in the present value of these companies. In other words, a reduction in corporate tax rates leads, all other things equal, to higher stock market prices.

Better yet, in a debate with Hillary Clinton, Trump said the following:

“Under my plan, I’ll be reducing taxes tremendously, from 35 percent to 15 percent for companies, small and big businesses. That’s going to be a job creator like we haven’t seen since Ronald Reagan. It’s going to be a beautiful thing to watch.”

Until the tax plans were twisted and tweaked. Suddenly nobody mentioned a 15% corporate tax rate, but 20% (still a large improvement compared to the current 35% rate).

But now it strongly appears that the tax plans of Donald Trump are off the table. First, a health care reform failed. The reform was not “liberal” enough (in the traditional, European sense) for the Freedom Caucus, a fraction within the Republican Party that stands for economic freedom. They were responsible for blocking the health care plans of Trump, which was called an ObamaCare-light elsewhere. As a result, no health care reform has passed.

Implementing Trump’s health care plans was, however, a first step toward implementing the promised tax reductions. With this health care bill, funds would be freed up to finance a tax reduction. Now, since the health care reform was not passed, there is no space to realize a corporate tax reduction. Trump’s health care reform represented a spending reduction of $1 trillion dollars in ten years time, which was needed to make a tax reduction possible without increasing the public deficit.

Second, Trump also depends on various interest groups within the Republican Party for tax reform. Some of these groups will not agree to a tax reduction that does not go hand in hand with a spending reduction. Any tax reduction must be “deficit neutral”, according to these groups. While Trump was planning on lowering taxes massively anyway, despite a higher budget deficit, that appears to be an impossibility for now.

Third, all these interest groups seem to have different priorities when it comes to a tax reform. The Trump Administration is already working on its third tax reform. With every new tax plan, the original corporate tax reduction to 15% disappears further and further into the distance.

If a (corporate) tax reduction will eventually pass, then it is very likely to be a much less rosy tax reduction than the original election promise of Trump.

Stock Markets Down?

As soon as the market realizes that the Trump Administration will not deliver on its promised tax reductions, stock markets will react in only one way: with a correction.

The advance on future tax reforms that investors took earlier (remember: the stock market is forward-looking, not backward-looking), will have to be compensated. And that will most likely occur through lower stock market prices, and not through higher gross profits.

The “Trump-trade” will no longer mean buying stocks in anticipation of lower corporate taxes, but selling stocks after a completely failed tax reform. Buying stocks in the US at current valuations is madness.

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