Trump fiscal policy faces big test

After heavy focus on the Federal Reserve in recent weeks, markets are likely to turn their attention to US fiscal policy in the coming one. The president Donald Trump will speak to a joint session of Congress on Tuesday with expectations that he will provide more details about his "phenomenal" plan to reform the US tax system, promised to be announced by early March.

Last week treasury secretary Steve Mnuchin also promised "very significant" tax reform, although he said it may not be ready before August and also forecast growth to be at 3 per cent before the end of 2018, lower than the 4 per cent objective promised by Mr Trump throughout the election campaign.

Markets softened a little towards the end of last week on the back of this, and ahead of Mr Trump’s speech, as the market rally since the election was largely predicated on expectations of substantial tax reforms and a powerful fiscal stimulus.

This week’s set piece speech therefore stands to be one of the most important events of Mr Trump’s first few months in the White House.

The main elements of the Republican tax plan are to reduce corporate taxes, cut and simplify household income taxes, offer a tax holiday on repatriated earnings, abolish deductions for debt servicing, allow expensing of capex, and to introduce a border adjustment tax (or BAT).

The BAT is one of the more controversial parts of the plan, and it is by no means certain that it will feature in Mr Trump’s speech, given that Mr Mnuchin recently said that the Treasury is still looking at the pros and cons of introducing one. If enacted, it could have big effects not just on major US corporations but also on financial markets, on consumers and even having significant impact overseas including here in the GCC by way of its possible impact on oil markets.

In essence, a BAT would mean that imported goods are no longer deducted from taxable income, while exports would be allowed to be shipped abroad free from tax.

The objective of the change would be to encourage exporters and thereby create US jobs, and to punish importers, to promote a policy that Mr Trump’s team is increasingly referring to as "economic nationalism". Others might call it protectionism, and it is quite likely that such a tax would fall foul of WTO rules.

Economic theory also suggests that such a tax would also result in an almost immediate strengthening of the US dollar, with some saying this could be by as much as 25 per cent, which could ultimately undermine the benefits of such a tax.

While a dollar rise would eliminate the increased cost of imports, thereby reducing the negative inflationary impact, the positive effect on exports could also be hurt.

However, whether this dollar appreciation will occur in practice also remains a moot point given the lags that can occur between currency moves and trade flows. What is certain is that it could produce tremendous amount of uncertainty for US corporations, in particular for those companies importing from abroad such as large parts of the retail sector.

As far as the oil sector is concerned there is already a lot of anxiety in the global oil industry about such a tax’s ramifications. The plan has the potential to substantially disrupt oil pricing: oil producers in the US would be incentivised to ship output abroad tax-free, while US refiners would need to bid up the price of US crude to ensure that domestic producers were indifferent to export of domestic markets.

The short-term response from US oil industry to higher domestic prices would almost certainly be positive and reinforce the recovery already under way in US production.

Further out, however, any extension of the supply/demand imbalance could potentially have more negative consequences for oil prices, or at the very least contribute to a lot more volatility in them. For GCC countries this would potentially be an additional complication as they seek to rebalance the sources of economic growth.

Fiscal policy reform was to the financial markets the cornerstone of the Trump manifesto, but until now investors have been disappointed by the greater focus on immigration, the media, the judiciary and other issues.

The coming week could determine if the White House can get back on track and if the markets are right to keep faith with the Trump agenda.

Click here to read Tim Fox's article in The National