US tax refrom: Europe must be vigilant

Article written by Michala Marcussen, Group Chief Economist and Head of Economic and Sector Research for Societe Generale, first published in the finance magazine Option Finance 11/12/2017.

The text of the US tax reform bill passed by the Senate during the night of December 1 now has to be reconciled with the version passed by the House of Representatives on November 16, before the final bill is presented for vote by both Houses, and signed by the White House. The Republicans are hoping to finalize this process before Christmas.

The goal of the tax reform bill is to make US business more competitive, by cutting corporate taxes to 20% from 35% and implementing a set of other measures aimed at boosting investments and exports while stimulating job creation. Some tax relief measures also target private households, but they are only temporary, and designed to demonstrate compliance with the budgetary rules and reassure some Republicans with a more conservative leaning when it comes to public deficits.

The tax reform’s potential to successfully boost growth is based on the premise that providing US firms with tax relief leads to investments and, in turn, job creation: firstly via the principle of substitution - by making national investments more attractive than foreign investments - and secondly, by offering tax incentives for investment. This second knock-on effect is based on the implicit theory that investments in the US are currently hampered by costs and not by projected future demand. However, most studies show that anticipation of future demand is the leading motivation driving investment.

While the reform bill also provides for tax relief for private households, in reality, by offering breaks to the wealthiest families, the impact in terms of demand is likely to be minimal.   As we observed through the example of QE policy, the effects of wealth have only a limited impact on demand.

There is therefore a real risk that these tax reforms will fail to deliver the expected results in terms of economic growth, which would then lead to the deterioration of US public finances. Indeed, the bond market would appear to suggest - both by its low long-term yields and the flattening of the curve - that investors are not very confident about the planned measures.

Outside of the US, and particularly in Europe and China, the US tax reform bill is being monitored extremely closely, driven by concerns about its compliance with international tax rules. If other countries respond to the US tax bill by adopting “counter measures”, international trade might sustain a blow.

In addition, President Trump is also considering a relaxation of financial regulation.  This has also been evoked by Randal Quarles, the new governor of the Federal Reserve in charge of bank regulation, and also appears to be supported (albeit to a lesser extent in terms of regulatory concessions) by both Janet Yellen and her successor as Chairman of the Federal Reserve, Jay Powell.

For US banks, which are already winning market share in Europe, the easing of regulatory uncertainty, combined with measures aimed at watering down regulation, could give fresh impetus to their competitive advantage. The governor of the Bank of England also appears to be favourable to a possible relaxing of bank regulation in order to guarantee the City’s competitiveness as a financial hub post-Brexit.  Here again, Europe needs to be vigilant, especially at a time when Chinese banks are getting a foothold in Asian markets.

Corporate taxation and banking regulation are two key issues for economic growth, not only in the US but worldwide.  And although certain aspects of the proposed reforms may be considered breaches of international rules, this is not true of all of them.  The planned reforms in the US and the approaching Brexit are two additional sources of motivation for Europe, underlining the urgent need to pursue the structural reforms that will enhance its competitiveness and constitute a source of funding for an independent economy, with the aim of protecting European growth and employment.

Is cure better than prevention ?

Prevention is better than cure, goes the adage. But history shows that economic and financial crises will inevitably happen, usually with unexpected causes. As a result, crisis management solutions are just as important as crisis prevention. The euro area was ill-prepared for the sovereign debt crisis in 2009. Since then, the region has set up several new institutions and mechanisms for managing and preventing crises.

Read the article