Tax cuts are typically politically popular. And, they are often justified by their potential to stimulate economic activity; the concept being that lower tax rates lead to higher real GDP growth, and down the road higher tax revenues. While tax rate reductions seem to support equity prices, the link between lower tax rates and future economic growth is exceedingly tenuous.
Economic theory sees lower marginal tax rates as driving more investment and economic activity; however, such an outcome depends on whether meaningful tax reform and simplification accompanies the marginal tax rate cuts. Unfortunately, meaningful tax simplification and reform rarely make it through the political process. Hence, loopholes, not tax cuts, continue to drive investment decisions, meaning that tax rate reductions often disappoint in terms of the political promise of higher future economic growth.
Looking forward, if the U.S. goes ahead with large corporate and personal income tax cuts effective in 2018, we see little prospect for higher real GDP growth resulting from any tax reductions because we are pessimistic about tax simplification. We do see tax reductions adding materially to the U.S. debt load. Indeed, tax cuts leading to higher debt loads might cause the Federal Reserve to be overly cautious on raising rates, which could negatively impact the U.S. dollar.