The US government has a brave plan to boost equity markets through tax reform, but it is likely to run into politcal roadblocks

It happened with the fiscal cliff, it happened with the debt ceiling. When it comes to the economy, the US is notorious for kicking the can further and further, but what happens when they reach the end of the road?

This was the question I put to Andy Friedman, an expert on political affairs and former senior partner at law firm Covington & Burling in Washington DC, at a briefing organised by Eaton Vance.

He agreed that the status quo cannot go on forever. As the Fed continues to borrow $1 trillion every year to finance the country’s debt, this will keep interest rates low.

Investors won’t be satisfied with returns of 3-4%, so will stop buying US treasuries. Interest rates will spike and the US will find itself back in a crisis situation, forced to adopt austerity measures.

The US cannot control the fiscal situation as it has been doing

“The US cannot control the fiscal situation as it has been doing,” warns Friedman. 

The repercussions of a US crisis would be felt around the world, and the US would no longer be viewed as a haven. So where would investors flee for safety?

No other currency is an obvious candidate

No other currency is an obvious candidate, so Friedman predicts they will turn to precious metals. China, he says, is already cutting back on its dollar investments and buying more precious metals as they are seen as more secure.

While bonds are suppressed, though, US equities could potentially get a boost through proposed tax reforms. It’s early days, but a recent proposal from David Camp, chairman of the House Ways and Means committee (responsible for tax writing) heralds a new, simplified tax regime.

The problem is this – unusually, US companies only pay tax on their overseas profits when they bring them back to the US, and they pay it at 35%. It is hardly surprising then, that many companies choose to keep their profits in the country where they earned them, thus avoiding this charge. Apple, for example, moved its operations to Bermuda and lowered its tax bill to 2.5%.

Sounds good, but the idea is universally hated by politicians

This is bad for the US economy which could benefit from the boost of this overseas revenue. So Camp has come up with a plan to tax overseas earnings at just 5% (or 15% on earnings from “intangibles” like patents, thus hurting technology companies more than manufacturing).

This would increase the overall tax received from these companies from nothing to 5-15% and stimulate the economy.

Sounds good, but the idea is universally hated by politicians. Republicans don’t like it because it punishes banks by introducing an asset-based (rather than income based) tax, and Democrats disapprove because it lowers taxes for the wealthy.

One thing is certain though - nothing will happen before the midterm elections in November, so schemes and their advisors will have to watch and wait.