Tax Reform: The Good, the Bad, and the Ugly—Part One

By John Mauldin | Feb 07, 2017

The Amazonian Jungle
The End of the Dollar Standard
The Double Pyramid of Credit
The Problem of Divergence
The Emergence of Trumponomics
There Is Nothing Immutable About a Dollar Standard
Postscript: A Modest Proposal to Save the World
Florida and the Caymans

Vizzini: He didn’t fall?! Inconceivable!
Inigo Montoya: You keep using that word. I do not think it means what you think it means.

– From The Princess Bride

“A tariff is a scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer.”
– Ambrose Bierce

“Vast possibilities matured into realities before their very eyes. Nevertheless, they saw nothing but cramped economies struggling with ever-decreasing success for their daily bread.”
– Joseph Schumpeter on the Industrial Revolution

The usual thrust of this letter is economics, finance, and investing. Lately, however, the political process has been invading my normal domain – sometimes to the dismay of some of my readers. I get that politics comes with the territory; and I think everyone, no matter their political persuasion, will agree that taxes, which are political in nature, have a major impact on economics, finance, and investment. And thus commenting on taxes is fair game.

My original intention for this letter was to do an analysis of the Republican tax reform proposals. My associate Patrick Watson and I spent two weeks doing a really deep dive into the proposed reforms. I had the privilege of talking taxes with the chairman of the House Ways and Means Committee, fellow Texan Kevin Brady, as well as his staff. The chairman was kind enough to allow his remarks to be on the record – but his staff made it clear that they were to be on background. We have also talked with numerous think tanks and other experts across the political spectrum. We’ve actually been able to get information on some of the proposed reforms that, as far as we can tell, isn’t available in anything that’s already out there on the Internet.

A few observations from 30,000 feet –

  1. This is a far more sweeping proposed tax reform than Reagan’s. Not even in the same league. When I tell you that it touches everything, I mean that it touches EVERYTHING. And not just in the US. When you begin to think it through, the global implications are truly staggering. If you think you can be in Europe, Asia, or Africa and just be an unaffected observer of these changes, you are not paying attention. They will have profound implications for currency valuations and global trade.

Thus what I have for you today is not a one-and-done letter on the proposed tax reform. This is the first part of a series (my guess is that it will run to at least three parts) on the implications of the proposed reform. I keep using the word proposed, as there is a great deal of contention around this legislation. What actually comes out of the sausage-making machine otherwise known as Congress is still hard to predict. But we’re going to explore the key proposals coming out of the Ways and Means Committee, which are what will be debated on the floor.

  1. There are parts of this tax proposal that I really like; there are parts I’m okay with; and there are parts that I think have potentially serious negative implications for some people and countries. There will be very clear winners and losers. But as one insider told me, there are always winners and losers in any major tax reform. If we leap ahead seven years, I think we’ll find the overall economic climate much improved by what I am seeing proposed today. It is the transition to that outcome that concerns me. The ride from here to there could get rather bumpy.
  2. At the heart of the proposed reform is the very serious objective of creating new jobs. But which jobs, what kind of jobs, and where? At the top of the letter I quoted Montoya from The Princess Bride (come on, you have to admit that you watched it at least once): “I do not think that word means what you think it means.” As we will see today, I am not sure that job creation means what the Republicans think it means.

We are going to look at the proposed tax reform on a philosophical level first and then drill down into the nitty-gritty of the actual proposals. As noted above, almost every person that I talked to about tax reform agreed that the first objective must be to create jobs.

I was told of a private conversation between Steve Bannon and Elon Musk. Bannon was laser focused on creating jobs. “How do we get solar jobs in West Virginia?” he demanded of Musk. The entire transition team’s number one objective is creating jobs. Good jobs, American jobs. That was the heart and soul of Trump’s campaign. Even Paul Krugman will tell you that the way to get out of our current malaise is economic growth through job creation. While there are serious disagreements on the path, everybody agrees on the objective.


I am not so sure that everyone understands the nature of the terrain we must cross in our quest to create jobs, let alone the changing characteristics of the objective.

The Amazonian Jungle

Let’s start with a story to illustrate my concern. There is a company in the United States that began by offering a few products directly to consumers, and then quickly expanded its offerings until they included almost everything a person could want. This company went directly to the consumer, bypassing local brick-and-mortar stores, and became enormously successful, meeting the needs of its customers all over the country. Of course, the local stores were often (as economists will say) “disintermediated,” which is a fancy way of saying they couldn’t compete on price and selection, let alone delivery and convenience, and went belly up. And with them went the jobs of the people they employed.

Recently I’ve been using that story in my speeches and conversations, and everyone nods their heads and says, either out loud or mentally, “Amazon.” Except that I’m not talking about Amazon. I’m talking about another icon of American retailing called Sears, Roebuck & Co.

In the late 1800s, Richard Sears began to sell watches by mail order. He sold that company, but a few years later he started another mail order business to sell clothing and other products. The initiation of rural free delivery in 1896 and parcel post in 1913 enabled Sears to send its merchandise to even the most isolated customers. The Sears catalog became a staple of American family life. By the 1960s one out of 200 US workers received a Sears paycheck, and one out of every three carried a Sears credit card. The Sears catalog was a book of dreams that allowed those of us who grew up in rural America to access products that were either not available or were very high-priced in our local general store.

It’s hard for the younger generation to understand, but the Sears catalog coming to our mailbox was a big event in my youth. The Montgomery Ward catalog was a close second. The whole family perused those catalogs page by page to mull over what we needed or wanted. I’m sure I was not the only kid who circled a few toys that he hoped Santa would bring him for Christmas.

It’s hard to believe, but Sears didn’t really have a physical store until the 1920s, by which time the company was the largest retailer in the world. But Sears’ experience enabled Sam Walton, who didn’t start until 1962, to surpass Sears by 1990; and by 2000 Walmart’s sales were six times those of Sears.

Fast-forward to 2017. The 178,000 current employees of Sears are an endangered species. Sears had 3555 stores in 2010, and today it has 1503 and will close another 10% of those this year. Additional stores will be closed sooner rather than later. Unless hedge fund genius Eddie Lampert can pull yet another rabbit out of his seemingly bottomless hat, Sears will pass the way of Blockbuster and Kodak.

Remember Blockbuster? Founded in 1985, at its peak in 2004 Blockbuster had 60,000 employees and 8,000 stores. By 2010 it was bankrupt. There are only about 50 Blockbuster franchise stores still left.

But what do these sober tales have to do with tax reform? Tax reform, at least the Republican version, is predicated on creating jobs in the United States. In his campaign and since, Trump has focused on how Americans are losing jobs to foreign competitors. A seemingly straightforward trend, right? Jobs leave here and go to China and Mexico.

The truth is a little more complex. The simple fact of the matter is that United States is producing more manufactured goods than ever before. And the growth trend in manufacturing, which was established in the 1920s, has shown no signs of slackening, even through recessions. The chart below is from a study done by two professors at Ball State University. It’s a fabulous analysis that shows that 80% of the jobs that have been lost in American manufacturing have been lost due to technology. American workers are now dramatically more productive than they were in just the year 2000. The authors point out that our 12 million manufacturing jobs today produce the same amount of goods as 21 million manufacturing jobs did in 2000.

That trend is not going to change. Technology is going to continue to increase the productivity of American (and global!) manufacturing. With companies like Foxconn in China creating robotic production lines, the cost of labor is truly becoming a rounding error in manufacturing.

Prediction: Apple will soon be manufacturing the iPhone 9 or 10 in the United States. But producing those iPhones here won’t create that many jobs, because the work will be done on a robotic assembly line. If the border adjustability tax, which is part of the proposed tax reform happens, Apple will onshore that production even faster. Why? Because the most tax-advantaged country in which to produce products will be the US. True, other countries might offer zero tax as well, but they don’t have the infrastructure and available talent that the US does.

I hear my friends in Europe protesting, but the proposed Border Adjustable Tax (BAT) is significantly different from the VAT (value-added tax) that is used in over 160 countries. That tax simply increases the cost of manufacturing in those countries. (As we will see next week, the BAT is both a feature and a bug of the tax proposal.)

We can all argue over the efficacy of supply-side economics, but the reality is that Reaganomics created a marvelous boom of both productivity and employment. Bill Clinton had the advantage of that wind in his sails, and when coupled with Newt Gingrich’s reforms, it allowed him to balance the federal budget. (It helped, too, that Ross Perot siphoned off enough votes to allow Clinton to become president. Timing is everything, and Bill Clinton had nothing if not remarkable timing.)

The current tax proposal would make Reagan proud. And the expectations of everyone I am talking to are that the planned tax reforms will have the same effects that reforms did in the ’80s and ’90s. Problem is, now it’s 2017.

I am worried that the future won’t see us losing manufacturing jobs so much as service jobs. Losing 178,000 Sears workers is a big deal. But Amazon is slowly putting small businesses out of work, too: we’re losing 5 jobs here and 10 jobs there.

Some of the biggest mall owners in the world (according to a Wall Street Journal cover story) are simply turning the keys over to the bondholders who financed the mall mortgages. They can no longer make money on their properties. If Sears closes down, that takes the anchor store out of hundreds of malls, making them less viable. Stores in the mall that depend on Sears building the traffic go away as well.

If you are in the market for a diamond, do you go to the mall to look in jewelry stores? Not if you’re a smart shopper. You might go to the mall to see what you like, but you buy at Blue Nile, which is a kind of eBay for diamonds and other jewelry.

Personal story: Some of my friends know that I am now actually engaged, so I was in the market for a nice diamond. I called two friends who turn up their noses at having to pay retail or even wholesale. I wanted to buy my diamond wherever they would go. They both said that the diamond market has completely changed. Go to Blue Nile, they said; you can get practically anything you can imagine, and it gets delivered quickly. Diamonds are typically sold at about a 3% margin, but that is not a margin that mall jewelry stores can survive on.

Amazon and Walmart did just fine last Christmas. Many other retailers, not so much. Online sales grew by 14% last holiday season, the fastest growth in five years. In-store sales grew by only 1.4%, not even keeping up with inflation. And that trend is going to continue. Amazon and its online cohorts are clearly the wave of the future. One of the last great catalog companies, U-Line, sends their catalog out as a spur to online purchasing, not so much as an alternative method. I have recently been in one of their million-square-foot warehouses, and they were literally shipping orders the same day.

As longtime readers know, I’m writing a book about what the next 20 years will look like. And as I’ve mentioned before, the most difficult chapter is on the future of work.

In the coming weeks, we are going to see that the proposed tax reform is going to turn the finance world on its head. That world – what we think of as traditional banking and investment –puts only about 15% of its investment money into new-business development. The rest goes to financialization and the buying and selling of existing companies (share buybacks, etc.).

In the proposed tax reform, 100% of investments will be allowed to be written off in the first year. Build a factory? Forget amortization: write it all off this year. Everything but the land will be a 100% write-off. Not only will that policy create construction jobs; it will create jobs for people who make the equipment that goes into the production lines, as well as jobs for people who work in those plants.

The current tax proposal works well for traditional businesses. And it will certainly kindle whatever animal spirits are out there in nascent form.

(Preview: I started asking the staff who are tasked with coming up with a myriad of rules that will be used in the tax proposal, Will we be able to write off this or that? How will you treat offshore service income? On and on I went. Their stock answer was, “We haven’t decided that yet.” But their thrust was to do everything they possibly could to spur investment today and create jobs now!)

Upon reflection, I am not sure that you could create more retail and service jobs with any other tax reform than what is proposed, but that reform may not be enough. As more and more retail jobs succumb to online sales, robots, artificial intelligence, and other technologies, it may be increasingly difficult to counter the losses with new job gains. Not this year or next year but sometime in the future we are going to have to consider what we as a society are going to do in a post-employment world.

By that I don’t mean that work will disappear, but there will be ever fewer jobs for workers who are “down the food chain.” Between 2022 and 2030 we are going to see the loss of roughly 3 million truck and taxi driver jobs. Where will those people find other work? And that is just one industry.

What happens when we have a silver bullet for cancer? Which we will, hopefully sooner rather than later. All those hospitals, all those healthcare workers, all those pharmaceutical companies that depend on a steady supply of cancer patients will be out of work. And we are talking hundreds and hundreds of thousands of workers, who are generally highly paid. What happens when we beat Alzheimer’s? Or any one of another dozen diseases that are terribly debilitating and that cost enormous amounts of money to take care of and require the services of hundreds of thousands of caregivers.

I’m going to stop here and pick up our discussion next week. But I’m going to leave you in the capable hands of my good friend Charles Gave, who will talk about yet another problem that could become a global issue because of the border adjustment tax (BAT). Rather than restate his brilliantly outlined concerns, I’ll share them with you in their original form. (I thank my friends at GaveKal for letting me use Charles’s work so freely.) At the end he offers what he calls a modest proposal to save the world. In one of the upcoming parts of this series I will offer my own version. And make no mistake, we are talking about saving the world. When I say this tax proposal touches everything, I mean everything.