Morgan Stanley
  • Research
  • Jan 18, 2017

How Tax Reform May Impact U.S. Consumer Outlook

Changes to the tax code may boost confidence and spending, if Trump and the Republican-controlled Congress can deliver.

As 2017 gets underway, one of the biggest questions facing the U.S. economy is: What about consumers? After all, their spending accounts for around two-thirds or more of annual GDP, and they have remained the pillar of growth—through thick and thin—these past few years.

Consumers would benefit from sweeping reform to the U.S. tax code later this year. If the Trump administration and Republican-controlled Congress can deliver, then “disposable income gets a lift, helping consumers maintain their pace of spending, despite slower job growth,” says Chief U.S. Economist Ellen Zentner in a recent report. Legislation likely wouldn’t happen until the fourth quarter of 2017, but merely the anticipation of such reforms may buoy consumer confidence much earlier.

Some sectors would benefit more than others. Big ticket consumer durables, travel and credit cards are among the likely standouts. As for rising interest rates, “Don't worry about the Fed,” says Zentner, “household balance sheets are strong and would stay protected in a rising rate environment.”

Tax Cuts Can Help Stem, Then Reverse, Slowdown in Real Disposable Income

e = estimated
Source: Bureau of Economic Analysis, Morgan Stanley Research

Scope of Reforms

What could the Republican-led tax plan look like? Using Speaker of the House Paul Ryan’s tax reform “Blueprint” as a rough guide, the reforms could collapse the number of tax brackets from seven to three and lower the top individual income tax rate to 33%, from 39.6%. It would tax capital gains and dividends as ordinary income, while eliminating the alternative minimum tax, the estate tax, as well as all standard itemized deductions, with the exception of charitable donations and mortgage interest.

Dynamic analysis by the nonpartisan Tax Foundation concluded that the distribution of changes in after-tax income look fairly even, averaging around 8.5% for all taxpayers, but skewing higher for the top 10% of taxpayers and beyond, the Morgan Stanley report notes.

Assuming that a President Trump can use the power of the proverbial “bully pulpit” to curb the deficit hawks among his own party, such a tax reform package would effectively act as stimulus for the U.S. economy, says Zentner. Morgan Stanley estimates that the tax plan would cost $240 billion a year, or about 1.25% of U.S. GDP. “While lower income groups tend to spend one dollar for every dollar in tax savings, upper income groups tend to have a much lower marginal propensity to consume and save a good deal of the tax cuts,” Zentner notes.

Gauging Buying Power

Among U.S. households, spending behavior is a combination of the ability and willingness to spend. The former depends on changes in real disposable personal income—for example, via higher wages. The latter, however, is largely about confidence. People will spend more money if they feel good about their prospects for the future.

Zentner and her team have combined these concepts into an index of “buying power” that broadly tracks consumer spending. Their finding: Growth in buying power has generally fallen, reflecting a decades-long slowdown in real disposable personal income; but it may be poised for a post-Trump rebound, if consumer confidence continues to rise ahead of an expected tax cut—and maintain momentum if tax reform is enacted.

Buying Power Has Fallen Over Time, But Personal Income Tax Can Provide Support

Source: Morgan Stanley Research

This could be crucial to sustaining the U.S. economy, because “in 26 of the past 27 months, growth in real consumer spending has been outpacing buying power,” says Zentner. In other words, Americans have again been spending more than they should, an unsustainable feature of the consumer cycle that usually results in higher levels of household debt—until something has to give. A tax cut that lifts real personal disposable income could help reverse that trend—at least in the near term.

In the meantime, growing consumer confidence is likely to swell revolving credit, such as credit card debt. Rosier perceptions of future employment, business conditions and income—all of which are included in measures of consumer confidence—tend to make households feel more comfortable about carrying higher levels of debt because they are more confident in their ability to pay down that debt in the future, Zentner says. “Historically, we find that consumer confidence tends to lead growth in revolving credit, primarily credit cards, by about six months. The jump in confidence, if sustained, may soon lead to an inflection higher in credit card usage,” she adds.

What About the Fed?

Zentner expects the Federal Reserve to take advantage of any signs of robust economic growth to normalize key interest rates more quickly—but still very cautiously. She now expects two more rate increases this year, followed by three more hikes in 2018. Historically, rising rates cause households to rein in spending to offset the higher cost of carrying household debt.

This time may be different. “Today, U.S. households are sitting on a nearly unprecedented counter-cyclical balance sheet with little interest rate exposure,” Zentner says. Unlike in prior business cycles, the bulk of outstanding household debt is being held at a fixed rate. Indeed, mortgages represent roughly 75% of outstanding household debt, 90% of which are held at a very low fixed rate—the effective yield on all outstanding mortgages stands at a record low 3.8%. The health of the household balance sheet also provides an important cushion, should rates increase faster than expected, or if the U.S. economy softens.

Several consumer categories most sensitive to changes in disposable personal income stand to benefit. These include highly discretionary categories, such as motor vehicles, motorcycles, and recreational vehicles, as well as other high-dollar consumer durables, such as furniture, and just about anything travel-related. Credit card companies also stand to benefit.

For more Morgan Stanley Research on how potential tax reform may affect U.S. consumers, ask your Morgan Stanley representative or Financial Advisor for the full report, “2017 U.S. Consumer Outlook” (Jan 4, 2017). Plus, more Ideas.