What the Tax Debate Could Mean for Markets

Summary

Podcast Summary: "What the Tax Debate Could Mean for Markets"

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Episode: What the Tax Debate Could Mean for Markets
• Release Date: May 14, 2025

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Introduction

In the May 14, 2025 episode of Thoughts on the Market, hosted by Michael Zezas, Global Head of Fixed Income Research and Public Policy Strategy at Morgan Stanley, alongside Ariana Salvatore, Public Policy Strategist, the discussion centers on Congress's deliberations regarding tax and fiscal spending. The conversation delves into the potential ramifications of the current tax debate on various market sectors, investor expectations, and the broader economic landscape.

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Congressional Tax and Fiscal Spending Deliberations

Michael Zezas opens the discussion by addressing the intense focus clients have on the ongoing tax and spending plans that Congress is pursuing. Ariana Salvatore elaborates on why this fiscal package is capturing significant attention from investors across different asset classes.

"Clients have reasons to focus on this tax policy bill across equities, fixed income, and for macroeconomic impacts."
— Ariana Salvatore, 00:36

Salvatore highlights the expiration of the 2017 Tax Cuts and Jobs Act (TCJA) at the end of the year, positioning the current bill as an opportunity for Congress to extend these tax cuts and potentially introduce additional ones proposed by President Trump during his campaign. She emphasizes the sector-specific impacts of the legislation and underscores the importance of deficit considerations on economic outcomes and bond yields.

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Investor Expectations and Market Implications

Zezas explores the multifaceted nature of the fiscal policy package and its varied interpretations among investors. He notes that the package allows for both optimistic and pessimistic projections, depending on the focus—whether on deficit expansion or economic growth benefits.

"We're not going to get policy that really justifies either your highest hopes or your greatest fears here."
— Michael Zezas, 02:20

Zezas posits that the likely outcome lies somewhere in the middle, suggesting that the policy may not significantly sway the markets toward extreme optimism or fear. He discusses scenarios where tax cuts could lead to deficit expansion, potentially increasing Treasury yields due to a higher supply of bonds needed to finance the cut. Conversely, tax cuts could stimulate economic growth, benefiting corporate earnings and equity markets.

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Deficit Impact and Fiscal Outlook

Transitioning the conversation, Salvatore identifies key areas of disagreement within Congress that could influence the final structure of the tax bill. The cap on state and local tax (SALT) deductions emerges as a significant sticking point, along with debates over spending cuts to programs like Medicaid and SNAP (food stamps).

"We think where that lands is effectively at a $90 billion or so deficit increase from just the tax policy changes next year."
— Ariana Salvatore, 05:33

Salvatore estimates that the tax policy changes alone could result in a $90 billion increase in the deficit, excluding tariff revenue, bringing the total to approximately $130 billion. When accounting for scheduled increases in outlays, the overall deficit could rise by about $310 billion.

Zezas contextualizes these figures by contrasting them with Congressional Budget Office (CBO) projections, which often span a decade. He advises investors to focus on the short-term impacts, as long-term policies remain highly uncertain and subject to future legislative changes.

"These numbers might seem a lot smaller than some of what's been reported in the press... policy uncertainty beyond a year is substantially higher than even the very high policy uncertainty we're experiencing right now."
— Michael Zezas, 06:55

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Key Policy Debates: SALT Cap and Spending Cuts

A central theme in the discussion is the SALT cap, initially set in the 2017 TCJA, which limits the state and local tax deductions that individuals can claim. Republicans are divided on this issue, with some advocating for a modest increase or income thresholds, while the SALT caucus seeks a full repeal or significant modifications.

"Republicans generally are okay with making a modification to that cap... but the SALT caucus... pushing for a full repeal or something bigger..."
— Ariana Salvatore, 05:33

Additionally, there is contention within the Republican party regarding the preservation of the Inflation Reduction Act and whether to impose spending cuts on social programs. These internal divisions create continuous tension points that Congress must navigate to finalize the fiscal package.

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Timing, Uncertainty, and Legislative Outlook

The timing of the tax bill's resolution remains a critical factor. Salvatore outlines the expected timelines, noting that the reconciliation bill aimed at addressing the expiring debt ceiling is scheduled to culminate around August or September, contingent on the exhaustion of extraordinary measures.

"The reconciliation bill is supposed to address the expiring debt ceiling... our estimate is that it's somewhere around August or September."
— Ariana Salvatore, 08:25

Key milestones include Treasury projections for the "X date"—the point at which U.S. finances could face default—and legislative markups where the details of unresolved disputes, such as the SALT cap, will be scrutinized. Salvatore anticipates that the House is tentatively pushing for a resolution by Memorial Day, which is six legislative days away at the time of the discussion.

Zezas emphasizes the evolving nature of the legislative process and the need for investors to stay attuned to daily developments that could influence fiscal policy outcomes.

"We're going to have to keep checking those regularly as we get new bits of information coming out of Congress on probably a daily basis at this point."
— Michael Zezas, 09:17

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Conclusions and Investor Recommendations

Both Zezas and Salvatore concur that while the current fiscal policy discussions introduce elements of expansion, the overall stance on U.S. fiscal policy is expected to remain largely unchanged. They caution investors to consider the short-term impacts of the tax debate, given the high level of uncertainty surrounding long-term policy directions.

Zezas concludes by reinforcing the importance of breaking down headline figures within their appropriate context and focusing on the immediate fiscal implications that are more predictable compared to the volatile policy landscape beyond the upcoming fiscal year.

"The context matters a lot here. We have been encouraging investors to really look through the headlines, really break down the context and really focus on these short term impacts because those are the most reliable impacts and the ones to really anchor to..."
— Michael Zezas, 06:55

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Final Thoughts

The episode provides a comprehensive analysis of the ongoing tax debate in Congress, highlighting its potential impacts on different market segments and the broader economy. With key issues like the SALT cap and spending cuts at the forefront, the discussions underscore the complexity and uncertainty inherent in the legislative process. Investors are advised to focus on short-term fiscal impacts while remaining vigilant of evolving policy developments.

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Notable Quotes:

1. "Clients have reasons to focus on this tax policy bill across equities, fixed income, and for macroeconomic impacts."
   — Ariana Salvatore, 00:36

2. "We're not going to get policy that really justifies either your highest hopes or your greatest fears here."
   — Michael Zezas, 02:20

3. "We think where that lands is effectively at a $90 billion or so deficit increase from just the tax policy changes next year."
   — Ariana Salvatore, 05:33

4. "These numbers might seem a lot smaller than some of what's been reported in the press... policy uncertainty beyond a year is substantially higher than even the very high policy uncertainty we're experiencing right now."
   — Michael Zezas, 06:55

5. "Republicans generally are okay with making a modification to that cap... but the SALT caucus... pushing for a full repeal or something bigger..."
   — Ariana Salvatore, 05:33

6. "The reconciliation bill is supposed to address the expiring debt ceiling... our estimate is that it's somewhere around August or September."
   — Ariana Salvatore, 08:25

7. "We're going to have to keep checking those regularly as we get new bits of information coming out of Congress on probably a daily basis at this point."
   — Michael Zezas, 09:17

8. "The context matters a lot here. We have been encouraging investors to really look through the headlines, really break down the context and really focus on these short term impacts because those are the most reliable impacts and the ones to really anchor to..."
   — Michael Zezas, 06:55

Transcript

[Michael Zezas]

Welcome to Thoughts on the Market. I'm Michael Zezas, global head of fixed income research and public policy strategy.

[Ariana Salvatore]

And I'm Ariana Salvatore, public policy strategist.

[Michael Zezas]

Today we'll dig into Congress's deliberations on taxes and fiscal spending. It's Wednesday, May 14th at 10am in New York. So, Arianna, there's been a lot of news around the tax and spending plans that Congress is pursuing this fiscal package and clients are really, really focused on it. You're having a lot of those conversations right now. Why are clients so focused on all of this?

[Ariana Salvatore]

Clients have reasons to focus on this tax policy bill across equities, fixed income, and for macroeconomic impacts. Starting with equities, there's a lot of the 2017 tax cut bill that's coming up for expiration towards the end of this year. So this bill is Congress's chance to extend the expiring TCJA and add on some incremental tax cuts that President Trump floated on the campaign trail. So there's some really important sector impacts on the specific legislation side. And then as far as the deficit goes, that matters a lot for the economic ramifications next year and for bond yields. But Mike, to pivot this back to you, where do you think investor expectations are for the outcome of this package?

[Michael Zezas]

So there's a lot of moving pieces in this fiscal policy package. And I think what's happening here is that investors can project a lot onto this. They can project a lot of positivity and constructive outcomes for markets and a lot of negativity and negative outcomes for markets. So, for example, if you are really focused on the deficit impact of cutting taxes and whether or not there's enough spending cuts to offset those tax extensions, then you could look at the array of possible outcomes here and expect a major deficit expansion that might make you less constructive on bonds because you would expect yields to go higher as there was greater supply of Treasuries needed to borrow that much to finance the tax cuts. Again, not necessarily fully offset by spending cuts. So you could look at this and say, well, this will ultimately be something where economic growth helps tax revenues and you might be looking at the benefits for companies and the feed through to the equity markets and think really positively about it. And we think the truth is probably somewhere in between. You're not going to get policy that really justifies either your highest hopes or your greatest fears here.

[Ariana Salvatore]

So it's really like a Rorschach test for investors when we think about our base case. How do you think that's going to materialize. What on the policy front are we watching for?

[Michael Zezas]

Yeah, so we have to consider the starting point here, which is Congress is trying to address a series of tax cuts that are set to expire at the end of the year. And if they extend all those tax cuts, then on a year over year basis, you didn't really change any policy. So that just on its own might not mean a meaningful deficit increase. Now, if Congress is able to extend greater tax cuts on top of that, but it's going to offset those greater tax cuts with spending cuts and revenue raisers elsewhere, then again, you might end up with a net effect close to zero on a deficit basis. The way our economists look at this mix is that you might end up with an effect from a stimulus perspective on the economy that something close to to neutral as well. There's a lot of policy changes happening beneath the surface, but in the aggregate it might not mean a heck of a lot for the economic outlook for next year. Now, that doesn't mean that there would be zero deficit increase in the aggregate next year because this is just one policy that is part of a larger set of government policies that make up the total spending posture of the government. There's already something in the range of 200 to $250 billion of deficit increase that was already going to happen next because of weaker revenue growth on slower economic growth this year and some spending that would automatically have happened because of inflation, cost adjustments and higher interest on the debt. Long story short, the policy that's happening right now that we think is going to be the endpoint for congressional deliberations isn't something our economists see as meaningfully uplifting and growth for next year. And it probably increases the deficit at least somewhat next year. Now, we're thinking very short term here about what happens in 2026. But I think investors need to think around that timeline because if you're thinking about what this means for getting deficits smaller multiple years ahead, or creating the type of tax environment that might induce greater corporate investment and greater economic growth years ahead, all those things are possible, but they're very high hypothetical and they're subject to policy changes that could happen after the next Congress comes in or the next president comes in. So, Arianna, that's the overall look at our base case. But I think it's important to understand here that there are multiple different paths this legislation could follow. Can you explain what are some of the sticking points and depending on how they're resolved, how that might change the trajectory of what's ultimately past year, there.

[Ariana Salvatore]

Are a number of disagreements that need to be resolved. In particular, one of the biggest that we're focused on is on the SALT cap. So that's the cap on state and local tax deductions that individuals can take that raised about a trillion dollars of revenue in the first iteration of the tax Cuts and jobs act in 2017. Republicans generally are okay with making a modification to that cap, maybe taking it a bit higher or imposing some income thresholds. But the SALT caucus, this small group of Republicans in Congress, they're pushing for a full repeal or something bigger than just a small dollar amount increase. There's also a group of moderate Republicans pushing against any sort of spending cuts to programs like Medicaid and snap. That's the food stamps program. And then there's another cohort of House Republicans that are seeking to preserve the Inflation Reduction Act. Ultimately, these are all going to be continuous tension points. They're going to have to settle on some pay fors, some savings. And we think where that lands is effectively at a $90 billion or so deficit increase from just the tax policy changes next year. Now, with tariff revenue excluded, that's probably closer to 130 billion. But Mike, to your point, there are these scheduled increases in outlays that also are going to have to be considered for next year's deficit. You're looking at an overall increase of about $310 billion.

[Michael Zezas]

Yeah, I think that's right. The different ways those different dynamics could play out I think puts us in a range of a $200 billion expansion maybe on the low end and a $400 billion expansion on the high end. These are meaningful numbers. But important context for investors is that these numbers might seem a lot smaller than some of what's been reported in the press. And that's because the press reports on the Congressional Budget Office scoring. And These are typically 10 year numbers. So you would multiply that one year number by 10, at least conceptually. And these are numbers relative to a reality in which the tax cuts were allowed to expire. So it's basically counting up revenue that is being missed by not allowing the tax cuts to expire. The context matters a lot here. We have been encouraging investors to really look through the headlines, really break down the context and really focus on these short term impacts because those are the most reliable impacts and the ones to really anchor to because policy uncertainty beyond a year is substantially higher than even the very high policy uncertainty we're experiencing right now. Sticking with the theme of uncertainty, let's talk timing here. We came into the year thinking this tax bill would be resolved late in the year. Is that still the case or are you thinking it might be a bit sooner?

[Ariana Salvatore]

I think that timing still holds up. Right now the reconciliation bill is supposed to address the expiring debt ceiling. The real deadline for getting the bill done is the X date or the date by which the extraordinary measures are projected to be exhausted. That's the date that we would potentially hit an actual default. Of course, that date is somewhat of a moving target. It's highly dependent on tax receipts from treasury, but our estimate is that it's somewhere around August or September. In the meantime, there's a number of key catalysts that we're watching, namely, I would say, other projections of the X date coming from treasury as well as some of these markups when we start to get more bill text and hear about how some of the disputes are being resolved. As I mentioned, we had text earlier this week, but there's still no quote fix for the salt cap and the House is still tentatively pushing for its Memorial Day deadline. That's just six legislative days away.

[Michael Zezas]

Got it. So I think then that means that we're starting to learn a lot more about how this bill comes together. We'll be learning even a lot more over the next few months. And while we set out our expectations that you're going to have some fiscal policy expansion but largely a broadly unchanged posture for US Fiscal policy, we're going to have to keep checking those regularly as we get new bits of information coming out of Congress on probably a daily basis at this point.

[Ariana Salvatore]

That's right.

[Michael Zezas]

Great. Well, Arianna, thanks for taking the time to talk.

[Ariana Salvatore]

Great speaking with you.

[Michael Zezas]

Michael, thank you for your time. If you find thoughts on the market and the topics we cover of interest, leave us a review wherever you listen and if you like what you hear, tell a friend or colleague about us today.

[Ariana Salvatore]

The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.