January was a month filled with change as the Trump Administration was inaugurated. Delivering on many campaign promises, President Trump’s first weeks in office were a whirlwind for investors. From immigration to regulation, the Administration was busy. While many of the headlines are simply noise, others have the potential to have a significant impact on the U.S. economy. In fact, some of the most impactful, like those reforming the tax code, are getting less attention than they should.

When considering potential tax reform, one area is largely over-looked: pass-through income. This applies to people who own partnerships, LLCs, and “S” corporations. Instead of paying taxes at the corporate level, taxes are paid at the individual’s marginal tax rate: the taxes are “passed-through” to them. This distinction is important, and how the evolution of the tax code treats and taxes it will have ramifications for the economic efficacy of tax reform.

With the sheer enormity of what pass-throughs have become to the U.S. economy, it is perplexing that there is not much more discussion relating to their health and security. More people in the U.S. are employed by these structures then traditional corporations, and it dominates the services industry. According to the Tax Foundation, the average marginal tax rate is over 47% with some states higher, some lower. When there is a serious debate about whether companies or individuals should receive the bulk of the tax cuts, it should be remembered that, in many cases, they are one and the same. It is much of the reason “individual” tax returns account for so much of the U.S. government’s income (chart 1).

Not all of the Administration’s actions have been greeted by markets with ebullience. For instance, pulling out of the Trans-Pacific Partnership trade agreement and the renegotiation of NAFTA have recently worried markets. Once considered the most ambitious free trade agreement in history, the TPP aimed to set the trajectory and tone of trade in Asia as a balance to a rising China. The demise of the TPP will not affect near term U.S. growth, but many of the U.S.’ staunchest Asian allies, including many in disputes with China, were among those negotiating the TPP.

The problem is that the U.S. would realize few immediate gains from striking the agreement. The TPP was a long-term investment in trade liberalization. Writing the rule of trade in Asia with a durable framework was a laudable goal. With the supposed job flight aftermath of trade agreements already in place, it is little wonder there is trepidation around trade. The demise of TPP suggests that prospects for the Transatlantic Trade and Investment Partnership—the free trade deal between the United States and European Union—are not much better.

Thus far, it has been a mixed bag from the Administration on policies affecting the economy, and there are more to come. The design of corporate tax adjustment and the evolution of deregulation will also drive economic growth. There is still a long, arduous policy agenda ahead that could cause economic and market volatility, particularly around trade. But, for the moment, the U.S. economy is on solid footing with little data pointing to an imminent slowing. By no means does 2017 appear to be a year of economic collapse. However, it may not be the year of great acceleration either. Growth is expected to pick-up in 2017 and 2018, but only to 2.3%. Fiscal timing (tax breaks) policy will largely determine whether it meets the elevated outlook or not. Irrespective of meeting growth targets, the unfolding of the 2017 economy will prove one of the most interesting in recent memory to observe.

Sam Rines

srines@avalonadvisors.com