U.S. tax reform: Will higher corporate profits boost investment spending?

This tax reform series looks at the impact of tax reform legislation that was passed on December 20, 2017. It reached the President’s desk just before the Christmas holiday, fulfilling the president’s promise of an early Christmas gift. As a result, the legislation will have an impact on every part of the U.S. economy. The goal of the new tax legislation is to boost economic growth and to that end, the centerpiece is a reduction in the corporate tax rate, from 35 percent to 21 percent. There are two key assumptions driving this:

1. A large tax burden on corporations puts downward pressure on economic growth

2. Corporations will use their tax savings to raise capital spending, increasing productivity, wages and overall output

We first tackle the question of whether U.S. corporations face a large tax burden that makes them less competitive on the global stage. Then, we investigate whether higher corporate profits actually result in higher investment spending, which in turn will raise productivity and wages, by looking at what corporations chose to do with their excess profits in years past.

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Historical perspective

The Reagan Tax Reform Act of 1986 has been a benchmark for tax legislation since it is believed to have generated solid economic growth. The goal of that legislation was to reduce the tax burden on businesses and individuals, while remaining deficit neutral by broadening the tax base. The corporate tax rate was dropped from 46 percent to 34 percent and almost all individuals and households saw their personal income tax rates fall. Interestingly, the bill actually ended up raising average business taxes by removing a number of deductions and investment incentives. Also, provisions like an increase in the capital gains rate (from 20 percent to 28 percent) resulted in revenue-neutral legislation.

Are corporate taxes too high?

The United States’ marginal corporate tax rate is in fact one of the highest in the world at 35 percent. This is especially high when compared to other regions like Europe and Asia – the weighted average corporate tax rate in the European union (EU) and Asian countries are 26.9 percent and 26.2 percent, respectively. However, 35 percent is not what U.S. companies actually end up paying.

In fact, U.S. corporations pay far lower than their counterparts in other developed nations, according to the OECD. Out of 5 select developed countries, we found that only Germany had a lower tax collection as a percentage of GDP. The other four – Ireland, the UK, Japan, and Korea – all collected more taxes as a percent of GDP than the U.S. As a percentage of GDP, U.S. tax collection has been below the OECD average since 1982.

Exhibit 1. Tax on corporate profits as a percentage of GDP. Source: OECD

We also looked at the effective tax rate that is paid by some of the largest companies in the United States. We analyzed financial data of all the Dow 30 companies and found that, over the past five quarters, only one paid a median effective tax rate greater than 35 percent – Home Depot at 36.2 percent. The median effective tax
rate for the entire Dow 30 over the same time period was only 25.4 percent. 21 companies from the Dow had an effective median tax rate below 30 percent, while 7 companies had median tax rates below 20 percent.

Exhibit 2. Median effective tax rates of Dow 30 companies. Source: Reuters, CSI Market.com

In fact, on aggregate, U.S. companies have seen a steady reduction in their effective tax rates since the 1960’s.

Exhibit 3. Taxes on corporate profits. Source: Bureau of Economic Analysis (BEA), Tax Policy Center

From the 1960’s to early 1980’s, the effective tax rate fluctuated between 40 and 35 percent before falling below 30 percent after the 1982 recession. As the economy began to recover in the mid-1980’s, the effective rate rose back to around 35 percent. However, since the 1990’s, companies began receiving a number of business
friendly incentives, as well as taking advantage of various accounting loopholes in the tax law, largely reducing their tax bill. In 2004, the Bush administration initiated the Homeland Investment Act, which allowed companies to repatriate foreign holdings from abroad at a discounted rate. This influx of repatriated cash likely resulted in the effective tax rate rising, but solely lowered back down in the subsequent years. In 2016, the effective tax rates on corporations fell even further to 23 percent.

A Treasury study also shows that the average effective corporate tax rate across major industries was less than 30 percent between 2007 and 2011. Sectors like utilities, leasing, transport and finance pay the least, with average effective tax rates less than 20 percent during the period.

Exhibit 4. Average effective federal corporate tax rates by industry. Source: Office of Tax Analysis at the U.S. Department of the Treasury

Companies have been able to see a real effective reduction in taxes due to aggressive tax shifting strategies (to tax havens) and a variety of business-friendly tax credits and deductions in the United States. These cost the government an estimated $660 billion over a five-year period (2012-2016), according to a 2010 study from the Tax Foundation. For example, many large multinational companies can defer income from controlled foreign corporations until they transfer overseas profits back into the United States, if the U.S. based company is replaced by a foreign parent or becomes a subsidiary of a foreign parent (called corporate inversion). However, nearly all of this money is almost never transferred back since companies wait for a tax holiday (like in 2004). Apple is one of the most well-known companies that have come under fire for conducting corporate inversion and avoiding significant U.S. corporate taxes.

U.S. corporations also reduce their tax liabilities through tax code provisions like the manufacturing deduction. While there are several legitimate uses of this deduction, an absurd example of a company taking advantage is the Cheescake Factory, which has reportedly claimed the deduction for manufacturing slices of cheesecake and garnishing them.

U.S. corporations have obviously found strategies reduce their tax burdens resulting in effect tax rates far below the marginal tax rate of 35 percent. So it is not clear that U.S. firms, especially the large ones, are at a competitive disadvantage globally thanks to the current tax code. While there may be a benefit to having a simpler tax code, so that corporations spend less effort on mitigating their tax liability, the reality is that even a reduction of the marginal rate to 20 percent is not significant enough to lower their tax burden, especially if some of the other incentives are also taken away.

Corporate profits have surged

As we previously discussed, companies have used a variety of strategies to keep their effective tax rates far below the marginal rate of 35 percent, and profits have soared. Corporate profits as a percentage of GDP fell from 7.6 percent in 1980 to as low as 3.3 percent by 1986, which was likely due to the recession in the early 80’s. However, by 2004 corporate profits surpassed 8 percent and reached as high as 10.8 percent of GDP by 2012. That figure has stayed relatively constant since, slowing to 9.2 percent of GDP in the second quarter of 2017.

Exhibit 5. Corporate profits as a percentage of GDP, historical tax rates. Source: St. Louis Federal Reserve FRED Economic Data, Tax Policy Center

Rising corporate profits can be good for an economy since it allows companies to spend more on investments that can spur growth (like automation), boosting productivity. Problems arise if companies choose not to spend more on productivity-enhancing investments.

Corporate investment has barely budged

More generally, companies have three choices to decide where to allocate their excess capital: increase capital investment, increase employee wages, and/or return capital to shareholders (dividends, buy-backs, paying off debt). Historical data shows us that the latter has been the case over the past 25 years. Returning capital to shareholders is not necessarily a bad thing, but it does tell you that corporations cannot find more productive uses for their excess capital.

Despite corporate profits rising to record levels, non-residential fixed investment (capital spending) has fallen since 2000. In 1990, non-residential fixed investment accounted for approximately 12.5 percent of GDP and rose to almost 15 percent amid the tech boom. That figure has fallen back to 12.5 percent of GDP, as of the second quarter of 2017. This is despite corporate profits rising from 4.4 percent of GDP at the end of 2000 to 9.2 percent today.

Exhibit 6. Non-residential fixed investment as a percentage of GDP. Source: St. Louis Federal Reserve, FRED Economic Data

Corporate savings have swelled

U.S. corporations clearly started to save a lot more after the tech bubble burst in 2000. Instead of spending excess profits on capital expenditures, many U.S. companies have built up significant cash holdings (including short-term investments and other liquid long-term investment). In total, Moody’s estimates that total corporate (non-financial) cash held by U.S. companies totaled $1.84 trillion at the end of 2016, compared to $1.24 trillion in 2010 – a 48 percent rise in 6 years. Five companies hold nearly a third of the non-financial cash holdings: Apple, Microsoft, Alphabet, Cisco Systems, and Oracle, totaling $594 billion (over 32 percent of 2016’s total).

Companies simply do not let cash sit in a bank account. Instead, many companies have a significant amount of funds held in investment securities. Out of the five companies with the largest cash holdings, Apple tops the list, with cash holdings of nearly $270 billion (as of the latest fiscal year), and Microsoft is just shy of $140 billion. Apple and Microsoft’s share of marketable securities (which includes fixed income and equity investments) to total investment securities surpassed 90 percent.

Exhibit 7. Total value of assets allocated to investment securities and cash by the top 5 largest cash holders; share of marketable securities and cash investments to total investments. Source: Apple, Microsoft, Alphabet, Cisco, and Oracle investor relations webpages

A large portion of these marketable securities and cash figures are likely invested in U.S. government debt, effectively helping fund the U.S. government and keeping interest rates low. In the 2017 fiscal year, over 80 percent of Microsoft’s $139 billion investments into cash, cash equivalents, short-term security investments, and equity investments went to U.S. government and federal agency securities.

Looking more specifically at the companies’ latest cash flow statements, all of them spent more on security investments – mostly debt, but also some equity – than capital investments. Of the five companies, Apple had the largest net purchase of investment securities, over $33 billion, versus nearly $13 billion spent on capital, which translates into a securities investment to capital expenditure ratio of 2.6. The company with the highest ratio out of the five is Oracle, which spent over $8 billion (net) on various investment securities, while spending only $2 billion on capital expenditures– putting the ratio of securities investment to capital expenditure just above 4 for the latest fiscal year.

Exhibit 8. Millions of dollars spent on investment securities versus capital expenditures. Source: Wall-Street Journal

As companies’ profits have surged, the financial data points to companies saving much of their excess cash by means of lending it to others (like the U.S. government), as opposed to using it for capital investment, or even wage increases for employees.

Previous tax incentives did not boost investment spending

The last time corporations had an incentive to boost capital spending was in 2004, with the Homeland Investment Act (HIA). HIA allowed for a one-time tax holiday when companies could repatriate foreign earnings at a discounted rate of 5.25 percent, far lower than the 35 percent marginal rate. Corporations returned an estimated $312 billion, avoiding over $3 billion in taxes.

The Bush administration and Congress required that the repatriated money be spent on capital investments or job creation. At the time, Congress argued the tax holiday would create over 500 thousand jobs over 2 years, and financial institutions estimated that capital spending would rise by 2 to 3 percent over the same time period. However, according to one study on the effect of the HIA, they found that for every $1 increase in repatriations, there was an increase of nearly $1 ($0.92 to be exact) in payouts back to companies’ shareholders.

Companies found ways to skirt around HIA requirements by disclosing possible uses of the repatriated funds, without actually committing to specific investments. For example, Dell lobbied for the HIA by saying that the repatriated funds would be used to build a new plant in North Carolina. They returned $4 billion from abroad and spent $100 million on the new plant, which, as it turns out, was already in the company’s plans from the start. Shortly thereafter, the company initiated a share-buyback program worth $2 billion.

In addition, some companies took advantage of the initial confusion over the law, which forced the U.S. Treasury to release various documents for clarification – companies sold assets to foreign subsidiaries that were subsequently repatriated and taxed at a discounted rate (known as roundtripping). In short, corporations successfully took advantage of the tax code to boost their profits, and promptly returned those profits to shareholders.

Corporate bond holders could benefit the most

As stockholders will likely benefit from share-buybacks, another winner of the current tax bill is likely to be corporate bond holders. For decades, business have been able to deduct interest expenses, which was supposed to encourage credit growth for capital investment. Over the years, this tax incentive has not changed, allowing companies to take advantage of the historically low interest rate environment.

As the Federal Reserve (Fed) cut rates to near zero percent and introduced three quantitative easing programs to keep the economy afloat after the 2008 financial crisis, businesses increased their debt load. Prior to the Great Recession, non-financial corporate debt reached over 27 percent of GDP in the fourth quarter of 2001, the highest rate at the time. By the third quarter of 2015, corporate debt amassed 30 percent of GDP and has stayed above that rate since.

Exhibit 9. Non-financial corporate debt as a percentage of GDP, in billions of dollars. Source: St. Louis Federal Reserve, FRED Economic Data

However, as the economy has continued to improve, the Fed has slowly begun to normalize rates. There have been five rate hikes since 2015, with one rate hike that year, one in 2016, and three in 2017. Despite rates rising at the short end of the yield curve, corporate bond yields have remained close to historical lows, indicating that firms are not constrained when they want to borrow. Yet, as we saw earlier, investment spending has barely budged.

Exhibit 10. Bank of America Merrill Lynch U.S. corporate master effective yield. Source: St. Louis Federal Reserve, FRED Economic Data

In addition, the new tax bill caps interest rate deduction for businesses at 30 percent of gross income (in this case, earnings before interest, taxes, and depreciation/amortization). This, in addition to the fact that cash-rich multinationals are likely to use repatriated cash to pay off outstanding debt, means that the future supply of corporate bonds is likely to be constrained, raising the price of existing corporate bonds. As a result, corporate bond holders could be the ultimate winners.

Expect more of the same

What makes the current tax reform bill strikingly different from previous reforms is that there is no specific mandate on corporations to use tax savings for capital investment. The hope is that corporations will use excess profits to increase investment spending, as opposed to simply returning it all to shareholders. Policymakers could have learned from the policy mistakes in 2004. For instance, they could have provided targeted incentives to companies that increase investment spending and promote job creation within the U.S. Instead, we are likely to see a continued rise in corporate profits as corporate tax rates are reduced, and corporate savings increase further.

Since there is no impetus for corporations to increase investment spending, we do not believe the reform will, at best, provide a significant boost to output. Large corporations already have significant cash on hand, not to mention the ability to borrow money at low rates. Yet they have not used it to make productivity enhancing investments. It seems highly unlikely that increasing their cash pile via tax cuts will induce them to do so. If anything, corporations will simply return those excess profits to shareholders.

 

Disclosures

This post is for informational purposes only and is not to be considered a recommendation to buy or sell a security or service. This report is not considered tax or investment advice. Please seek tax advice from a qualified tax professional. Convex Capital Management LLC (“Convex Capital”) utilizes best efforts to ensure the content displayed herein is from sources believed to be reliable and accurate, but makes no representation thereof and accepts no liability or any loss arising from use or reliance of any of the information herein. The opinions expressed are a reflection of Convex Capital Management’s best judgement at the time this report is compiled, and any obligation to update or alter forward-looking statement as a result of new information, future events, or otherwise is disclaimed. There is no guarantee that Convex Capital has not changed its research views at the time of this post. Past performance is no guarantee of future success.

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