Corporate Tax Cuts: "The Seen & The Unseen"

Authored by 720Global"s Michael Lebowitz via RealInvestmentAdvice.com,

Since Donald Trump was elected President, the S&P 500 has rallied over 21% or nearly 500 points. In our opinion, a good portion of the gain is attributable to his promise, as well as congressional efforts, to reform the tax code. In particular, the proposed sharp reduction in the corporate tax rate has the equity market’s attention. At first blush, the simple logic driving equity investors appears reasonable.

Appearances, however, can be deceiving, and history is littered with failed investors that banked on a faulty thesis. As such, instead of tripping head first into that same category, we decided to assume nothing and look at the proposed reduction in the corporate tax rate and historical data to better understand how the legislation might affect the economy and corporate earnings.

Corporate Tax Rates

The graph below highlights the statutory and effective corporate tax rates since 1947.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The statutory tax rate is the legally mandated rate at which corporate profits are taxed. As shown above, the rate has been consistent over the last 75 years except for one significant change as a result of the Tax Reform Act of 1986.

The effective corporate tax rate is the actual tax rate companies’ pay. One can think of the statutory rate as similar to the MSRP sticker price on a new car. It provides guidance on cost but consumers always pay something less. The effective tax rate, like the “discounted” price one pays for a car, is the actual percentage of profits that corporations remitted to the government. This rate is calculated by dividing a company’s tax payments by their pre-tax profit. Deductions of all sorts reduce the pre-tax profit, thus creating a difference between the statutory and effective tax base and therefore the amount paid. For purposes of this article, we aggregate corporate tax receipts and corporate profits to calculate an effective rate for all corporations.

From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.

Based on this simple analysis thus far, it is easy to understand why equity investors are giddy over a sizeable reduction in the corporate tax rate. If the statutory rate is reduced to 20% as proposed, and the effective rate remains 10% lower, the amount of money corporations pay in taxes will be reduced sharply. Based solely on this assumption, corporate after-tax profits, in year one alone, should increase by almost $200 billion while federal corporate tax receipts will be reduced by the same amount. Such a boost in corporate earnings would increase the forecasted internal rate of return (IRR) on the S&P 500 by approximately .90%.  Holding everything else constant this equates to a price increase of 285 points for the S&P 500 or an 11% gain from today’s level. It is impossible to assess how much of the gain since the election is due to tax reform expectations and how much is due to other factors, but we wager a good portion of it has been based on the promise of tax reform.

History

While the math and logic above seem sound, we can turn to historical data to understand the relationship between taxes and economic growth and profits. In doing this, we can better forecast the actual effects that lower corporate taxes might have on economic growth and corporate profits.

The graph below compares the effective corporate tax rate to the running three-year average GDP growth rate. The dotted trend lines smooth the data to allow for a clearer comparison.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As is clearly observable, GDP has trended lower at a very similar pace as the effective corporate tax rate. The graph below puts the data in a scatter plot format to evaluate the statistical relationship between corporate tax rates and economic growth rates.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The R² shown above (.3552), a statistical measure of correlation, is far from perfect, but there is a reason to believe that lower effective tax rates may partially explain the weakening trend in GDP growth.  Based on statistical regression, every 1% decrease in the effective tax rate should diminish GDP growth by 0.12%. 

The President, his economic team, and lawmakers are selling the tax bill with claims that a reduction in corporate taxes will boost economic growth. Based on data from the last 75 years, that has never been the case. In fact, the average annualized GDP growth rate in the five years before the major statutory tax reduction in 1986 was 3.90%. In the five years following the tax cut, the average annualized growth was reduced by more than half to 1.93%.

Next, we show a scatter plot comparing effective tax rates to corporate profits.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As measured by a R² of .051, the graph above shows that over the last 75 years, there has been no measurable relationship between effective corporate tax rates and corporate profit growth.

Who Pays

The historical evidence above tells a different story than the bill of goods being sold to citizens and investors.

 Corporate tax rates are positively correlated with economic growth which means that lower corporate tax rates equate to slower economic growth. Further, there is strong evidence that corporate profits are largely unaffected by tax rates.

Investors buying based on the benefits of the tax proposal appear shortsighted. They value the benefits of corporate tax cuts, but they are grossly negligent in recognizing how the tax cuts will be funded.  

The tax bill, as it is currently proposed, will increase the deficit by $1.5 trillion over ten years. As such, the government will borrow an additional $1.5 trillion on top of current projections of approximately $1 trillion per year.

When the government borrows money to fund a fiscal deficit they effectively crowd out investment that could have funded the real economy. Said differently, the money required to fund the government’s deficit cannot be invested in the pursuit of innovation, improving workers skills, or other investments that pay economic dividends in the future. As we have discussed on numerous occasions, productivity growth drives economic growth over the longer term. Therefore, a lack productivity growth slows economic growth and ultimately weighs on corporate earnings.

A second consideration is that the long-term trend lower in the effective corporate tax has also been funded in part with personal tax receipts. In 1947, total personal taxes receipts were about twice that of corporate tax receipts. Currently, they are about four times larger. The current tax reform bill continues this trend as individuals in aggregate will pay more in taxes.

As personal taxes increase, consumers who account for approximately 70% of economic activity, have less money to spend.

Summary

As is often the case in economics and investing, there is a “seen” and an “unseen.” The “seen” is widely visible and, right or wrong, generally represents a consensus agreement about reality. The “unseen,” while equally important, largely goes under-appreciated. In time, it is the “unseen” that will affect economic growth rates and corporate earnings. It is the “unseen” that investors must grasp if they are to be successful. In this case, the “unseen” is the massive federal deficit. Its burden on the economy prevents traditional forms of stimulus from having their desired effects.

Given the historical evidence regarding the implications of corporate tax cuts, we are left questioning the so-called “Trump bump.” We would argue that a market rally based on that premise is incoherent, and the market should be discounting prices and valuations due to the tax cuts not inflating them.

Just 10 Companies Account For 33% Of All Market Gains Since Trump"s Election

Yesterday we laid out the reasons why French bank SocGen unveiled a surprisingly contrarian forecast, according to which the S&P would tumble from its current level over 2,600 to 2,000 in 2018, representing a more than 20% bear market drop...

... the drop catalyzed by rising interest rates pressuring P/E multiples, a late cycle economy nearing recession, equities trading at record valuations, and with everyone short vol begging for a vol short squeeze. Not surprisingly, SocGen"s unspoken advice was to get out now.

And while many of the negative factors highlighted by SocGen had already been discussed here in the past, there were two we warned to bring attention to: the market"s multiple expansion since Trump"s election, and the narrow leadership in the S&P.

As we noted yesterday, contrary to the widely accepted narrative, while the S&P 500 has risen 24% since Trump"s election, only half of this performance has been driven by earnings growth; the other half is from P/E expansion. But why would P/Es rise at a time when the Fed is tightening? As SocGen speculated, assuming that analysts have not factored tax reform into their earnings forecasts, tax reform expectations have been the driver of P/E expansion. There is a problem with this: while the S&P 500 index tax rate is currently 26.6%, assuming that US companies generate 43% of their profits abroad (here) and pay 35% of their US profits on taxes (i.e. with no loopholes for US profits), the average tax rate outside the US would be 15.5%. A decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would thus theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months. In other words, roughly 150% of Trump"s tax cuts have been priced in!

However, another especially interesting observations goes to the leadership of this 24% rally since Trump"s election, which - while hardly a surprise - was largely driven by a handfull of companies, or ten to be precise.

As SocGen calculates, just 10 contributors of the S&P 500’s bull run have accounted for 33% of the S&P 500 performance. Tying to the above, the bank also points out that all of the companies listed below have seen their P/Es expand over the last 12  months, in some cases - like Nvidia, WalMart, Boeing and Amazon - dramatically. In fact, only three companies (Apple and the two banks) have 12-month P/Es that are below the market average (18x). Lastly, keep in mind that except Amazon, all of the companies already pay a  corporate tax rate below the current US federal tax rate (35%), and five companies even pay a tax rate that is below the 20% rate targeted by Trump’s tax reform.

As we asked two days ago when we showed that the bulk of hedge funds gains in 2017 have come from holding this same handful of companies, what happens to hedge fund performance - and the S&P 500 - when, for whatever reason, the tide turns and the winners are the first to be sold?

Illinois Taxoholics Wear Down Rauner: Massive Tax Hikes In The Works

Authored by Mike Shedlock via MishTalk.com,

Total capitulation by Governor Bruce Rauner is in the works. The taxoholics wore him down.

In the emergency session, Rauner has agreed to hike the personal income tax rate to 4.95% from the current 3.75%. The corporate income tax rate will rise to 7% from the current 5.25% rate.

For what? Nothing. Reforms are non-existent.

Another Deadline Come and Gone

Illinois failed to approve a budget today and thus heads into its third fiscal year without one.

A vote has been scheduled for Sunday.

I do not expect your opinion will matter, but in the slim chance I am wrong, Please Email Your Representative voicing displeasure of the tax hike.

The preceding link will find your rep based on your address.

Rule of Nothing

A zombified Rauner has capitulated in every way but the final signing.

Tax hikes have been agreed to with no reforms in return.

The Rule of Nothing is clearly in play.

Rule of Nothing

In any given political situation, the best outcome one can reasonably expect generally happens when politicians do nothing.

Implied corollary#1: When politicians attempt to fix any problem, they are highly likely to make matters worse.

Corollary #2: Politicians almost never do nothing. It’s why we have a messed up healthcare system, education system, public pension system, etc..

Taxoholics Win Again

Chicago schools will not get fixed. The hikes will not shore up pension plans.

Within one month of tax hikes, public unions will ask for more money. And people will leave the state. So will corporations.

Rauner pledged 44 reforms. He is 0-44 on his pledges.

The property tax freeze currently under debate has so many holes it is as useful as a bucket with no bottom.

Trading tax hikes for nothing is a horrible deal. Nonetheless, the taxohalics won again.

More business flight and human capital flight is the guaranteed outcome. Doing nothing at all would have been a far better outcome.

Goldman: "The Boost From Lower Taxes Will Now Be Smaller, Occur Later Than Expected"

With both JPM and Goldman having warned for months that the market is far too sanguine about the implementation (and effectiveness) of Trump"s proposed domestic fiscal policies, Friday"s events were a rude awakening for some, and framed how contentious the passage of any stimulus measures by the new president - one who as the WSJ writes this morning is realizing he misses a governing coalition - will be. And while coming to grips with the qualitative aspects of Trump"s failure to cobble together a deal was Friday"s business, the key question now deals with the quantitative aspects of what happens next, starting with Trump"s tax reform which as the president himself said will be his immediate next focus as Obamacare repeal is left indefinitely on the back burner.

Here are some thoughts from Goldman"s David Kostin.

Investors have begun to appreciate that the boost to S&P 500 earnings from corporate tax reform will likely be delayed until at least 2018.

* * *

The boost to S&P 500 earnings from a lower corporate tax rate is likely to be smaller and to occur later than investors originally expected.

The House Republican blueprint proposes a reduction in the statutory federal corporate tax rate to 20% from the current 35%. We estimate that a 5 pp reduction in the effective tax rate would boost ROE by 100 bp and lift S&P 500 EPS by about 6%.

However, our Washington, D.C. economist expects the tax rate will be cut less than proposed to roughly 25%. Investors have also reduced expectations for the timing and size of tax reform. After outperforming the S&P 500 by 520 bp post-election, our basket of stocks with the highest effective tax rates has given back all of its post-election gains in the last three months (see Exhibit 1).

The flipside, however, is that according to Goldman, the market appears to have now largely priced this in, and as a result over the past month, companies in the "high-tax rate basket" have given up all their post election gains and then some. In fact, if anything, there is some modest scope for upside surprise should Trump fail to disappoint on his next key legislative item.

How Trump's Tax Changes Will Impact You?

"Reduce taxes across-the-board, especially for working and middle-income Americans" - that was Trump’s campaign pledge. And now he is about to move into the White House and is backed by Republican majorities in both House and Senate, he has a real shot at fulfilling that pledge to the letter. So, what are the specifics of his plan, and how would it affect you?

As HowMuch.net details, first and foremost, Trump’s income tax reform is a simplification: he wants to cut down the number of tax bands from seven to three. But simplifying is not necessarily the same as reducing taxes. As this graph demonstrates, some taxpayers would definitely benefit from Trump’s tax reform – especially those at the higher end of the income scale. There are others, however, who would see their tax rates go up. Especially those on lower incomes.

The current income tax bands range from 10% and 15% at the lower end of the scale over 25%, 28%, 33% and 35% in the middle to the top band of 40%. Under the Trump plan, only three tax bands would remain: 12%, 25% and 33%.

This would be good news for everyone currently in the top two brackets (35% and 40%). These taxpayers would see their effective rate drop down to 33%, by 2 and 7 percentage points respectively. Conversely, the simplification would bad news for the taxpayers in the lowest bracket (10%). These would see their effective tax rate go up by 2 percentage points, to 12%.

But even in the middle, where many would stay in the same bands as before (25% and 33%), there would be losers as well as winners. Most people in the 15% bracket would drop down to a 12% rate. But a tiny sliver of top earners in this bracket (earning between $37,500 and $37,650) would have the misfortune of seeing their effective tax rate go up by 10 percentage points, to 25%.

A similar thing would happen to the old 28% bracket: taxpayers with incomes between $91,150 and $112,500 would drop three percentage points to 25%, while those between $112,500 and $190,150 would see their tax rate go up 5 percentage points to 33%.

All income amounts quoted here apply to single filers (left side of the graph); but the graph also shows the changes for joint filers (on the right). The calculation is pretty easy – double the amounts for the single filers.

The graph does not take into account other aspects of the Trump tax plan not directly related to the changes to income tax bands, such as the increase of standard deductions and a cap on itemized deductions, although of course these would also have an impact on net incomes.