Tax Reform – A Twice in a Lifetime Recalibration

During the Post-WWII period, the US had no effective competition, the industrial competitors had been destroyed during the war. Consequently, US tax policy did not provoke business to leave since they had no place to go. Tax rates could be whatever Congress desired, so corporate rates were 61% and depreciation schedules were complicated and only allowed recovery of the investment in plant and equipment over long periods of time … largely governed by the obsolescence rates of the 1930’s and before.

When the Europeans and Japanese began to recover, the US did not react, so our post-war tax policy destroyed the manufacturing base in the US. It penalized wealth, success in business, successful investors, and above all made investing in manufacturing prohibitive. The little publicized truth is that the Germans, Japanese, Koreans and Chinese did not out-compete US business, they attracted US capital and expertise with more favorable tax regimes and overt government support.

There was a minor reduction in taxes in 1964 – corporate rates were lowered from 61% to 58% and maximum individual rates from 91% to 70%. In 1971 depreciation schedules were simplified, but not liberalized. The Reagan tax cut in 1986 dropped corporate rates to 34% and maximum individual rates to 36%. Accelerated depreciation was introduced for corporations, but no effort was made to equalize taxes with competing countries.

Enter 2017 Tax Reform, which is crucial to the future prosperity of this country and deserves a close evaluation.

How has our corporate tax structure negatively impacted trade as well as business balance sheets?

Number One. The current tax structure favors debt over equity. Companies are allowed to expense the total amount they spend on interest. This is a huge incentive for them to borrow as much money as possible, because it reduces their cost of capital. For instance, $1.00 borrowed costs about 5% (3.25% after tax, if your bracket is 35%). This would equate to common stock at nearly 31 times earnings (PE+ 30.76).

When looking at the opportunities to raise capital or manage the capital already on the balance sheets of most corporations; the CEO and CFO considers what that capital will cost. When funds are borrowed, the cost is the after-tax interest rate. When evaluating equity, the cost is the earnings yield, the E/P, which is the inverse of the Price to Earnings Ratio, the P/E or PE. A PE of 20 indicates that the price of the common stock is twenty times greater than the after-tax earnings. Earnings of $2 indicates a share price of $40. The earnings yield is the inverse, $2 divided by $40 or 5%.

This explains why, since 2000, most of the net debt issued by corporations has gone to share buybacks (and acquisitions, which is essentially the same). This does not build the asset base under a company, and it lowers gross after-tax earnings, though it has increased earnings per share. Let’s call it ‘financial-engineering’ or maybe ‘smoke & mirrors.’ Leveraging one’s balance sheet does nothing to build overall enterprise value, put people to work, or create products for customers/consumers.

These actions are bound to cause problems when interest rates reverse. As of the fourth quarter of 2016, investment-grade corporations were spending over $300 billion annually on interest expenses. In total, U.S. corporate debt has soared from less than $3 trillion to almost $7 trillion in just the last decade. Worse, a higher percentage of this debt is rated as “junk” than ever before. (“Junk” is the equivalent term in corporate bonds to Sub-Prime borrowers).

Thus, investors are now more exposed to rising default rates and rising interest rates than they have ever been before. By the way, this has been great for the market because it has increased per share earnings and reduced the number of shares outstanding. And the issuance of debt and share repurchases along with acquisitions and mergers have funneled large fees into the Wall Street banks. One additional but crucial factor is that leveraging a balance sheet makes corporate expansion more difficult because of restrictive loan covenants on the borrowing as well as higher interest rates on future debt, which would be necessary for business expansion.

Enter corporate tax reform. What happens if we suddenly remove the incentives that created the debt that threatens our economy, by eliminating this tax preference for debt funding? Congress will stop rewarding public company executives for taking huge balance-sheet risks. You don’t have to be in favor of taxes (and we are not) to see that the tax code should not reward CEOs for doing the wrong things. A drop-in tax rates from 35% to 20% increases the cost of debt by 23% for the maximum business tax bracket. At 4% after tax cost of debt, that equates to a common stock PE at 25, not 31. Lowering the corporate tax rate raises the after-tax cost of debt, making equity issuance more attractive to corporate CFOs.

The natural result of this reduction should be issuance of more equity and retirement of debt. However, it will take years to recalibrate corporate balance sheets back to the 2007 levels of debt to equity. In the process, overall cash flow will increase (but not on a per share basis), and companies will feel the pressure to use this capital to grow their business. As you can see in the chart below, US capital spending has declined significantly from prior decades. For this stage of the economic expansion, we should be close to 26% of GDP and we are only 75% of that, at 20%.Although not as bad as 1960’s depreciation schedules, current tax laws extend the depreciation beyond the useful life of the equipment. Technology has reduced the lives of many items, even real estate. Above all, our schedules are very restrictive compared to other countries.

Some items – like computers and software – can be fully expensed in the year they’re purchased. They’re treated like a routine cost of doing business. But longer-term corporate investments must be expensed over many years. Dollars spent today are not able to be recovered for years thus those same Dollars have reduced purchasing power. Inflation effectively robs companies of the real value of these tax credits, providing a perverse incentive to not make big, long-term investments in the US.

Allowing companies to reflect their actual expenses (all capital investments ex-real estate) in the year they are incurred would provide corporate America with an important tax break. The liberals may scream, but the reason for doing so is vitally important if we want our economy to grow over the long term … and it puts people to work. Capital investment and increased R&D are the proven ways of increasing productivity (and thus, wages and wealth).

Finally, the current tax regime makes it logical for every company to store as much of its value as possible overseas … and only import what they plan to sell in America – nothing else. By keeping their core intellectual property in countries like Ireland, these companies can pay far, far less in taxes. Meanwhile, they can develop new intellectual property overseas and immediately write-off that expense then import that intellectual property back into the U.S. (as manufactured goods) for free. This allows them to pay a tiny fraction of the taxes they would otherwise have to pay. Because of favorable foreign taxes, companies keep a lot of their employment and capital outside of the U.S.

Similar strategies are being employed at some level by almost every U.S. multinational company. Lower wages are no longer the driving force behind U.S. companies doing research and manufacturing overseas. Compared with the costs of setting up infrastructure, supply chains, and transportation costs involved with manufacturing overseas, the difference in wage rates between the U.S. and a foreign country is almost irrelevant. The principle reason most U.S. companies are setting up manufacturing and research and development overseas is to avoid U.S. taxes and regulation.

Without speculating as to how one develops a new tax structure to mitigate these factors, and assuming it could be done on a tax revenue neutral basis, the change itself may be wrenching. Looking back to the last major change in tax structure in 1986, the impact (particularly on real estate) was devastating and bankrupted the Savings & Loan industry. Regardless, of how the new structure is formulated, there will be obvious winners and losers, AND there will be unintended and unanticipated consequences.

We believe that 1) lowering the corporate tax rate, 2) liberalizing the depreciation schedules and 3) leveling the tax/trade playing field with other countries, alone would drive U.S. gross domestic product growth from around 2% to well over 3.5% – something we haven’t seen for more than eight years. There should also be ancillary benefits to repatriating the trillions of Dollars of corporate earnings held overseas, which we believe would be part of the overall tax restructure.

The expected increase in employment would help alleviate all the government’s other entitlement funding problems, as increases to wages and salaries would power funding for those programs. As corporations reduce the money spent on interest, more funds would be available for dividends to the benefit of equity investors. There would be strong benefits for the major manufacturing states, California, Michigan, Ohio, Indiana and Pennsylvania. Those in prime position will be the builders of industrial process components that automate manufacturing.  Students should take note of curriculums in engineering of all description, industrial software, machine repair and maintenance, etc. Investors should take note of those companies with higher effective tax rates than 20% and those companies with large investments in plants (operating assets as opposed to office buildings) and equipment.

The losers would be the industries that have tax rates below 20% currently and face reductions in the deductions which lower their tax exposure. Potentially, reductions in tax rates may impact those ensconced in the regulatory/bureaucratic regimes in Washington. It seems neutral to the large investment banks, which will benefit from reissuing stock to pay off the debt so recently issued. There is no question, countries with large trade surpluses with the U.S. will be losers, among them many of the Emerging Market countries. If this recalibration of corporate taxes comes to pass the recent bounce in Emerging Market equities will be a dead-cat bounce … until these countries figure out how to generate generic growth through public works spending.

This is likely to be a watershed economic event. The disruption and dislocations will not be known until these changes begin to take effect. We believe that numerous subsidies and special tax breaks will also die with this legislation. Though we think that it is a major positive, we would not be surprised to see the markets contract as the details emerge; the fear of change is always a negative.

A housekeeping note. For those of you who bought Neustar and Mobileye after our blogs on those issues, it is best to sell now. The prospective closing dates on the acquisitions will not get the investments to long term gains.

At this point, only a few of our clients or family members hold long positions in Neustar and Mobileye.

3 thoughts on “Tax Reform – A Twice in a Lifetime Recalibration”

  1. Very interesting article…I had not thought of tax policy post WWII in the competitive context of the destruction of Europe’s and Asia’s manufacturing base.

    One other point about corporate debt…as a public company, a CEO and CFO have no choice but to leverage their capital structure – if they don’t you will have “activists” who will come in and do it for them…they will also generally replace the CEO and CFO as part of their play book. So as a CEO and CFO of a public company, you really do not have a choice…if you want to keep your job.

      1. Yes… also, the activists generally have a much different idea of what appropriate leverage levels are than operating management…they seem to live by the old saying “a dollar borrowed, is a dollar earned”. So as management you have to wrestle with having enough leverage that the company is not interesting to an activist, but not so much as to limit your operating options…and if you can’t invest in your business (or fast enough) in some logical way, what else are you going to do with the borrowed funds but buy back stock..?

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