US corporate tax reform

 why look at the corporate tax rate?

As I’ve mentioned on occasion in other posts, one of the features of today’s US stock market is that it seems to pay no attention at all to the rate at which publicly traded companies pay tax.  All that counts is (after-tax) eps and eps growth.

A generation ago, when I entered the market, the opposite was the case.  Acting on the assumption that a company couldn’t sustain a super-low tax rate for a long time, analysts scrupulously adjusted, or “normalized,” a company’s tax rate, usually to the statutory maximum.  Of course, it has turned out that some firms–and some industries–have been able to maintain a sub-par tax rate for far longer than anyone imagined possible back then.

the US tax system

There are two main issues with the current US corporate tax system, as I see it.  The statutory rate of 35% is very high in comparison with the world average of around 20%.  So, if there isn’t a crucial reason to locate here, the US is financially a bad place for a company to have operations.  Also, politically savvy industries–oil and gas drilling, for example–have been able to lobby for special breaks that make the tax code unduly complex and the amount that the IRS collects less than it should be.

reform likely

President-elect Trump is promising to address this issue by lowering the federal corporate tax rate to perhaps 15%.  Implied, but not yet stated, is that the tax code will also be simplified by wiping out special exemptions for certain industries.  There seems to be widespread support for both parts of such reform.  So it seems to me that the effort, which has always previously been derailed by special interests, has a good chance to succeed.

market consequences

This means, though, that for the first time in a long while, analysts will be scrutinizing company financials to try to separate winners from losers.

potential winners

The obvious winners are firms that have large amounts of US taxable income and that pay cash taxes at the full 35% rate.  The pharmaceutical industry is one.  No surprise that most of the tax inversions of the recent past have been in pharma.

More tomorrow.

 

 

the fiscal cliff: why not just raise income tax rates?

There are several arguments–some theoretical, some the fruit of bitter experience–against raising income tax rates beyond a certain level.

To be clear, personally I don’t think they apply in the present argument about how to close the current US annual $1 trillion+ Federal deficit.  After all, the country seemed to run perfectly fine in the 1990s, when rates were higher.   So I don’t see how turning the clock back to the status quo ante can be so bad.  (Following that logic would also imply rolling back the extra healthcare benefits enacted at the same time.)

I suspect that the biggest stumbling block is that patronage politicians know very well how to divide up shares in an ever-expanding economic pie (who wouldn’t?) but are incapable of agreeing on how to apportion mutual sacrifice.  It doesn’t help matters that, in my view, Republicans have an antediluvian economic philosophy and Democrats have none.

Nevertheless, there’s a limit to how high rates can be pushed.

how can higher tax rates be bad?

When rates reach a certain point:

1.  people start to work less.  I had an eccentric uncle (one of my favorites) who quit his brokerage house back-office job (the only position Irish Catholics would be hired for) and supported himself for the rest of his life investing his own portfolio–turning $400 into $1 million+.  Why leave?  …he was so incensed at the income tax he was paying on overtime.  Uncle Harry wasn’t your typical worker.  But if you’re losing, say, 70% of your incremental income to the tax man, what’s the point of doing extra work?

2.  people spend increasing amounts of time on gaming the tax code, diverting economic energy from more productive uses. Behavior can get crazy.  In the UK in the early 1980s, companies were buying suits and renting them to their executives rather than giving pay raises, because the tax on incremental individual income was so high.  If history runs true, the loophole-ridden US tax system would spawn huge amounts of new tax shelters–very profitable for promoters, disastrous for the purchasers.

3.  tax avoidance accelerates.  I was sitting next to the Spanish finance minister at a lunch early in my career.  I naively suggested that his country would have to raise income taxes in order to close a troublesome budget deficit.  The minister looked at me like I had dropped from the moon.  He explained that income tax rates in Spain were already as high as they could go.  Experience showed that pushing them higher resulted in lower tax receipts.  Very many people would begin to hide substantial amounts of their income from official eyes through off-the-books transactions.

4.  people leave the country.  In the US, we can see this behavior on the state level, in the steady migration from high-tax areas like New York, New Jersey or California.  France, which has recently raised the top income tax rate on high earners to 75%, is now seeing the wealthy starting to renounce their French citizenship and move elsewhere in the EU, like the UK or Belgium.