Friday, October 6, 2017

Tax Reform, 2017: Promise of Plenty or Poisoned Chalice?

Every decade or two, the political class in the United States wakes up to the reality that the US tax code, as written, is an abomination that encourages and rewards bad behavior, and works on a tax reform package. In each iteration (and I have had a front row seat with the 1986, 1993 and 2001 attempts), the reformers start with the claim that the changes they make will make the system “fairer” and “simpler”, with the added bonus of increasing economic growth. And with each one, the end result is that we end up with a system that is more complex and less fair. I am not a utopian and I understand that tax reform is a political exercise where different interests have to be balanced, but as we start to see the contours of the 2017 reform package, the big question becomes whether, on balance, it does more good than bad. As with prior tax debates, this one follows a predictable path, with support or opposition to the package, depending on who is initiating the reform. Since this version of tax reform comes from Republicans, Democrats are vehement that this reform will benefit the rich and devastate the middle class. The Republicans are just as assertive in their claims that this reform will help US companies compete better in the global economy, and increase economic growth. I would love to tell you that I am completely unbiased on this issue, but I cannot, because no one is objective when it comes to taxes. We all have our priors on taxes and look for data and evidence to back up those preconceptions. Nevertheless, my intent in this post is to start with a general assessment of how taxes affect value and to then look at both the current and proposed corporate tax models, with the objective of evaluating how the planned changes will affect value at companies.

Taxes and Value
To understand how the tax code affects the value of a business, let's go back to basics, and link the value of a business to three component parts: the cash flows generated from existing assets, the value of future growth and a risk adjustment, usually taking the form of a cost of capital or discount rate. 

Where does the tax rate show up in value? Everywhere, since each of these drivers is affected by not just the tax rate, but also by other provisions in the tax code. 
  1. Cash flows from existing investments: The cash flow from existing investments is estimated by starting with after-tax operating income and then subtracting out the reinvestment needed to sustain future growth. Since the cash flow is an after-tax cash flow, the effective tax rate paid by a firm will affect that cash flow, with higher effective tax rates resulting in lower after-tax cash flows. The statutory tax rate in the tax code is a driver, albeit not the only one, of the effective tax rate, but so are the provisions of the code that relate to the taxation of foreign income, as well as tax credits and special tax deductions that are directed at specific sectors. 
  2. Cost of capital (or discount rate): The cost of capital is a weighted average of the cost of equity and after-tax cost of debt, with the weights reflecting how much of each is used to fund operations. The most direct effect of the tax code arises from its tilt being towards debt, in much of the world. In particular, the tax benefit of debt takes the form of tax deductible interest expenses and the benefits of borrowing will increase with the statutory tax rate (or the marginal tax rate). There are more subtle effects, as well, that come from how the tax code treats investment income in the hands of investors, since changing tax rates on dividends and capital gains can affect the price charged by investors for taking equity risk (i.e., the equity risk premium) and altering the tax rates on interest income earned by investors can affect the price charged by investors in the bond market (i.e., default spreads).
  3. Value of growth: The value of growth can be traced back to the amount that companies reinvest back into themselves (measured as a reinvestment rate) and the excess returns generated on those investments (captured as an excess return, or the difference between return on invested capital and the cost of capital). The tax code can affect both the reinvestment rate and excess returns, with provisions either encouraging or discouraging more investment and the after-tax earnings showing up in the return on capital and excess returns. It is on this dimension that the effects of changes in the tax code become most unpredictable, since they affect both returns and costs of capital. Lwering the statutory tax rate can increase after-tax cash flows and returns but also increase the cost of capital, by reducing the tax benefits from debt.
The figure below captures the full picture of how taxes affect almost every input into value, and thus value.

The Current Tax Code
It is no secret that I think that the current US tax code is a mess, creating perverse incentives to under invest in the US and over borrow, and from that perspective, I welcome change. To see how the current tax code plays out in the numbers, I have taken the picture where I have connected taxes to value and looked at the tax code, as it exists today.

The US has one of the highest statutory tax rates for corporate income in the world, at 35% (and this is before state and local taxes, which push it up to 40%) and it combines this rate with a “global” tax model, where it aims to tax foreign income earned by US companies, at the US tax rate, after allowing a credit for foreign taxes paid. In theory, then, a US company that earns income in a foreign market with a 20% corporate tax rate would first pay those taxes and then pay an extra 15% (the difference between the US marginal rate of 35% and the foreign country's tax rate of 20%) to the US government. In practice, this seldom happens because the US also has a provision in the code that specifies that this extra tax is due only when foreign income is remitted back to the US. The result is no surprise. US multinationals have held off on remitting foreign income back to the US, resulting in “trapped cash” of $2.5 trillion or more, “trapped” because this cash cannot be invested back in the US or used to pay dividends or buy back stock. This behavior also, in large part, explains why the aggregate effective tax rate paid by US companies in 2016 amount was just above 26%, well below the statutory tax rate. At the same time, the high statutory tax rate encourages US companies to borrow and often in the US, where the tax benefits from debt are the highest (because of the high marginal tax rate).  At the start of 2017, non-financial service US companies funded themselves with a debt ratio of 26.3%, partly because the after-tax cost of debt (at 2.22% for the typical US company) was so much lower than the average cost of equity of 8.59%. Finally, the US taxes dividends and capital gains income at a maximum rate of 23.8%, at the investor level, lower than the federal tax rate of 40% (at the highest bracket) that these investors pay on their other income (including earned and interest income). 

The Proposed Tax Code
There is many a slip between the cup and the lip and I am sure that there will not only be many changes that will be made between now and the eventual legislation, but also a chance that there may be no change at all. At least, as described by its proponents last week, there are four significant changes being planned to the tax code:
  1. Statutory Tax Rate: If this reform passes in the current form, the statutory tax rate for corporate income generated in the United States will become 20%, almost halving the existing statutory tax rate of 35%.
  2. Foreign Income: In almost as significant a shift, the US will shift to a territorial tax model, used by most other countries in the world, resulting in foreign income being taxed at the foreign tax rate, with no additional assessments for US taxes. Thus, if a corporation generates income in a country with a 15% tax rate, it will pay the 15% in taxes but no more. Twinned with this change, and perhaps with the intent of generating some revenues, there will be a one-time tax that will be assessed on trapped foreign income (rumored to be about 10%), and after the tax is paid, the cash will be effectively untrapped, to be used for new investments, dividends and stock buybacks.
  3. Expensing & Capitalizing: In an upending of accounting tradition, the tax code will allowing for the expensing of capital investments, at least for tax purposes, for a period of five years. Thus, rather than amortize/depreciate these expenses, which spreads the tax benefits over time, companies will get the tax deduction up front, which increases value.
  4. Interest Expense Deduction: While there were rumors initially that the entire interest tax deduction would be done away with, it looks more likely that there will be limits put on how much interest expense will be deducted for tax purposes, and only for some types of corporations. 
In the table below, I take each of these changes and look at the potential impact on after-tax cash flows, the value of growth and the cost of capital:

After-tax Cash FlowsCost of CapitalValue of Growth
1. Lower Statutory tax rate on US incomeLower effective tax rate, leading to higher after-tax cash flows and returns on capital. Bigger effect on firms that derive most or all of their income in US.Lower tax benefits from debt, raising after-tax cost of debt & capital, and more so for firms with a lot of debt.Depends on how much return on capital changes, relative to cost of capital. Firms with little debt & high effective tax rates will see biggest benefit and firms with high debt & low effective tax rates will be hurt.
2. Taxes on Foreign incomeLower effective tax rate & higher after-tax cash flows. Bigger effect on firms that derived & repatriated substantial foreign income.May induce more borrowing outside US in higher tax countries.One-time release of trapped cash could increase reinvestment, but value will depend upon whether investments generate excess returns.
3. Expensing & CapitalizingReduce cost of investing, by moving tax benefits up front rather than spread over time.None.Will increase value of growth at firms with substantial physical assets. Low or no effect at companies with intangible assets.
4. Interest Tax Deduction LimitsNone.Will increase cost of capital at companies that test the limits. (Too much debt or debt in the wrong places)Will decrease value of growth and more so at firms that violate interest deduction limits.

Overall, if this tax reform is put into the code, you can expect to see after-tax cash flows and returns on capital rise, costs of capital also go up and the effects on the value of growth will vary across companies.

Winners and Losers
Looking at the list of effects, it is clear that not all companies will win with the new tax code but that should come as no surprise and is good news for taxpayers in general. Looking at the big picture, the biggest winners will be companies that have the following features:
  1. Pay high effective tax rates, either because they derive most or all of their income in the US or because they repatriate foreign income
  2. Have low or no debt in their capital structure, thus immunizing themselves from the loss of tax benefits of debt. 
  3. Earn healthy returns on capital, which will allow them to reinvest their higher earnings back to generate value.
  4. Have more physical assets than intangible assets, enabling them to get a bigger boost from the immediate expensing of capital expenditures.
To screen for these firms, I used a simple test. Taking all 7000+ publicly traded companies, listed in the US in October 2017, I looked for companies that met the following screens:
  1. Effective tax rate > 30%, the 75th percentile for US companies
  2. Total Debt/EBITDA = 0, i.e., the company has no debt
  3. Return on capital > 20%, the 75th percentile for US companies
  4. Capital expenditures/sales > 2%, the median for US companies
A list of companies that passed all four screens is available at the bottom of this post. Note that these are crude screens, based upon the most recent twelve months of data, and that you could refine them by looking at the averages across time or using other proxies.

The biggest losers will be companies that pay low effective tax rates currently, have substantial debt in their capital structure and low returns on capital. Though some of these firms may gain from the one-time release of trapped cash in overseas locales, that cash will most likely be returned to shareholders in the form of dividends and buybacks and there will be little benefit from new investments, and will be small if the cash balance is small. To find these companies, I looked for the following:
  1. Had effective tax rate < 10%, the 25th percentile for US companies, while also reporting positive taxable income
  2. Had Total Debt/EBITDA >4, the 75th percentile for US companies
  3. Had return on capital < 5%, the 25th percentile of returns on capital for money-making companies
I also eliminate real estate investment trusts and master limited partnerships, which pay no corporate taxes currently, but pass through income to their shareholders, since they will be unaffected by the change in corporate tax rates and may even benefit from having a lower tax rate on pass through income. The list of screened companies is at the bottom of the post but here again, there are refinements that you could add to come up with a better listing of companies.

As for the overall market, if this tax reform comes into effect, the aggregate effective tax rate will decrease, pushing up after-tax earnings, cash flows and returns on capital. The cost of capital will increase, as the cost of debt goes up, but that increase should be small and become smaller as companies adjust to the new tax code, reducing debt. There are two unknowns that will determine the effect on aggregate equity value. The first is the impact that the reform will have on real economic growth in the US since higher real growth will allow firms to generate higher earnings, cash flows and value. The second is how it will affect interest rates, both through the effects on real growth as well as on budget deficts in the future. I am no market timer but while I see this tax package as a net positive for markets, I don’t see it, standing alone, as an impetus for a new bull market. That has to come from other fundamentals changing.

Taking Stock: The Good and the Bad
I think that US tax code is vastly over due for change and I think that there are components of this tax reform package that move us in the right direction. By lowering the US statutory tax rate on corporate income towards that of most other industrialized countries and shifting from a global to a territorial tax system, the reform package moves the US towards a healthier system, where companies will spend less time on transfer pricing and managing trapped cash, and more on core businesses. I also think that the changes that are designed to reduce the tax tilt towards debt are sensible and will hopefully shift the focus of corporate restructuring from recapitalization (where the bulk of the value comes from increasing debt) to real operating changes. There are changes in this tax reform, though, that will create costs and unintended consequences.
1. Tax Books versus Reporting Books: I understand the motives behind the  immediate expensing of capital expenditures, but it will make the gap between reporting books and tax books into a chasm. Companies will eagerly expense their capital investments, in their tax books, report low income and pay low taxes, but will keep to GAAP rules in their reporting books, with the only clue to the divergence being very low effective tax rates. 
2. Divergent Tax Rates: I remember a time when individual investors were taxed at rates as high as 70%, capital gains were taxed at 28% and corporations were taxed at 40%, and the tax game playing that those divergent tax rates created. In fact, the 1986 tax reform act was specifically focused on eliminating these differences, trying to bring the tax rate to 28% for all income. This tax reform act moves us in the opposite direction, creating divergent tax rates (federal) again: 

While most wage earners have no choice but to pay the individual earned income tax rate, a business owner will now pay very different taxes, depending on whether he or she files as an individual, a partner in a business or as a corporation. I know that the reform act plans to counteract this by requiring owners of pass through entities to pay themselves salaries (which will be taxed as individual earned income), but I, for one, don’t feel comfortable, asking the revenue authorities to make judgments on what comprises “reasonable” salaries.  

My Tax Reform Package
I am not a tax expert, but if I were given a chance, there are a few changes that I would make to this package. First, I would eliminate the provision on the expensing of capital equipment, since the benefits in terms of additional corporate investment will be small, relative to the costs of the complexity that it will add to financial statements. Second, I would try to push for convergence in tax rates on all types of income (investment, earned, pass through and corporate income), since that will reduce the incentives to play tax games and I would .make the targeted tax rate about 25% (to keep it close to corporate tax rates elsewhere in the world). Third, I would remove the tax credits and deductions that have been added over time to the tax code; they skew business decisions and almost never accomplish the objectives that they were designed to accomplish. Fourth, I would start a weaning away from debt, by putting limits on interest tax deductions that would become more stringent over time. To those who would accuse me of being politically naive, since this package would never pass, I plead guilty. To those who would argue that I am giving too much away to the rich (who will see their marginal tax rates cut from 39.6% to 25%), my answer is that no matter how egalitarian you make your tax code, the very rich will find a way to pay little in taxes and all you will do is enrich tax lawyers and tax havens, on that path.

YouTube Video

The Tax Reform Proposal
  1. The 2017 Tax Reform Proposal (in outline)
Data Links
  1. Effective Tax Rates by Industry (for US companies)
Blog Posts on Taxes
  1. The Insanity of the US tax code (August 2014)
  2. The Tax Dance: To Pass or Not Pass Through Income (September 2014)
  3. The Tax Story in 2015: Myths, Misconceptions and Reality Checks (January 2015)
  4. Value and Taxes: Breaking down the Pfizer-Allergan Deal (November 2015)
Tax Winners (High effective tax rate + No debt + High Return on capital + High cap ex/sales)

Company NameExchange:TickerEffective Tax RateTotal Debt/EBITDAReturn on CapitalCap Ex/Sales
Ulta Beauty, Inc. (NasdaqGS:ULTA)NasdaqGS:ULTA35.88%0.00132.46%7.85%
Anika Therapeutics, Inc. (NasdaqGS:ANIK)NasdaqGS:ANIK35.31%0.0014.36%7.24%
AAON, Inc. (NasdaqGS:AAON)NasdaqGS:AAON31.87%0.0023.57%7.19%
R1 RCM Inc. (NasdaqCM:RCM)NasdaqCM:RCM49.65%0.0063.13%6.87%
Sanderson Farms, Inc. (NasdaqGS:SAFM)NasdaqGS:SAFM34.40%0.0020.84%6.39%
CorVel Corporation (NasdaqGS:CRVL)NasdaqGS:CRVL37.90%0.0033.19%5.89%
Sturm, Ruger & Company, Inc. (NYSE:RGR)NYSE:RGR35.14%0.0032.01%5.59%
Texas Pacific Land Trust (NYSE:TPL)NYSE:TPL32.37%0.00106.64%5.29%
Insteel Industries, Inc. (NasdaqGS:IIIN)NasdaqGS:IIIN33.64%0.0014.02%5.26%
Capella Education Company (NasdaqGS:CPLA)NasdaqGS:CPLA35.72%0.0021.90%5.24%
The Boston Beer Company, Inc. (NYSE:SAM)NYSE:SAM33.96%0.0021.91%4.61%
Exponent, Inc. (NasdaqGS:EXPO)NasdaqGS:EXPO30.07%0.0017.05%4.33%
Monster Beverage Corporation (NasdaqGS:MNST)NasdaqGS:MNST33.37%0.0021.83%3.84%
Zix Corporation (NasdaqGS:ZIXI)NasdaqGS:ZIXI42.00%0.0013.09%3.42%
Trex Company, Inc. (NYSE:TREX)NYSE:TREX33.73%0.0053.07%3.27%
PetMed Express, Inc. (NasdaqGS:PETS)NasdaqGS:PETS37.20%0.0026.32%3.14%
Omega Flex, Inc. (NasdaqGM:OFLX)NasdaqGM:OFLX32.04%0.0031.57%3.03%
Jewett-Cameron Trading Company Ltd. (NasdaqCM:JCTC.F)NasdaqCM:JCTC.F40.00%0.0013.08%2.58%
Dorman Products, Inc. (NasdaqGS:DORM)NasdaqGS:DORM36.84%0.0018.37%2.45%
F5 Networks, Inc. (NasdaqGS:FFIV)NasdaqGS:FFIV32.60%0.0035.44%2.35%
Lancaster Colony Corporation (NasdaqGS:LANC)NasdaqGS:LANC34.30%0.0022.97%2.25%
Nutrisystem, Inc. (NasdaqGS:NTRI)NasdaqGS:NTRI31.21%0.0045.46%2.17%
Collectors Universe Inc. (NasdaqGM:CLCT)NasdaqGM:CLCT35.76%0.00110.70%2.01%

Tax Losers (Low Effective Tax Rate + High Debt + Low Return on Capital)

Company NameExchange:TickerIndustry GroupEffective Tax RateTotal Debt/EBITDAReturn on Capital
Lions Gate Entertainment Corp. (NYSE:LGF.A)NYSE:LGF.AConsumer Discretionary (Primary)0.00%9.003.38%
AV Homes, Inc. (NasdaqGS:AVHI)NasdaqGS:AVHIConsumer Discretionary (Primary)8.63%11.604.36%
Smart & Final Stores, Inc. (NYSE:SFS)NYSE:SFSConsumer Staples (Primary)0.00%4.883.19%
Orchids Paper Products Company (AMEX:TIS)AMEX:TISConsumer Staples (Primary)0.00%9.781.06%
Cheniere Energy, Inc. (AMEX:LNG)AMEX:LNGEnergy (Primary)1.35%22.303.23%
U.S. Silica Holdings, Inc. (NYSE:SLCA)NYSE:SLCAEnergy (Primary)0.00%4.132.10%
Envision Healthcare Corporation (NYSE:EVHC)NYSE:EVHCHealthcare (Primary)0.00%6.444.87%
CIRCOR International, Inc. (NYSE:CIR)NYSE:CIRIndustrials (Primary)0.00%4.464.15%
Pangaea Logistics Solutions Ltd. (NasdaqCM:PANL)NasdaqCM:PANLIndustrials (Primary)0.00%5.504.52%
DXC Technology Company (NYSE:DXC)NYSE:DXCInformation Technology (Primary)0.00%6.122.71%
GoDaddy Inc. (NYSE:GDDY)NYSE:GDDYInformation Technology (Primary)0.00%13.101.83%
Park Electrochemical Corp. (NYSE:PKE)NYSE:PKEInformation Technology (Primary)0.00%5.623.21%
Brocade Communications Systems, Inc. (NasdaqGS:BRCD)NasdaqGS:BRCDInformation Technology (Primary)0.00%4.334.74%
Hickok Incorporated (OTCPK:HICK.A)OTCPK:HICK.AInformation Technology (Primary)0.00%12.102.88%
Olin Corporation (NYSE:OLN)NYSE:OLNMaterials (Primary)0.00%4.304.32%
Venator Materials PLC (NYSE:VNTR)NYSE:VNTRMaterials (Primary)0.00%4.242.22%
Xenia Hotels & Resorts, Inc. (NYSE:XHR)NYSE:XHRReal Estate (Primary); Real Estate (Primary)2.19%4.054.15%
Connecticut Water Service, Inc. (NasdaqGS:CTWS)NasdaqGS:CTWSUtilities (Primary)3.29%5.734.59%

1 comment:

Peter said...

Hi Prof. Damodoran,

I'm wondering why the interest tax deduction limit won't have any affect on after-tax cash flows. Wouldn't cash flows decrease since they will have to spend more money on taxes?