Investor Taxes and Stock Prices: Threading the Needle!

In my last post, I looked at the Biden Administration's proposal to increase corporate taxes, to provide funding for an infrastructure bill, and concluded that while there is room for raising corporate taxes, it would be more efficient and fairer to do so by reducing the tax credits and deductions in the code, than by raising the tax rate. In the weeks since, the administration has come up with its follow-up  proposal, this one funded by increases in individual taxes, primarily on the wealthy. While one part of the proposal, reversing the 2017 tax cuts for those in the highest tax brackets from 39.6% to 37%, was anticipated, the other one, almost doubling the capital gains tax rate for those making more than a million dollars in investment income, was a surprise. While supporters of the increase point to the fact that only a very small portion of individuals will be affected by the change, those individuals, through their wealth, own a significance percentage of financial assets, and how they react to the change, assuming it happens, will determine whether their pain will become all of ours. In this post, I will start by looking at investment income and how it is taxed today, compare it to how it was taxed in the past, and finally look at how individual investor taxes play out in stock prices. 

The Taxation of Investment Income

In much of the world, income from investments (interest, dividends) is treated differently than earned income (salary, wages), by the tax code, and the reasons for the divergence are both practical and political:

1. Prevent or reduce double taxation: One argument, grounded in fairness, is that it is wrong to subject the same income to multiple tax hits, and it can be argued that dividend and capital gain income is particularly exposed to this critique. The dividends that companies pay comes out of the earnings that they have left over after corporate taxes, and taxing that dividend again, when investors receive it, is clearly double taxation. It is for this reason that some countries, like the UK and Australia, allow investors to claim a tax credit, for corporate taxes paid, on dividend income. On capital gains, the same argument can be made, but it is less direct, since stock prices can go up, even if a company is money-losing and has no taxable income.  Others like Estonia and Latvia, levy taxes on corporations on the income that is returned to shareholders as dividends, and individual investors pay no taxes.

2. Encourage savings/ capital formation: In an economy, where private capital is  behind the bulk of economic investment and growth, governments are dependent up the health of capital markets (stocks and bonds) for continued growth. To encourage investors to put their savings into stock and bond markets, the tax code is sometimes tilted to make these investments more attractive. Thus, there are countries, where capital gains tax rates are effectively zero, to induce investors to buy and hold financial assets. In Europe, for instance, Belgium, Luxembourg, Slovenia, Slovakia, Switzerland and Turkey don't tax capital gains, and in most European countries, the capital gains tax rate is lower than the tax rate on ordinary income. In an extension of this rationale, there are many countries where capital gains on investments that have been held for longer periods is taxed at a lower rate than investments held for shorter periods.

In the United States, the discussion of what individuals pay as taxes on their investment income is complicated by where that investment income originates. For instance, income on an individual's holdings in a pension fund or a Roth IRA account are tax exempt, at least while they continue to stay in that account, but income from the rest of the individual portfolio are taxed. On top of all of this complexity is estate and inheritance tax law, where when an individual dies, the investments in his or her estate can be marked to market, without any tax consequences, allowing those capital gains to be sheltered from taxes.

A History of Investment Income Taxation in the US

For much of the last century, investment income in the United States has been taxed differently from income earned from salaries or business. The graph provides a general framework for understanding the structure of the US tax code:

Note that there are times when income can span multiple categories, and especially so, if are a private business owner. The business that you own is an investment, but since you work actively at that business, you may generate a salary, real or imputed, earn dividends, if the business has partners, and when sold, the business may generate a capital gain. When the US government started taxing individual income more than a century ago, in 1913, there was one tax rate on all income, earned or investment, but that changed in 1920. In the graph below, I look at the highest marginal tax rates on dividends and capital gains since the advent of US individual taxes:

Tax rates on dividends and capital gains: US

Starting in 1920, and for much of the rest of the century, dividends were taxed like other earned income, but capital gains tax rates were much lower; it is worth noting that these lower tax rates were only for long term capital gains, i.e., investments held for a year or longer. The divergence between tax rates on ordinary income/dividends and capital gains peaked in the 1950s, at least for those in the highest tax brackets. Note that since the capital gains tax rates have no brackets, those who faced lower taxes on ordinary income saw a much smaller divergence between dividend and capital gain taxes. In 1986, a tax reform act built around the premise that having different tax rates for different types of income created a whole host of unhealthy tax behavior, separated dividends from other earned income, and taxed dividends at the same rate (26%) as long term capital gains, but that promise of rational taxes was very quickly forgotten as tax rates on dividends were raised again in 1992, while capital gains tax rates remained unchanged. In 2003, another tax reform act with lofty objectives brought convergence on the tax rates to 15% for both capital gains and dividends, and while those rates have increased since, the convergence has remained, at least until now.

Taxes and Stock Prices

In my last post, I looked at how corporate taxes affect the company values, but personal taxes, i.e., the taxes paid by investors on the income that they receive from companies also affect value, albeit through more indirect means. In this section, I will trace out that link.

Pre and Post Tax Returns to Investors

When individuals invest in stocks, bond and other assets, they do so with an expected return in mind, but that expected return is in post-personal tax terms, and as my investment income gets taxed at a higher rate, they need to make higher returns, before personal taxes, to break even. To illustrate with a simple example, assume that you are a taxable investor who pays a 25% tax rate and that you are considering investing in a company, where you believe that you need to make 6%, after personal taxes, to break even. You will need to make 8% on a pre-personal tax basis, to break even:

Pre-personal tax return (with 25% tax rate) 

= Post-personal tax/ (1- personal tax rate) = 6%/ (1- .25) = 8%

If you were valuing the company, you would use the 8% as your required return, since the earnings and cash flows that you are evaluating are after corporate, but before personal, taxes. If the tax rate were raised to 40%, all else being held equal, your expected pre-personal tax return will have to increase to 10%:

Pre-personal tax return (with 40% tax rate) 

= Post-personal tax/ (1- personal tax rate) = 6%/ (1- .40) = 10%

With a 10% required return, the company will be significantly less valuable.

Extending this concept to actually investing in stocks, you are faced with complications. The first is that you pre-personal tax return on stocks is composed of dividends and price appreciation, and as we noted in the earlier section, the tax rates on the two can diverge. Thus, the post personal-tax return on stocks can be written as:

Post-personal tax return on stocks = Dividend yield (1 - tax rate on dividends) + Expected Price Appreciation (1 - tax rate on capital gains)

Thus, if a stock has a 2% dividend yield and an expected price appreciation of 6%, and your tax rates were 20% for dividends and 40% for capital gains, your post-personal tax return would be:

Post-personal tax return = 2% (1-.20) + 6% (1-.40) = 5.20%

As a final complication, you have to consider the fact that tax rates can vary across individuals, there are some investors who do not pay taxes on any investment income (pension funds) and some who pay taxes only on some types of investment income.

Historical Stock Returns: Pre and Post-tax

At the start of every year, I update a dataset, where I look at historical returns on stocks over time, and compare these returns to returns on treasury bonds/bills, corporate bonds and gold. At first sight, stocks have had an impressive run over much of the last century, delivering substantial return premiums over treasury bonds, treasury bills and corporate bonds:

Historical returns on stocks, bonds and bills: 1928 -2020

These returns, though, are prior to personal taxes, and the tax bite can be substantial. To see the most dire version of the tax effect, assume that you were in the top tax bracket through this entire period, paying the highest marginal tax rate on dividends and capital gains, and that you trade at the end of each year, thus paying capital gains taxes each year. The returns you would have made on a post-personal taxes basis are shown in the graph below:

Historical pre and post-tax returns on stocks: 1928 -2020

Over this period, the taxes would have cost you more than a third of your annual returns on stocks, but the extent of the damage can be seen when you look at the cumulative effect. An investment of $1000 in stocks at the end of 1927, assuming that dividends and price appreciation are reinvested back each year, would have amounted to $5.93 million by the end of 2020. However, paying the highest marginal tax rate each year on dividends and price appreciation would have reduced the end value of this investment to $278,489, a drop of 95.3% in value. It is no wonder that those most heavily invested in stocks look for ways to reduce their tax hit, starting with steering away from stocks that pay dividends to holding on to stocks for long periods, since capital gains apply only when stocks are sold. It is also not surprising that they are targets for investment vehicles that claim to protect them from taxes.

Forward-looking Expected Returns

If you start with the premise that investors have a post-personal tax return in mind, when they invest, can you back out that expected return? I think so, but to do it, you have to start with a pre-personal tax expected return. With stocks, I compute this pre-personal tax return at the start of every month, using the current level of index and expected cash flows to back out an internal rate of return; this is the basis for the implied equity risk premium. At the end of trading on May 7, with the S&P 500 trading at 4201.62, I compute this expected return to be 5.73%:

Download spreadsheet

This expected return is prior to personal taxes, and to compute the post-personal tax return, at current tax rates, I have to make assumptions about what percentage of investors in the stock market are tax paying and that number will be different for dividends and capital gains. For dividends, since about 37% of equities are held by tax exempt investors (pension funds) that pay no taxes, I will assume that the remaining 63% pay taxes).  With capital gains, in addition to pension funds, foreign investors are not required to pay capital gains taxes (though they face taxes on dividends), resulting in an even smaller percentage of tax paying investors (I estimate 50%, but it is a shifting number). Starting with the 5.73% pre-personal-tax return, and using 23.80% as the tax rates for dividends and capital gains, I back into a post-personal tax return of 5.01% for the aggregate market:

The Biden Capital Gains Tax Plan

The Biden proposal on capital gains is still in nascent form and will morph as it goes through the Congressional meat grinder, but as it stands now, it is built on two building blocks. The first is that tax rates on capital gains will be raised to 39.60% (effectively 43.4%, with the health care add on tax) but only for those who earn more than $ 1 million in investment income (not all income). The second is a change in estate tax law to require that inheritors of investments will be required to pay capital gains taxes, at the time of inheritance, on capital gains on these investments. That is a change from the current law where these capital gains are effectively not taxed. This change will affect a broader swath of individuals. To assess the impact of the first of these proposed tax changes, I had to start with an estimate of the percentage of stocks that are held by those that will be impacted by the law. While the administration is pointing out that only 0.3% of individuals will be affected by the law, these individuals hold a disproportionate share of stocks, because of their wealth. If it is estimated that the top 1% (in terms of wealth) in the United States hold 51.8% of stocks, and it stands to reason that the top 0.3% hold 30% or more of stocks. Using the 30% threshold, I can recompute the returns you would need to make on a pre-personal tax basis to arrive at the same post-personal tax return earned before the tax change:

With the increase in capital gains tax rates for the wealthy, the pre-personal tax expected return has to rise to 6.05% to get the same post-tax expected return of 5.01%. 

Revaluing the index using the same cash flows as we did before, but with the higher expected return, we can estimate a new value for the index:

Download spreadsheet

If nothing else changes in the estimation, an increase in the capital gains tax rate for the wealthiest subset of investors will cause value to decline by about 7.09%. This computation ignores what may be the bigger change in the tax code, which is the capital gains assessment on inherited assets. That effect will affect more investors, and thus potentially cause a further reassessment of pre-personal tax returns.  In defense of the Biden proposal, the counter argument could be that the funds raised from these taxes will be invested back in the economy, and create higher economic growth, which, in turn, will benefit businesses by delivering higher earnings. 

    Even though the effects of this tax code change on stock prices are likely to be modest, there are aspects of this tax proposal that I do not like. 

• Not only does it pick on a tiny group of individuals as deserving of paying more in taxes, but it seems to be motivated less by the desire to raise revenues, and more by the urge to punish. As always, this is rationalized by arguing that the rich don't pay their fair share of taxes, though the evidence for that proposition is either anecdotal, or based upon a selective reading of the data. The wealthiest among us can afford to pay more in taxes, but insulting them or treating them as a pariah class, while asking them to pay more, will only induce them to find ways to avoid doing so, and who can blame them? If they decide to do so, this is also the group with the most weapons at its disposal for sheltering income from taxes, and I have a feeling that one group that will clearly benefit, if this proposal goes through, are tax accountants and lawyers.
•  If you are not among that tiny targeted group, it is delusional to think that forcing individuals in this group to pay more in taxes will have no effect on you, since this group punches well above its weight. There is a very real danger here that as we take aim at what we think are the idle rich, we risk shooting ourselves in the foot. 
• Finally, if the most effective tax codes are simple and direct, changes like the proposed one, where segments of taxpayers are assessed a higher tax rate on portions of income are exactly what cause them to become complex and inefficient. 

I have a feeling that both sides of this tax debate will find my analysis wanting, with those in support of the proposal feeling that I am taking too narrow a perspective, by just changing the tax rates, and those opposed arguing that an increase in the tax rates will have negative consequences that stretch well beyond the tax rate effect, driving investors out of stocks into more opaque (from a tax perspective) investments.

The Bottom Line

    May intent in this post was less to focus in on the Biden proposal, and more to open a discussion of how personal taxes affect not only valuation, but also corporate finance behavior. That effect is often missed by analysts because it is not explicitly part of the valuation of publicly traded companies, but it implicitly plays a role, and perhaps even a key one. 

• As capital gains and dividend tax rates are changed, the changes percolate through into expected returns and risk premiums, and through those into value. It is one more reason that blindly using historical risk premiums can lead to static and strange values. 
• Companies, faced with investing, financing and dividend questions, may answer them differently, when personal taxes change. Thus, is it possible that the increase in capital gains taxes could reduce cash returned, especially in the form of buybacks? Absolutely, and especially so at closely held firms. 
• For governments, changing the tax rates on investment income to increase tax revenues is fraught with uncertainties. For instance, if the capital gains tax change goes through, it will almost certainly not begin until 2022, and there will be a significant amount of selling towards the end of 2021, as some wealthy investors lock in the current favorable capital gains tax rate. Going forward, a higher required return on stocks will mean lower market valuations, which reduces capital gains in general, and tax collection from those capital gains, as a consequence. One reason to be wary of government forecasts of large tax collections from increases in capital gains tax rates is that these forecasts are built on the presumption that the market that is the goose that lays this golden egg will continue going up, since rising markets deliver higher capital gains, and the tax rate hike may kill that goose. 

YouTube

Datasets

1. Tax rates on dividends and capital gains: US
2. Historical returns on stocks, bonds and bills: 1928 -2020
3. Historical pre and post-tax returns on stocks: 1928 -2020

Spreadsheets

1. Impact of investor tax rate changes on stock prices

The Corporate Tax Burden: Facts and Fiction

The Biden Administration's $ 2 trillion infrastructure plan, announced with fanfare a few weeks ago, has opened up a debate about not only what comprises infrastructure, but also about how to pay for it. Not surprisingly. it is corporate taxes that are the primary vehicle for delivering the revenues needed for the plan, with an increase in the federal corporate tax rate from 21% to 28% being the central proposal. I will leave the debate on what comprises infrastructure to others, and focus entirely on the corporate tax question in this post. I do this, knowing fully well that tax debates quickly turn toxic, as people have strong priors on whether corporations pay their fair share of taxes, and selectively find inforrmation to back their positions. I will begin by laying out the pathways through which corporate taxes affect company value, and then looking at how the 2017 tax reform act, which lowered the federal tax rate from 35% to 21%, has affected corporate behavior.

Taxes, Earnings and Value

At first sight, this section may seem useless, because the effect of tax rates on value seems blindingly obvious. As the corporate tax rate rises, all else being held constant, companies will pay more of their earnings in taxes, and should be worth less. That facile assessment, though, can falter for the following reasons:

1. Feedback effect on taxable income: This may seem cynical, but it is nevertheless true that the amount that companies report as taxable income and how much they choose to defer taxes into future years is a function of the corporate tax rate. As tax rates rise, corporations use the discretion built into the tax code to report less taxable income and to defer more taxes to future years. It is for this reason that legislatures around the world over estimate how much additional revenue they will generate, when they raise taxes, and investors over estimate how much corporate earnings will rise when tax rates are decreased. 
2. Contemporaneous changes in the tax code: When corporate tax rates are changed, it is a given that there will be other changes in the tax code that may either counter the tax rate change or add to it. For instance, the 2017 US tax reform act, in addition to lowering the corporate tax rate, also changed the way that foreign income to US companies was taxed and put limits on the tax deductibility of debt.
3. Financing Mix: Companies can raise capital either from equity or debt, and the costs of equity and debt can be altered when the tax rate changes. That is because interest on debt is tax deductible, and as the corporate tax rate rises, the after-tax cost of debt falls, making debt more attractive as a financing option for companies, relative to equity.

The picture below maps out how tax rates can affect earnings, cash flows and value:

Note that it is the effective tax rate, determined by tax deferrals and other tax management tools, that drives after-tax earnings and cash flows, and the marginal tax rate, i.e., the tax rate on the last dollar of income earned that determines the corporate after-tax borrowing cost. It is this reason that the effect of raising or lowering corporate tax rates on value can get murky, with the following general propositions:

• Tax Deferral Options: Companies that have more options when it comes to deferring taxes than others can buffer the impact of higher corporate taxes by choosing to defer taxes and report less taxable income. The most significant of those options, in my view, is foreign sales, with companies that generate more of their income overseas acquiring more tax freedom than purely domestic companies. There are other options embedded in the tax code allowing for tax credits and deductions for some investments and expenses, with sectors like real estate being prime beneficiaries.
• Debt funding: Firms that are heavier users of debt financing will be able to offset some or even all of the impact of a higher corporate tax rate, by increasing their debt funding and using the tax advantages that come with the higher tax rate to lower their costs of capital.

Put simply, when corporate tax rates are raised, not all companies will lose equally, and there may even be a few companies that emerge as net winners.

Marginal Tax Rates

    Much of the discussion about corporate taxes is centered on the corporate tax rate, enumerated in the corporate tax code. As the proposal to raise the US corporate tax rate from 21% to 28% (or some number in the middle) is discussed, it is worth looking at the history of US corporate tax rates, going back to their inception early in the twentieth century:

For proponents of raising corporate taxes, this picture is their strongest suit, since corporate tax rates are now lower than they have been since the 1930s.  For much of this history, the US also adopted a global tax model, which required US companies to pay the US tax rate not just on income earned in the US, but also in foreign markets, with the caveat that the foreign income would be taxed, when repatriated to the US. In a predictable consequence, US multinationals chose to leave their foreign income outside the US, creating the phenomenon of trapped cash, i.e., income held in foreign locales to avoid taxes, but also trapped because that income could not be used to pay dividends, buy back stock or invest in projects in the United States.

While that system worked well for most of the twentieth century, it started to break down towards the end of that century, as the US became a less dominant player in the global economy, and other countries lowered their corporate tax rates. The first development meant that larger proportions of US corporate income was generated overseas, and the second increased the differential tax rates and thus the repatriation penalty. By 2014, when I wrote this post, the US tax code had become dysfunctional, as the trapped cash cumulated to trillions of dollars and some US companies sought to move their incorporation to other countries.  This history is worth emphasizing, because the change in the US corporate tax rate in 2017, from 35% to 21%, accompanied by the abandonment of the global tax model just brought the US closer to the rest of the world in terms of both tax rates and treatment of foreign income. In fact, at the start of 2021, the picture below summarizes corporate tax rates around the world:

Source: KPMG

Note that the marginal tax rate for US companies is close to 25%-27%, with state and local taxes added on, and is roughly equal to the average tax rates in almost every region of the world. 

Effective Tax Rates

Governments set corporate tax rates, but companies use the tax code to full advantage to try to minimize taxes paid and delay the payment of taxes. The effective tax rate measures the actual taxes paid, relative to taxable income, and it is the number that determines how much governments collect as tax revenues. 

Measures of Taxes Paid

To measure how much companies pay in taxes, you have to start with the financial statements of the company, recognizing that these are reporting documents, not tax documents. Put simply, what you see as taxable income in the annual report or public financial filing for a company can be very different from the taxable income in the tax filings made by the same company. Since we have no access to the latter, at least for individual companies, there are clues in the reported financials that can nevertheless help us assess how much a company pays in taxes:

Note that effective tax rate is computed based upon the income statement, and is computed by dividing the accrual measure of taxes by the accrual taxable income. While that is the tax rate that most databases report, it may fail to capture the true tax burden for two reasons:

1. Accrual income: It is worth remembering that accrual income is after accounting expenses, some of which are related to operations (cost of goods sold, marketing), some to financial (interest expenses) and some of which are determined by the tax code (depreciation and amortization, write offs, special charges). A company that is savvy about using tax provisions to lower its accrual income may be able to look like it is paying a high effective tax rate, but is actually paying very little in absolute terms.
2. Cash taxes versus Accrual taxes: The actual taxes paid by to the government (cash taxes) can be higher or lower than the accrual taxes, and the difference should be visible in the cash flow statement in the form of deferred taxes. 
3. Past tax behavior: One final factor that can affect a company's tax burden is its past history. A company that has lost considerable amounts in prior years can accumulate net operating losses and reduce taxes paid in the current period. Alternatively, a company that has deferred taxes in prior years will find itself playing catch-up and paying more in taxes in the current year, just as companies that have pre-paid taxes in previous years may be able to pay far less in taxes in the current year.

As a result of these three phenomena, you can sometimes see effective tax rates that look implausible or even impossible, ranging from rates in excess of 100% to rates less than zero. You can already see, from this description, that computing effective and cash tax rates for individual companies and then averaging across those tax rates can be problematic for a few reasons. The first is that any grouping of companies, where a fairly large number are money-losing and not paying taxes, will give you an average tax rate that is low, even if companies are paying their fair share. The second is that extreme values on tax rates for some companies can skew averages, and if your grouping includes both small and large companies, looking at the average tax rate across companies will not accurately reflect whether companies collectively are bearing a fair burden. If it sounds like I am spending time in the weeds, it is because I face this challenge every year when I report average effective tax rates by sector for companies around the world on my website. To cater to different needs, I report four different tax measures, each of which can yield different values and come with different caveats:

1. Taxes paid in dollar value (Accrual and Cash): This reflects the aggregate amount paid by all companies in a grouping  during the most recent year. Ultimately, this is the number that matters most from a tax collection perspective.
2. Average effective tax rate across all companies: This is the average tax rate across all companies in a grouping, including money losing companies. Not surprisingly, the average will be pushed down as the number of money losing firms increases.
3. Average effective tax rate across money making companies: This deals with the problem of money losing companies, but it is a simple average and it weights very small companies and very large companies equally.
4. Aggregate tax rate: This is the tax rate that best captures how much companies pay in a sector, and is computed by dividing the sum of taxes paid by all companies in a sector by the sum of taxable income. It thus weights bigger companies more than smaller companies.

To illustrate, for US pharmaceutical companies, at the start of 2021, and using income from the trailing 12 months (through September 2020), we find that the these companies collectively paid $9.43 billion in accrual taxes and $15.98 billion in cash taxes. This translated into an average tax rate across all companies of 1.88%, an average tax rate of 16.30% across only money making companies, an aggregate tax rate of 18.19% with accrual taxes (and 32.96% based upon cash taxes).

US Effective Tax rates

The United States is fertile ground to examine how companies manage taxes for two reasons. The first is that until very recently, US companies faced among the highest marginal tax rates of companies anywhere in the world. The second is that the US tax code also has more credits and deductions, often put in by Congress with the best of intentions, that allow companies more discretion when it comes to computing taxable income and tax deferrals. To measure how much companies pay in taxes, I look at how much US companies have, in the aggregate, paid in taxes between 2016 and 2020, in the table below:

Note that while the corporate tax rate dropped by 14% (from 35% to 21%) from 2017 to 2018, the effective tax rate decreased by 6.8% and the cash tax rate by 2.75%. In a more telling statistic, the dollar value of taxes paid increased between 2017 and 2019 by 1.4% and cash taxes by almost 18%, as companies reported more taxable income. To put corporate tax behavior in larger perspective, I looked at corporate pre-tax income and taxes reported by the Bureau of Economic Analysis, going back to 1929:

While there are differences in year to year numbers, looking at this source rather than corporate filings, the story remains the same. Over time, the effective tax rate for companies has drifted down, with the decline accelerating over the last twenty years. It is also clear that the big disruptions in tax rates have come from economic shocks, with taxes collected and tax rates paid declining economic slowdowns and recessions. While the arguments about the right tax rate for US companies and whether they pay their fair share in taxes are legitimate ones, it has to start with a reality check. The perception that US companies are now paying significantly less in taxes than they were prior to 2017, while it may fit your preconceptions about corporate tax behavior, is not backed up by facts. Of course, you could believe that they should pay more than they have historically, but that discussion has to start with the recognition that lowering the tax rate in 2017 is not the reason, and that reversing it will not be the solution.

International Tax Behavior

There is a widespread belief that US companies pay less in taxes than their global counterparts, and to see if that is true, I look at effective tax rates paid by companies in different countries in the map below:

On this measure, I do think that those who believe that US companies pay less than their "fair" share have a point, since the effective tax rate paid by US companies is lower than the effective tax rates of companies in much of the rest of the world (barring Canada). The differences are smaller when you look at the cash tax rate, but there is evidence here of the drag created by the tax credits and deductions added over multiple tax reform acts to the US tax code. The differences in tax rates across the world also underlie the challenge that Janet Yellen will face in trying to get companies to agree to a global minimum tax rate. The countries with tax rates much lower than the global average benefit because they draw in corporate subsidiaries that hope to benefit from the lower tax rates.

Sector-specific Tax Behavior 

It is true that companies in different sectors are affected by the tax code differently, partly because there are tax credits and deductions that are directly specifically at specific sectors. To examine differences in tax rates paid by US companies in each industry grouping, I decided to go back to 2019, rather than 2020 numbers, because the COVID crisis wreaked havoc in some sectors. 

Data for all industries

There are clear differences in taxes paid across sectors, with some of the reasons being obvious (REITs are pass through entities that pay no federal taxes) and some not. For instance, technology companies and pharmaceutical businesses are mostly in the first two columns (with the lowest tax rates) and retail  companies pay much higher tax rates.  Pharmaceutical and technology companies do share a common characteristic, which is that their primary capital expenditure takes the form of R&D, which has historically been expensed at these companies, rather than capitalized and depreciated. To see if that has explanatory power, when it comes to effective tax rates, I broke down US companies into quintiles, based upon R&D as a percent of sales, again using 2019 data, and computed effective and cash tax rates, by quintile:

Companies that have the highest percent of R&D as a percent of sales not only have the smallest proportion of firms with taxable income, but also pay the lowest effective and cash tax rates. However, these are also younger, money-losing companies, and their tax behavior may just reflect where they are in the corporate life cycle. In fact, when you compare all firms with R&D expenses to those without those expenses, the results are mixed. A larger proportion of firms with R&D expenses report taxable income, and while they pay a lower effective tax rate than non-R&D firms, they pay a highest cash tax rate.

Finally, there seems to be a perception that it is the largest companies that are not paying their fair share in taxes, fed by anecdotal evidence of high profile companies that pay no taxes; in the last few years, those examples have included GE, Amazon and FedEx. To see if this is true, across companies, I broke US companies down my market capitalization into ten deciles and looked at the tax behavior in each grouping.

There is little evidence in this table to support the notion that larger companies are more likely to evade taxes than smaller ones. In fact, the percentage of companies with taxable income rises with market capitalization, and the effective tax rates of the top deciles are clearly higher than those of the bottom deciles.

Thoughts on new tax laws

If Congress gets around to passing another tax reform act, I am sure that legislators will gets lots of opinions on what they should be doing, not to mention millions of dollars off lobbying directed at them. I am sure that my thoughts on what good tax legislation should look like matter little, but here they are:

1. Pinpoint your mission: In keeping with the saying that if you do not know where you going, it does not matter how you get there, the starting point for all tax legislation has to be with the end game. Early on, legislators have to decide whether they consider corporate taxes to primarily a source of revenues to the government or a weapon to punish "bad" corporate behavior and to "reward" good corporate behavior. While I understand the urge to use the tax code to mete out punishment to "bad" companies or to encourage companies to pay a living wage and keep their operations in the United States, the resulting laws may actually result in less tax revenue to the government, with only fleeting benefits.
2. All tax talk is agenda-driven: Undoubtedly, there will be research from the Congressional budget office on the revenue consequences of tax law changes and testimony from economists and tax experts. They will use numbers that back their arguments and look like facts, but in my experience, it is easy to lie with numbers, especially when it comes to taxes.  
3. Focus on removing tax deductions/credits, not on increasing tax rates: If the end game is to get companies to pay more in taxes, removing tax deductions and credits will be more effective than increasing the tax rate. In fact, raising the tax rate will not only raise the effective tax rate paid by companies far less than expected, but it will also have disparate effects across companies, with sectors (like retail) that have fewer degrees of freedom, when it comes to changing taxable income or deferring taxes, bearing the brunt of the pain. I know that this is easier said than done, since every tax deduction/credit has a constituency that will plead for its preservation, but one reason why the tax code has become the convoluted mess that it has become, is because we have not frontally dealt with this problem. An added benefit of doing this will be that there will be less work for tax accountants and lawyers and fewer tax-driven investments and decisions.
4. You operate in a global economy: No matter how careful you write the tax laws, multinationals will retain a substantial amount of freedom to move their operations and income around the world. A country that is an outlier when it comes to taxes, as the United States was prior to 2017, will lose out in the competition for new businesses. While I do think that a global corporate minimum tax can reduce this cost somewhat, getting countries to sign on, especially when they realize that they will be "net losers" from being part of it, will be difficult.
5. Provide long-term predictability: Whatever Congress decides to do with the tax code, it should also provide a degree of predictability for an extended period. Changes to the tax law that are temporary or come with sunset provisions create uncertainty for businesses trying to make investment decisions for the long term. In addition, changes in tax law take a while to work their way into corporate behavior. One of the better features of the 2017 tax act was that it had provisions designed to make debt financing less attractive, relative to equity, but we will not get a chance to see if companies become less dependent on debt, if tax rates are hiked and/or the limitations on interest tax deductions are eliminated.

Am I hopeful that Congress will keep these in mind, while it writes new tax laws? Not really, but there is no harm in hoping!

YouTube Video

Datasets

1. Marginal tax rate by country
2. Effective tax rate by country
3. Effective tax rate, by sector (US, Global)

January 2018 Data Update 8: Debt and Taxes

In the United States, as in much of the rest of the world, and as has been true for most of the last century, the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to those that use equity to fund their operations. While the original rationale for this debt bias was to allow the large infrastructure companies of the equity markets (railroads, followed by phone and natural resource companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment of the economy is built on debt. The most revolutionary component of the US tax reform package that passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so, challenges companies that have long depended on debt to reexamine their financing policies. 

The Trade Off on Debt and the Tax Reform Package

In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper than equity and dilution benefits:

The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to borrowing were greater in the United States than in any other country last year, for a simple reason. The US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%, that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year, partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction against its highest taxed income (its US income). For those of you who find this unethical, please spare me the moralizing since your disdain should be directed at those who wrote the tax code.

As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax benefits of debt, which will be dramatically decreased starting this year, for two reasons:

1. Lower marginal tax rate: The marginal tax rate for the United States has gone from being the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been entirely in shades of red last year, before the tax rate change, since there was no other country with a corporate tax higher than 40%.

via chartsbin.com
2. Limits on interest tax deductions: Until last year, as has been the case for much of the last century, US companies have been able to claim their interest expenses as tax deductions, as long as they have the income to cover these expenses. With the new tax code, there is a limit to how much interest you can deduct, at 30% of adjusted taxable income. Any excess interest expenses that cannot be deducted can be carried forward and claimed in future years, and that provision will help companies with volatile earnings, since they will be able to claim back deductions lost in a bad year, in good years. As is its wont, Congress has chosen to make up its own definitions of adjusted taxable income, with EBITDA standing on for operating income until 2021 and then transitioning to earnings before interest and taxes (EBIT). 

There are two other provisions in the tax code which will also indirectly affect the debt trade off.

1. Capital Expensing: Attempting to encourage investments in physical assets, especially at manufacturing companies, the tax code will allow companies to expense their capital investments for a temporary period. The resulting tax deductions may be large enough to reduce the benefit to having the interest tax deduction. That effect will be magnified by the fact that the companies that are most likely to be using the capital expensing provisions are also the companies that have used debt the most in funding their operations.
2. Un-trapped Cash: As companies are allowed to pay a one-time tax and bring trapped cash back to the United States, the cash will be now available for other uses and reduce the need for debt as a funding source. Note that estimates of this trapped cash, collectively held by US companies, exceed $3 trillion and that even if only half of this cash is brought back, it would still be a substantial amount.

All in all, there are multiple provisions in the tax code that handicap the use of debt and very few, perhaps even none, that would make debt a more attractive source of financing. 

Optimal Capital Structure

To quantify the impact of the tax code’s change on how much debt a company should have and how much value it adds, I used an old but flexible optimizing tool: the cost of capital. It is, of course, the number around which a post looking at how it varies around the world and sectors. In the follow up post, I used the cost of capital as a hurdle rate to judge the quality of a company’s investments. In this one, I will use it to talk about the right mix of debt and equity, and how it affects value:

Note that as you borrow more money, your costs of equity and debt go into motion, increasing as the debt increases and the trade off from the last section plays out, with the tax benefits showing up as an after-tax cost of debt and the bankruptcy costs partially captured in the higher costs of both equity and debt and partially as drops in operating income. Note that the key changes in the 2017 tax reform package, at least as they relate to the trade off, are highlighted. I used Disney as an illustrative example, and computed the costs of capital at every debt ratio under the old tax regime and the new one and the results are in the graph below:

Disney Capital Structure Spreadsheet

The cost of capital is a driver of the value of the operating assets, and since the costs of capital are higher at every debt ratio than they used to be, it should come as no surprise that the value added by debt has dropped at every debt ratio, with the new tax code.

Download spreadsheets: Disney, Facebook & Ford

The easiest way to see the effects of the new tax code are to look at how it plays out in the cost of capital and values of real companies. I will use Facebook, Disney and Ford as my examples, partly because they are all high profile and partly because they have widely divergent current debt policies, with Facebook having almost no debt, Disney a moderate amount and Ford more debt. With each firm, I computed the schedule of cost of capital, holding all else constant (both micro variables like EBIT and EBITDA and macro variables like the risk free rate and ERP.), with the old and new tax codes. I do this, not because I believe that these numbers will not be affected by the tax code, but because I want to isolate its impact on debt. 

For all three firms, the effect of the new tax code is unambiguous. The value added by debt drops with the new tax code and the change is larger at higher debt ratios. Taking away 40% of the tax benefits of debt (by lowering the marginal tax rate from 40% to 24%) has consequences. Note, though, that the lost value is almost entirely hypothetical, for Facebook, since it did not borrow money even under the old code and did not have much capacity to add value from debt in the first place. It is large, for Disney and Ford, as existing debt becomes less valuable, with the new tax reform. Note, though, that both companies will also benefit from the tax code changes, paying lower taxes on income both domestically, with the lowering of the US tax rate, and on foreign income, from the shift to a regional tax model. Ford, in particular, could also benefit from the capital expensing provision. My guess is that both firms will see a net increase in value, with all changes incorporated. With these three firms, at least, the cap on the interest expense deduction (set at 30% of EBITDA for the near term) does not affect value at their existing debt ratios and is not a binding constraint until they get to very high debt ratios. 

Debt Ratios- Cross Sectional Distributions

If you accept my reasoning that the new tax code will lower the value of debt in capital structure, and that the effect will be most visible at firms that borrowed a lot of money under the old tax regime, the only way to assess the tax code’s impact is to look how debt ratios vary across companies, and what type of firms and in what sectors borrow the most.

To get a measure of what comprises a high debt ratio, I started by looking at the distribution of debt ratios across companies, for both US and global companies:

I was surprised by how many firms in the global sample have little or no debit their capital structure, with more than half of all firms in the sample having total debt to capital ratios of less than 10%. In fact, netting cash out from debt would lead to even lower net debt ratios. That said, there is enough debt at the largest firms that the aggregated debt ratios across all firms is significantly higher. Looking at these aggregated debt ratios, you would expect US companies to have been borrowing more money than companies in other parts of the world, and to see if they did, I looked at measures of financial leverage, from debt scaled to capital to debt to EBITDA globally:

Sub Group	Debt/Capital (Book)	Debt/Capital (Market)	Net Debt/ Capital (Book)	Net Debt/ Capital (Market)	Debt/EBITDA
Africa and Middle East	45.23%	34.00%	30.27%	21.31%	5.99
Australia & NZ	61.66%	43.48%	57.82%	39.60%	8.57
Canada	55.35%	42.42%	52.46%	39.60%	7.16
China	51.63%	39.34%	41.83%	30.40%	8.52
EU & Environs	60.75%	47.17%	53.68%	40.07%	7.78
Eastern Europe & Russia	31.02%	38.05%	21.35%	27.05%	2.47
India	54.89%	20.85%	50.58%	18.15%	3.92
Japan	56.16%	49.11%	27.64%	22.35%	7.61
Latin America & Caribbean	51.67%	40.01%	46.23%	34.90%	5.74
Small Asia	44.04%	34.76%	36.01%	27.59%	4.54
UK	63.74%	46.39%	53.68%	36.33%	7.94
United States	64.06%	37.11%	60.86%	33.99%	7.09

The results are mixed. While US companies look like they are the most highly levered in the world, if you scale debt (gross and net) to book value, US companies don’t look like outliers on any of the dimensions. In fact, the only real outliers seem to be East European companies that borrow far less than the rest of the world, relative to EBITDA, and Indian companies, that borrow less, relative to market value. Looking across sectors, you do see clear differences, with some sectors almost completely unburdened with debt and others less so. While you can get the entire list from clicking on this link, the most highly levered sectors in the US are highlight below, relative to both market capital and EBITDA.

Download full sector spreadsheet

I removed financial service firms from this list, since debt to them is a raw material, not a source of capital, and real estate investment trusts, since they do not pay corporate taxes, under the old and new tax regimes. As I noted in my post on tax reform, it is the most highly levered sectors that will be exposed to loss of value and it is entirely possible that the net effect of the tax change can be negative for them. 

Implications
You seldom get to observe a real world experiment of the magnitude that we will be faced with in 2018, with the tax code in change and the loss in value added from debt. Given the changes, I would expect the following:

1. Deleveraging at firms that have pushed to their optimal debt ratios, under old tax code: While there are many firms, like Facebook. where debt was never a source of added value, where the tax code will affect that component of value very little, there will be other highly levered firms where the value change will be substantial. In fact, many of these firms, which would have been at the right mix of debt and equity, under the old tax regime, will find themselves over levered and in need of paying down debt. Given that inertia is the primary force in corporate finance, it may them a while to come to this realization.
2. Go slow at firms that have held back: For firms like Facebook that have held back from borrowing, under the old tax code, the new tax code reduces the incentive to add to debt, even as they mature. As you can see from the numbers on Facebook, Disney and Ford, the benefits of debt have been significantly scaled down.
3. Transactions that derive most of their value from leverage will be handicapped: Since the mid-1980s, leveraged transactions have been favored by many private equity investors. While one reason was that they were equity constrained (and that reason remains), the bigger reason was that it allowed them to generate added value from recapitalization. At the risk of over generalizing, I will argue that for a large segment of private equity investors, this was the primary source of their value added and for these investors, the new tax code is unequivocally bad news, and I will shed no tears for them. 

As I noted at the start of this post, debt is part of the fabric of business in the United States, and there are some businesses and asset classes that have been built on debt. Real estate and infrastructure businesses have historically not only used debt as a primary source of funding but as a value addition, with the added value coming from the tax code. Now that the added value is much lower, it remains to be seen whether asset values will have to adjust.

Conclusion
From financial first principles, there is nothing inherently good or bad about debt. It is a source of financing that you can use to build a business, but by itself, it neither adds nor detracts from the value of the business. It is the addition of tax benefits and bankruptcy costs that makes the use of debt a trade off between its benefits (primarily tax driven) and its costs (from increased distress and agency costs). The new tax code has not removed the tax benefits of debt but it has substantially reduced them, and we should expect to see less debt overall at companies, as a consequence. In my view, that is a positive for the economy, since debt magnifies economic shocks to businesses and not only creates more volatile earnings and value, but deadweight costs for society.

YouTube Video


Datasets

1. Debt Ratios by Sector, US (January 2018)
2. Debt Ratios by Sector, Global (January 2018)

Spreadsheets

1. Capital Structure Optimizing Spreadsheet (with 2017 US Tax Code changes built in) (with YouTube guide to using this spreadsheet)
2. Disney Optimal Capital Structure 
3. Facebook Optimal Capital Structure
4. Ford Optimal Capital Structure

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!

January 2018 Data Update 3: Taxing Questions on Value

If you have read my prior posts on taxes, you already know my views on the US tax code, especially as it relates to corporate taxes. Without mincing words, the US corporate tax code, as it existed in 2017, was an abomination, a carry over from a prior century where the US was the center of the global economy and companies would do anything demanded of them, to preserve their US incorporation. I was therefore predisposed to favoring tax reform and Congress delivered its version towards the end of 2017. While the process was messy and partisan, it represents the most significant change in corporate taxation in the United States in the my lifetime, and as with all tax reform, it is a mix of the good, the bad and the ugly, with your political priors determining which one you believe dominates. No matter what you think about the tax reform package, there is the one thing that is not debatable: it will impact equity value and affect corporate behavior in the coming year. 

The 2017 Tax Reform: Key Changes

The tax reform package that passed Congress is more than a 1000 pages long and it is easy to get lost in the details. While it makes changes in individual, private business and corporate tax law, I will focus this post on the corporate tax law changes. In my view, there are four big changes embedded in this packet that deserve attention:

1. Corporate Tax Rate: The federal corporate tax rate on the income that corporations generate ion the United States has been lowered from 35%, at the federal level, to 21%. This is the portion of the bill that attracted the most media attention, primarily because of the magnitude of the drop, bringing corporate taxes in the United States down to levels not seen in the country since the second world war.
2. Treatment of Foreign Income: The other big change in corporate taxation that attracted less attention but my be just as consequential in the long term is that the US has now joined the rest of the world, replacing its global tax with a regional tax model. Put simply, until 2017, US companies were required to pay the US tax rate on all of their global income, though the differential tax on foreign income does not have to be paid, until repatriated to the US.  Starting in 2018, US companies will have to pay only the foreign taxes due on foreign income and will be free to bring the money back, when they want. There are two ancillary changes that the package makes to foreign income. First, it tries to clean up for past sins by imposing a one-time tax to un-trap cash that companies are holding in foreign locales. As I noted in this earlier post, the trapped cash is a predictable side effect of the global tax model, and not surprisingly, companies with global revenues have built up more than $2 trillion in foreign cash cash balances. The one-time tax rate will be 15.5% on cash invested in liquid assets and 8% on harder-to-sell assets. Second, the tax code also tries to put in disincentives for companies moving intangible assets to tax havens, by imposing a minimum tax rate of 13.1% (rising to 16.4% in 2025)  on excess profits (over and above a 10% cost of capital) earned in foreign subsidiaries. This seems to be specifically directed at technology and pharmaceutical companies that have found ways to create foreign subsidiaries for intangible assets.
3. Limitation on Interest Deductibility: For the first time, the US tax code will put a limit on the deductibility of interest expenses, restricting it to 30% of the "adjusted taxable income" (with taxable income defined as EBITDA through 2022 and EBIT thereafter). To provide a cushion for companies that may have cyclical income, the lost (non-tax deductible) interest expense deductions can be carried forward and used in future years, with no expiration date.
4. Capital Expensing: US companies will be allowed to deduct their investments in tangible assets in the year of the investment, for taxable income calculations, rather than have to depreciate it over time. This provision will remain intact until 2023 and be phased out by 2027.

The two best features of the tax reform package, in my view, are the changes in the taxation of foreign income and in the treatment of debt, and I will trace out the consequences for value in the next section. There are three features of the tax reform that I do not like. First, the package does little to reduce the complexity in the code, and in some cases, adds to that complexity. In particular, I don't like either the capital expensing rule change or the way in which it deals with intangible assets overseas. Second, I don't believe that tax codes are good instruments to do economic engineering and I don't think that the provisions that are in the changed code to encourage companies, especially in old-economy sectors, to reinvest more will make a significant difference. Third, by increasing the divergence in tax rates between individual income, pass-through business income and corporate income (the highest marginal federal tax rates will be 37%, 29.6% and 21% respectively), it is going to encourage tax gaming on the part of those who have a choice.

The Value Change

As I read the many assessments of how the tax reform bill will affect stock prices and values, I am reminded of the old parable of the seven blind men and the elephant, where each one after feeling a different part of the elephant's body gives a very different description of the animal. Analysts seem to be picking either one aspect of the tax code (lower tax rates, debt interest restrictions, foreign income taxation) or one dimension of value (cash flows, risk or growth) to arrive at a conclusion that reflects their political biases. Thus, I have seen supporters of the bill zero in on the drop in the tax rate from 35% to 21%, assume that this will increase after-tax income proportionately and extrapolate to a value increase of more than 20%. At the other end of the bias spectrum, there are pessimists who argue that the loss of the tax benefits from debt, from both lower tax rates and interest deductibility restrictions, will push up the after-tax cost of debt and capital for firms, and lower value. Both analyses are incomplete because they are focused on pieces of the valuation puzzle, rather than the entire valuation. The tax code, after all, affects every dimension of value, as can be seen in the picture below:

To assess the impact of tax reform on overall equity value, we have to move through each dimension of value. In making these assessments, I will focus on non-financial service firms, partly because the tax effects on debt and value are cleaner and more transparent.

1. The Cash Flow Effect: The cash flows that a firm generates on operations are after taxes, but the relevant tax rate is not the statutory tax rate but the effective rate. It is true that the reduction of the statutory tax rate from 35% to 21%, will reduce taxes paid, but the reduction will be from the aggregated effective tax rate that companies paid in 2017, not the marginal rate. Based upon my estimates, in 2017, US non-financial service companies reported $330.8 billion in taxes on taxable income of $1,342.1 billion, translating into an effective tax rate of 25.19%. Since this tax rate includes state and local taxes and taxes on global income, these companies were paying an effective federal tax rate of closer to 23% on all of their taxable income in 2017. With the drop in the US corporate tax rate and the shift to a regional tax model, we would expect this tax rate to drop, but the magnitude of the decline is likely to be far smaller than optimists are assuming. My guess is that the effective tax rate next year will be about 20%, including state and local taxes, after the tax rate changes, resulting in an increase in after-tax operating earnings of approximately 6.67% [(1-.20)/(1-.2519)] in the next year. 
   
2. The Cost of Capital Effect: The cost of capital is a weighted average of the cost of equity and the after-tax cost of debt. In computing the after-tax cost of debt, the tax rate that matters is the marginal tax rate on US income, since even companies that have low effective tax rates, like Apple, have found it in their best interests to borrow money in the US and set off interest expenses against their highest-taxed income. The marginal tax rate for a US company in 2017 was close to 38%, with state and local taxes added to the US federal tax rate of 35%. Moving that tax rate down to 24% (my estimate of the marginal corporate tax rate, with state and local taxes, in 2018) will increase the after-tax cost of debt. In 2017, US non-financial service firms collectively reported a debt to capital ratio, in market value terms, of 23.5% and faced a cost of equity of 7.85% and a pre-tax cost of debt of 3.91%. With a 38% marginal tax rate, that would have resulted in an after-tax cost of debt of 2.42% and a cost of capital of 6.57%. Keeping the pre-tax cost of debt and debt ratio fixed, and reducing the marginal tax rate to 24% will increase the cost of capital to 6.70%. 
   
3. The Growth Effect: The growth effect is the trickiest one to assess, since the value of growth is a function of both how much companies reinvest but also how well they reinvest, measured as the return they earn on investments over and above their cost of capital. We do know that the incentive to reinvest has increased, especially at companies with physical and depreciable assets, because of the capital expensing provision and we also know that excess returns will change, as after-tax earnings and the cost of capital go up. In 2017, non-financial service companies in the US collectively reinvested 59.27% of their after-tax operating income back into their businesses and earned a return of 12.76% on their capital employed; the sustainable growth rate, if those numbers are maintained, is 7.56%. Increasing the return on capital to reflect the growth in after-tax earnings yields 13.65%, and assuming that reinvestment increases marginally to 65% of the after-tax earnings, because of the capital expensing rule change, yields an expected growth rate of 8.87%.
   

With these inputs in place, we can value US companies collectively, pre and post tax reform,  and the effect on firm value is captured in the table below:

Download spreadsheet

In making my estimates, I have assumed that the revenues and Note that this is the estimated increase in firm value, but equity value will rise proportionately, if the debt ratio remains unchanged. Does this mean that stock prices will rise 9.70% over the next year? No, and here is why. This tax reform package has been floating around for almost a year now and investors have had a chance to not only read it but incorporate its effects into prices. While the final package contained some surprises, the final version of the bill preserved the key ingredients that we introduced in April 2017. The strong returns posted by US stocks last year already include some of the value effects of the tax law. Note that this does not mean that the effects of the new tax code have already worked their way into prices since we still do not know how companies or the US economy will respond to the changes. This analysis is static, insofar as it does not allow for the changes in investing, financing and dividend behavior that we will see, as a consequence of the tax change. For instance, firms may decrease how much they borrow, since the tax benefit to debt has decreased, and that will lower debt ratios and change the cost of capital further.

Value Redistribution

While much of the discussion about the tax reform has been about its impact on the overall economy and equity values, the bigger effect of the changes to the code will be redistributive, with some sectors gaining and other losing. To identify the winners and the losers across sectors, we can use the same framework that we used to assess the value change and isolate the value effect on a sector to three variables:

Variable	Effect on Value	Proxy
Effective tax rate	Companies that are currently paying high effective tax rates (>23%) will benefit the most from the tax reform. Companies that are paying low effective tax rates under existing law may pay higher taxes, if their tax deductions /credit have been removed or restricted.	Effective Tax Rate
Reinvestment in fixed assets	Companies that invest large amounts in tangible assets (that are capitalized under existing law) will benefit the most from the capital expensing provision. Companies that invest in R&D or intangible assets, which are already expensed, will benefit less.	Capital Expenditures as % of Sales
Debt Ratio	Companies that have high debt ratios will see bigger increases in costs of capital, and value decreases, as the tax benefits from debt are reduced. Companies with little or no debt will see little change in the cost of capital.	Debt/ (Debt + Equity), in market value terms

Put simply, companies (sectors) that are currently paying high effective tax rates, invest large amounts in tangible (depreciable) assets and have little or no debt will benefit the most from the tax code changes. Companies  (sectors) that are currently paying low effective tax rates, invest little or nothing in tangible (depreciable) assets and have high debt will be hurt the most by the tax code changes. To identify the sectors that will benefit the most or will be hurt the most by the tax reforms, I looked at effective tax rates, capital expenditures/sales and debt ratios across all non-financial service sectors in 2017 and used the market aggregate value as the comparison to identify which side of the divide (higher or lower than the market aggregate) each sector fell. The full list is at the link at the end of this post, but the sectors that delivered the benefit trifecta (high effective tax rate, high cap ex as a percent of sales and low debt ratio) and cost trifecta are listed below:

Download full sector spreadsheet

All the caveats apply, insofar as we are using effective tax rates and capital expenditures for one year (2017) to make the comparisons. There is one sector, real investment trusts (REITs) that showed up the loser trifecta but it's special tax treatment (where its income is not taxed, but passed through) led to its removal from the lists. Again, this should not be taken as an indication that the market will look favorably on the benefited sectors and punish the hurt sectors, since market prices have had time to adjust to the expected tax code changes. In a later post on how the pricing varies across the sectors, we will revisit this question.

Conclusion
It would be hubris to argue that we know what will happen over the next year, as a result of the tax code, but we know what we should be watching out for:

1. Taxable income and tax rates:  Facing a more benign domestic tax environment, will companies be more expansive in their measurement of taxable income?  How much of this income will they pay out in effective taxes? 
2. Capital Expenditures in tangible asset sectors: The capital expensing provision should make investing in depreciable assets more attractive, but will that be sufficient to induce companies to reinvest more? If so, how much?
3. The Untrapping of Cash: How much of the trapped cash will companies bring back home, paying the one-time tax penalty? Will they reinvest this cash or return it (in the form of dividends and buybacks)?
4. The Debt Shift: Will highly levered businesses react to the reduction in tax benefits from debt by retiring debt? What effects will a system-wide delevering have on bond default spreads?

On top of these company-level concerns are questions about how the economy will react to the tax changes, how much of the benefit will be redirected to employees and what effect there will be on interest rates. It is going to be an interesting year!

YouTube Video

Data/Spreadsheet Links

1. Value Effect on Market (Spreadsheet)
2. Sector Proxies (Data on tax rates, cap ex and debt ratios by sector)

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!