Corporate Tax

Who pays for a US corporate tax enhance?

Joe Biden intends to raise taxes on corporate profits and is likely to succeed. It may not fully hit the rate from 21 percent to a planned 28 percent, but some increase is likely.

Who bears the higher tax burden: company, employees or shareholders?

Higher corporate taxes mean lower earnings per share. Naively, all other things being equal, this would mean stocks should be worth less. The value of a share is the present value of its future cash flows. If the discount rate on future profits stays the same and taxes decrease, the price should decrease. So the shareholders pay.

However, the U.S. stock market has only risen since Biden became the front runner, won the election, and finalized his tax plan (which was clearly outlined all along).

Not everything else is the same. Perhaps the exuberance at the end of the pandemic outweighed the opposition in the tax news. But the point can be generalized. The corporate tax rate fluctuated widely from near zero before 1917 to teenagers by World War II to nearly 50 percent in the middle of the century, and then to 30 to 40 percent from the 1980s until Trump lowered it to The Long-Term Data on Earnings, Earnings Growth, and However, ratings do not show incremental changes that come with changes in rate. The market doesn’t care.

The economist Paul Krugman used to believe that the tax came from business investments. That view makes sense. The market sets the global return that investors expect. That is the hurdle that business investment must overcome. Higher taxes reduce the company’s return on investment, so fewer potential investments cross the hurdle. So there is less investment and less economic growth.

Because of this, as Krugman recently wrote, the corporate rate cut was the part of Trump’s 2017 tax cut that he disliked. Now he thinks he was wrong because corporate investment has not changed in relation to gross domestic product.

Why not? First, he says, most business investments are funded by debt, which is tax deductible anyway. Next, most business investments in software and equipment only take a few years, so the cost of capital is less important (just as a mortgage rate is more important to a person than what they pay on a car loan). After all, companies like Apple, Amazon and Google are quasi-monopolies with enormous market power. Monopoly profits are free money, not a return on investment, so they ignore taxes.

Andrew Smithers – venerable city economist and occasional contributor to the Financial Times – disagrees. On the issues of debt and investment lifespan, he referred to data from the Bureau of Economic Analysis and the Fed that the average lifespan of corporate assets is 16 years and net debt is only 30 percent of corporate capital employed. In the case of the monopolies, the profit share of production has not increased in recent years and is close to the historical average, which is inconsistent with claims of growing monopoly power.

But Smithers’ refutation is as logical as it is factual. Corporate income tax needs to be removed from the private sector’s ability to consume or invest. If it comes from consumption, there are three groups it could hit: shareholders, debtors, or corporate employees. We know that regardless of the corporate tax rate, shareholder return on shares has been constant over time, so shareholders don’t pay. We know that when taxes go up, lenders don’t charge less interest so debtors don’t pay. And Smithers argues that wages relative to corporate output have remained stable over time and are on average reversing regardless of the corporate tax rate. So employees don’t pay. Private investment is all that’s left for taxes.

Smithers believes that the reason investments stopped rising after the tax cut was because of skewed incentives for executives. In a “bonus culture”, executives would rather buy back shares to increase earnings per share and their share price than invest in long-term growth.

I’ll have better economists than me named the winner here. But my experience with a mutual fund makes me lean a lot the Smithers’ way. What we were looking for were companies that increased free cash flow, which is profits after investments and taxes that could be returned to shareholders. Companies know this is what investors want and promise to make it happen. When taxes go up, something has to be cut to give investors what they want. Long term investing is a natural place to look.

robert.armstrong@ft.com

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