The 6/25 WSJ included an article titled “The $1.5 Trillion Business Tax Change Flying Under the Radar.”
It noted: “Republicans looking to rewrite the U.S. tax code are taking aim at one of the foundations of modern finance—the deduction that companies get for interest they pay on debt. … Thanks in part to the deduction, the U.S. financial system is heavily oriented toward debt, which because of the tax code is often cheaper than equity financing—such as sales of stock. … Getting rid of the deduction for net interest expense, as House Republicans propose, would alter finance. It also would generate about $1.5 trillion in revenue for the government over a decade, according to the Tax Foundation, a conservative-leaning think tank.”
Eliminating the deductibility of interest expense would be paired with the immediate deductions for capital spending. Dividend payments are not deductible as an expense, but they are subject to personal income taxation. This amounts to the double taxation of dividends.
With the subsidization of borrowing, the tax code clearly favors debt over equity financing by corporations. It also favors borrowing money by corporations to buy back their equites, particularly if their after-tax cost of funding is less than their forward earnings yield. Joe and I figure that’s been the case since late 2004, when S&P 500 buybacks took off (Fig. 1). The S&P 500 forward earnings yield has exceeded the pre-tax AA-AAA corporate bond yield since then. The former is currently 5.7%, while the latter is 4.0%.
Almost since the start of the current bull market, we have argued that from a flow-of-funds perspective, it has been driven by corporate cash used to buy back shares and pay out dividends, which often are reinvested in stocks. The correlation between the S&P 500 and the sum of the two corporate cash flows back into the stock market has been very high since 2004 (Fig. 2). Eliminating interest expensing could pose a threat to debt-financed buybacks as a driver of the bull market. However, that hasn’t happened yet, and it might not happen at all. We are monitoring developments in Washington’s sausage factory as best we can.
As Joe reports below, Q1 data for S&P 500 buybacks were released late last week. Here are some top-line observations on this and other corporate finance matters:
(1) Buybacks & dividends. Over the past four quarters through Q1, buybacks totaled $508.1 billion, down 13.8% from the record high of $589.4 billion through Q1-2016 (Fig. 3). Dividends totaled a record $400.0 billion through Q1. S&P 500 operating earnings totaled $958.1 billion over the past four quarters. So buybacks and dividends accounted for 94.8% of this total. The dividend payout ratio of the S&P 500 remains around 50.0% (Fig. 4). The implication is that corporations are spending all their extra cash on buybacks rather than capital spending and wages.
The problem with this widely circulated myth is that profits are not the same as cash flow, which is the sum of after-tax profits and depreciation expense. Capital spending by nonfinancial corporations (NFCs) has been hovering at a record high over the past year because corporate cash flow has been doing the same (Fig. 5). In other words, there has been enough cash for buybacks, dividends, and capital spending!
The effective corporate tax rate for the S&P 500 was 26.4% during 2016 (Fig. 6). S&P 500 companies had pre-tax interest expense of $22.90 per share during 2016 (Fig. 7). This implies that the after-tax interest expense was $16.85 per share during 2016. Their after-tax reported earnings was $101.06 per share, with the expensing of interest benefitting S&P 500 corporations $6.05 last year.
(2) Debt. The Fed’s Financial Accounts of the United States shows that NFCs had a record $8.6 trillion in debt at the end of Q1-2017 (Fig. 8). That included $2.7 trillion in loans and a record total of $5.2 trillion in bonds (Fig. 9). Data available annually show that NFCs had monetary interest expense of $487 billion during 2015, implying that the pre-tax interest rate paid on all their debts was 6.1%, the lowest since 1966 (Fig. 10 and Fig. 11).
(3) Bond issuance. Monthly data compiled by the Fed show that NFCs borrowed at a near-record $855.7 billion during the 12 months through April (Fig. 12). However, quarterly data through Q1 show net issuance of $244.6 billion. We calculate that NFCs refinanced a record $599.5 billion in their bonds over the past four quarters at record-low interest rates (Fig. 13). The resulting reduction in interest expense certainly boosted earnings over this period.
(4) Dividend yield. The dividend yield of the S&P 500 was 1.96% during Q1 (Fig. 14). It has been hovering around 2% since the mid-1990s. This means that the S&P 500 has been growing at the same trend as dividends, which is around 7.0% per year (Fig. 15). Interestingly, the dividend yield has been about the same as the US Treasury 10-year bond yield in recent years for the first time since the late 1950s. In between, the bond yield has always been higher. The higher yield reflected a premium for inflation, which erodes bond coupons but not dividends. That’s because dividends tend to grow along with nominal GDP, while coupons are fixed. Apparently today, investors believe that inflation is dead, so they don’t need an inflation premium in the bond yield relative to the dividend yield. With both yielding around 2.00%, stocks are cheap relative to bonds, since dividends grow while coupons remain fixed.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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