US Taxes I: Too Stimulative? In the past, Congress often has cut taxes to revive economic growth following a recession. Last year’s tax cut came long after the last recession and despite clear signs that the US economy is strong.
This potentially raises the risk of a typical boom-bust scenario. If so, then it’s quite possible that the economy will heat up, with real GDP closer to 3% than 2% and inflation moving higher. Debbie and I won’t be surprised to see higher growth, but we still believe that global competition, technological innovations, and aging demographics will keep a lid on inflation. If so, then productivity could make a long-awaited comeback.
For the stock market, this scenario provides more support for our meltup-meltdown scenario. Joe and I continue to assign subjective probabilities of 55% that stocks will melt up, 20% that stocks will march higher at a moderate pace in line with earnings, and 25% that stocks will melt down. Notably, these are not independent scenarios, since the latter one depends on whether the first scenario unfolds.
The tax cuts enacted at the end of last year are likely to push stocks higher as investors anticipate that corporate earnings will be significantly boosted as a result. Joe and I are forecasting that the Trump administration’s tax cuts and deregulatory actions will boost S&P 500 earnings this year by $6 per share to $147, up 11.8% from last year. Also driving stock prices higher should be significant repatriation of foreign earnings, boosting share buybacks and dividends.
So what could go wrong? Bond yields could jump as the Fed continues to normalize monetary policy, possibly faster than widely expected. Now let’s turn to how the tax cuts might affect earnings and buybacks.
US Taxes II: Deferred Tax Assets & Earnings. Tech companies took big earnings hits after the tech bubble burst in 2000. Financial services companies took huge hits during 2008. But on the plus side, many firms in both sectors converted their losses into “deferred tax assets,” using the accumulated losses to reduce their reported earnings when they turned profitable again. The bad news is that now those assets are worth much less after Congress lowered the statutory corporate tax rate from 35% to 21%. The good news is that affected companies will take one-time charge-offs and enjoy a lower corporate tax rate.
During the late 1980s and through the 1990s, the NIPA data (i.e., the National Income and Product Accounts data that the Bureau of Economic Analysis uses to calculate GDP) showed that the global effective tax rate (G-ETR)—which includes taxes paid to the IRS as well as other domestic and foreign taxing authorities—was quite close to the IRS statutory tax rate (IRS-STR) (Fig. 11). During 1999, the G-ETR was 34.1%, about the same as the 35.0% IRS-STR. The tech wreck caused the effective rate to plunge to around 25% during 2002-2007. Then the financial crisis of 2008 pushed the effective rate down to around 20% from 2008-2017.
Previously, Melissa and I have observed that the NIPA corporate profits and taxes paid data include the profits earned and taxes paid by the Federal Reserve. Both rose sharply as a result of the “profits” earned by the Fed on its mounting QE assets (Fig. 12). Removing the Fed from the numerator and denominator of the G-ETR calculation doesn’t change the basic story other than to show an even lower global effective tax rate (Fig. 13).
Now corporations will have fewer deferred losses but also a lower IRS-STR. Melissa and I aren’t sure how this will all add up for S&P 500 operating earnings. Presumably, pre-Trump reported earnings and taxes were held down by the deferred tax losses. We can’t quantify it for the S&P 500, but we suspect that deferred losses were excluded from operating earnings, which are often referred to as “EBBS,” i.e., “earnings before bad stuff.” The hits to deferred tax assets most likely will be treated as one-time charges this year, which means that they won’t depress operating earnings.
In the short term, this implies a wash for the tax impact on operating earnings. Instead of paying a 20% G-ETR, with the help of deferred losses, they’ll be paying a 21% statutory rate on US income. So why are Joe and I adding $6 per share to S&P 500 earnings this year? Chalk it up to “animal spirits” as Trump’s pro-business policies boost earnings growth. Besides, lots of companies and industries don’t have enough in deferred assets to rack up significant tax savings.
US Taxes III: Overseas Cash Stash & the Meltup. On Friday 12/29, the IRS and Treasury issued new regulations on the taxation of foreign profits. Bloomberg reported: “The tax-overhaul bill signed last week by President Donald Trump requires companies to pay taxes on those earnings at two discounted rates—15.5 percent on income held as cash and cash equivalents and 8 percent for illiquid assets. Those rates apply to an estimated $3.1 trillion in earnings stockpiled overseas since 1986.” Previously, repatriated earnings were taxed at 35%, though companies were allowed to defer paying taxes on foreign earnings until they were brought back to the US.
The Fed’s Financial Accounts of the United States includes a series for “foreign earnings retained abroad” by nonfinancial corporations (NFCs) (Fig. 14). It is shown as an annualized quarterly flow. The level is not available. It isn’t insignificant, but it is a relatively small percentage of NFCs’ pretax profits (Fig. 15). However, on a cumulative basis, it totals $3.5 trillion since 1986 (Fig. 16). The Bloomberg article mentions “an estimated $3.1 trillion in earnings stockpiled overseas since 1986.” If much of that gets repatriated, the result could be a meltup in the stock market and a boom in the US, followed by a meltdown in stocks and possibly a bust for the economy.
US Taxes IV: More Taxing Math. Melissa and I continue to tinker with the macro corporate tax data for clues to the likely impact of the tax cut on corporate taxes. The conclusion we keep coming up with is that it isn’t all that significant, running around 20% since 2000. Above, we discussed the “wash effect” on operating earnings between the tax rates with and without deferred tax assets. Now let’s look at how much taxes paid overseas amounts to. The surprise is that it’s not much, which is consistent with the Fed’s data showing that NFCs’ profits retained abroad have accounted for about 20% of total profits since 2000. Consider the following:
(1) At the end of last year, we sought to compare the NIPA data on taxes paid by corporations to the IRS data. The former is global, including taxes paid to the IRS as well as other domestic and foreign entities. Subtracting the “taxes” paid by the Fed and taxes paid to state and local governments should yield a series reflecting corporate taxes paid to the IRS and foreign taxing authorities (Fig. 17).
(2) Now let’s subtract from this derived series the amount of corporate taxes paid to the IRS. The result is a surprisingly small number for what should be taxes collected overseas from US corporations (Fig. 18). Over the past four quarters through Q3, the residual was $50 billion ($347 billion minus $297 billion), presumably collected by foreign taxing authorities.
This implies either that US corporations collectively aren’t doing as much business overseas as they are domestically or that they are paying very low tax rates overseas, or both. Whichever the case, the fact remains that the US corporate tax rate now is more important in determining their after-tax profits.
(3) Accounting for corporate taxes at the macro level gets even messier when we consider that the profits of S corporations are included in NIPA pretax profits, but their profits get taxed by the IRS as individuals when the owners pay themselves dividends. We do have data on dividends paid by S corporations. However, these data can’t be used as a proxy for their profits since there are plenty of money-losing S corporations that aren’t paying dividends. So we probably have hit a dead end regarding a macro analysis of the effective corporate tax rate. We may have gone as far as we can trying to analyze corporate taxes at the macro level.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
© 2022 Newsmax Finance. All rights reserved.