Download Will corporate tax reform lift business investment?

Will corporate tax reform lift business investment?
> Business investment growth needs to increase in the
US to lift productivity growth and living standards.
> Corporate tax reform is a key priority for the new US
Trump administration, which could provide a boost to
business investment.
> Theoretically, lower corporate tax rates increase
disposable income, encouraging business investment.
But, empirical evidence on this impact is still mixed
because it is hard to distinguish the influence of
corporate tax reform on the economy.
> There are numerous proposed changes to the corporate
tax system by President Trump & the Republican Party.
A cut to the Federal corporate tax rate (from 35% to
20%) is the most likely of these in 2017.
> Investors are expecting better growth & higher inflation
in the US because of expected changes to corporate
taxation, individual tax cuts and infrastructure spending.
Any suggestion that corporate tax reform would not go
through would be a negative for equities & US growth
forecasts.
> Trump’s focus on improving production and income for
US-domiciled companies means that investors would
benefit from being overweight to corporates with
sizeable US earnings or above-average tax rates. The
banks, consumer staples and consumer discretionary
sectors currently pay above-average tax and stand to
benefit the most from a cut to the headline tax rate.
Introduction
The slump in global business investment growth over recent
years has been particularly evident in advanced economies.
3.8
% of GDP
% of GDP
3.3
Business
Investment (rhs)
Non-Defence
Government
Investment (lhs)
03
05
07
09
In the absence of improving business capex, there have been
calls for corporate tax reform, with the argument now
particularly prominent in the US. Theoretically, a cut to the
corporate tax rate increases disposable income and therefore
purchasing power. What is the empirical evidence around the
impact of corporate tax reform? Does it indeed lift business
investment?
Corporate taxes and business investment
We collated the statistics around OECD corporate tax rates and
levels of business investment in 2015 (see chart below):
20
18
11
13
Global corporate tax rates & business investment
(2015)
Ireland
Switzerland
16
Japan
Sweden
Australia
14
Netherlands Canada
12
US
France
Germany
NZ
Italy
10
UK
15%
20%
25%
30%
35%
Total Corporate Tax Rate (%)
40%
45%
Source: Reuters, AMP Capital
13
9
01
An improving growth backdrop should provide a favourable
environment for stronger business investment growth, but
concrete signs of higher business spending are still mixed.
Perhaps businesses are still waiting for even better growth
outcomes before committing to large capex programs.
15
11
2.3
99
The need to lift business investment is around the requirement
to replenish the capital stock as it becomes depleted, to
improve growth in productivity and living standards.
8
10%
US Investment
2.8
recently fallen to its lowest level since 2012. Non-defence
government investment is also running around record low levels
(see chart above).
Business Investment (% of GDP)
Key points
February 2017
15
Source: Reuters, AMP Capital
In the US, business investment growth has been poor over the
past two years. Over the long-term, business investment (as a
share of GDP) is still tracking at moderate-high levels, but has
At face value, there does appear to be some negative
relationship between the corporate tax rate & business
investment. Therefore, counties (like Ireland and Switzerland)
that have low corporate tax rates have high levels of business
investment. And countries with a high corporate tax rate (US
and France) have lower levels of business investment.
Empirical studies around the impacts of tax rate changes are
limited because of the difficulty in isolating tax reform from
broader economic events. For example, good economic
outcomes may lead the government to cut the tax rate because
of a better revenue position. At the same time, a recession
could prompt a cut to the tax rate to spur spending.
A 2016 Federal Reserve Board paper analysed the impact of
state tax changes in the US between 1970-2010 and found that
tax increases hurt employment and income but tax decreases
have little effect generally on employment and income, expect
for times during a recession.
A recent argument against a corporate tax cut is that the
additional earnings will be distributed through dividends, as
shareholders have become accustomed to higher dividend
payouts over recent years.
A large increase in government debt (which is already elevated)
could lead to higher interest rates and therefore a tightening in
financial conditions, which would be detrimental to private
investment.
What else is needed to lift business investment?
The US tax system
The latest OECD corporate tax data indicated that total US
profits are taxed at 39.9% at the headline level, which includes
both federal (35%) and state & local taxes. Average OECD
taxes are lower, at 24.7%, in 2016. In reality, the effective rate
of tax paid by companies tends to be lower because of
business write-offs and allowances, with estimates suggesting
an effective tax rate of 25% for the S&P500.
The uptick in global manufacturing PMI’s is a positive sign of an
improving outlook for business investment and it appears that the
worst is now behind us for the capex cycle. Corporate tax reform
is one tool to lift long-term business investment. But, there are
also other factors which may be required for better business
investment:

Better corporate earnings. Earnings growth and earnings
expectations are lifting, at least in the US and in Australia
which is a positive sign that the nominal income
recession is over. Rising inflation tends to be a good sign
for corporate earnings

Lower business hurdle rates which haven’t dropped by
as much as expected, given how low interest rates are

Better confidence about the economy, with businesses
normally citing better consumer spending as a sign of
better future growth prospects
Corporate tax reform is a key “to do” item on the agenda for US
President Trump and for the Republican Party. The key items
that have been discussed include:


A cut to the Federal corporate tax rate (currently at
35%). The initial Republican Party proposal suggested
a 20% tax rate and Trump is now suggesting a tax rate
“between 15% to 20%”. Currently, it appears that this
policy has the best chance to be pass in Congress
Introduce immediate write-off of capital investments,
rather than capitalising and depreciating these
investments over time

A change in net interest expense deductibility to
equalise treatment of debt and equity financing

Cut the taxation of US offshore earnings brought back
onshore and introducing a one-time transition tax of
“up to 10%” on these repatriated funds, payable over a
number of years

A border tax adjustment which is an additional tax on
importers and (ultimately) a tax rebate to exporters to
encourage domestic production

Lower regulation, but the actual details on this are less
clear with Trump saying he would get rid of “75% of
regulation”
A number of these policies could push up the value of the US
dollar as investors price in higher expectations for inflation and
US exports which would offset some of the positive impacts to
exports. Impacts of the border tax adjustment are suggesting
that the US dollar could appreciate by around 25%, if the
corporate tax rate is cut to 20%.
The other key issue is around how much debt will lift on the
back of these taxation changes. The US Tax Policy Center
have estimated that the corporate tax policy changes would
decrease government receipts by ~$890bn over the next
decade which equates to around 0.3% of GDP per year. This
doesn’t include any potential changes to personal income taxes
and infrastructure spending, which are also key priorities for the
new US administration.
Another point to keep in mind is that business investment in the
advanced economies may be stuck in a structurally lower level for
a while because of the increased significance of the service
sectors. Service sectors tend to require less investment,
compared to the traditional industrial sectors of an economy.
Implications for investors
Markets have priced in an expectation that US corporate tax
reform will be positive for US growth and will lift inflation. While
the evidence on the actual short-medium term impact of
corporate tax cuts is still mixed, any backing away from this will
be detrimental to equity markets and growth expectations.
Trump’s focus on improving production and income for
US-domiciled companies means that investors would benefit
from being overweight to corporates with sizeable US earnings
or above-average effective tax rates. Investors could also
maintain exposure to sectors that benefit the most from a
corporate tax cut (see chart below). Banks, consumer staples,
consumer discretionary and telecommunications companies
currently incur above-average tax rates and could therefore
benefit the most from a lower tax rate (see chart below).
US Government Debt
4
% of GDP
% of GDP
120
2
105
0
90
-2
75
-4
60
-6
-8
-10
45
Total Federal
Public Debt
(rhs)
Federal Budget
Balance
(lhs)
-12
30
15
0
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16
It is also important to keep a close eye on the US dollar. A
significant appreciation in the US dollar, because of
expectations for higher growth, inflation and interest rates,
could put a halt on a rebound in earnings and growth for
exporters.
Diana Mousina
Economist
AMP Capital
Source: Reuters, FRED economic data, AMP Capital
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