Practical analysis for investment professionals
04 April 2017

Corporate Taxes Matter, But Not in the Way You Think

Posted In: Drivers of Value

After the failure to repeal and replace the Patient Protection and Affordable Care Act, Congress and President Donald Trump are turning their attention to tax reform. One of the initiatives that will be discussed in the coming weeks is the significant reduction in corporate tax rates, among other key measures, to stimulate the economy.

The depth of the cuts is still unknown, but it is safe to say that businesses will heed the maxim of Arthur Godfrey, who said, “I am proud to be paying taxes in the United States. The only thing is — I could be just as proud for half the money.

As I have explained before, most political events do not leave a lasting impression on financial markets. Changes in tax rates, however, are exceptions that prove the rule, albeit not in the way most investors expect.

Lower taxes don’t imply higher profits or growth.

The common assumption is that lower tax rates should increase corporate profits, share prices, investment, and consumption, and thus lift the entire economy. Unfortunately, this is not quite how it happens in the real world.

We don’t need Arnold Schwarzenegger to break apart this assumed chain of events. All we need is a guy like me.

Why does the chain break? Because of that first link. There is little evidence that lower corporate tax rates lead to higher corporate profits. The chart below demonstrates that the current secular rise in corporate profits as a share of GDP started only a decade or so after President Ronald Reagan instituted his tax cuts in the 1980s — hat tip to Ben Inker, CFA, and GMO. A statistical analysis confirms this.

There is no correlation and no identifiable causation between corporate tax rates and corporate profits. Neither the level of corporate taxes nor changes in corporate taxes have any effect on corporate profitability. The same holds true for either effective corporate tax rates or the top corporate tax rates.

Consequently, there is also no relationship between lower corporate tax rates and higher economic growth. Tax rates don’t matter much: The United States currently has one of the lowest corporate tax rates in its history, yet economic growth is significantly below historical averages.

Changes in corporate tax rates don’t stimulate the economy either. In the immediate aftermath of the tax hikes in the 1950s, real US economic growth accelerated above 8%. Following the Reagan tax cuts, real economic growth hovered around 4% without receiving much of a boost.

So investors who expect potential tax cuts to spur economic growth better not hold their breath.


Profits as a Share of GDP and the Top Corporate Tax Rate

Profits as a Share of GDP and the Top Corporate Tax Rate

Sources: Internal Revenue Service (IRS), Bureau of Economic Analysis (BEA) National Income and Product Accounts


Good things come in unexpected ways.

That doesn’t mean corporate tax cuts don’t provide a lasting benefit to financial markets and the economy overall. They lift the spirits of business owners and corporate managers. As Godfrey would attest, if we pay only half as much in taxes, we are not only proud to be American but may say so in public.

There is an intriguing correlation between changes in corporate tax rates and the willingness of businesses to invest more and increase capital expenditure (capex) spending. Since the 1960s, the US Federal Reserve Bank of Philadelphia has asked firms on a monthly basis about their expectations for business conditions in the coming six months. And it turns out the expectations for future capex are positively correlated with both the level of corporate taxes as well as changes in taxation. Declining corporate tax rates usually trigger an increase in optimism about future capex. And this optimism in turn usually triggers a healthy dose of action. There is high correlation between capex expectations and actual capex spending six to 12 months later.


Changes in Corporate Tax Rates and Capex

Changes in Corporate Tax Rates and Capex

Sources: Internal Revenue Service (IRS), Federal Reserve Bank of Philadelphia, Datastream


This tide only lifts some boats.

But changes in corporate taxation are not reflected in corporate profitability or economic growth. Rather they are found in increased business optimism and higher capex and profits for firms that benefit from this increased capex. This focused outcome has some implications for equities investors:

  1. If tax changes benefit corporate profits and economic growth, the whole stock market, as well as stock market valuations, should elevate — perhaps permanently — to a higher level. But there is little evidence that tax reductions are a tide that lifts all boats.
  2. If tax changes lead to higher capex, the effects on the overall equities markets cannot be predicted. But the industrial and tech sectors, particularly hardware and equipment producers, should receive a boost. Other potential beneficiaries? Banks that finance corporate investments and capex. Still, these gains are likely temporary and won’t lead to a permanent increase in equity valuations. Lower corporate tax rates can invigorate stocks for one to two years at best, but after that, additional capex growth is needed to sustain the boost.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/retrorocket

About the Author(s)
Joachim Klement, CFA

Joachim Klement, CFA, is Head of Investment Research at Fidante Capital and a trustee of the CFA Institute Research Foundation. Previously, he was CIO at Wellershoff & Partners Ltd., and before that, head of the UBS Wealth Management Strategic Research team and head of equity strategy for UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich, Switzerland and Madrid, Spain, and graduated with a master’s degree in mathematics. In addition, he holds a master’s degree in economics and finance.

15 thoughts on “Corporate Taxes Matter, But Not in the Way You Think”

  1. R. Barry Ellis says:

    The first link is to investment, not profits.

  2. MICHAEL HUSSEY says:

    “profits as a share of GDP” is not the same as “corporate profits”. one is a ratio — the other is an absolute dollar figure. your argument that “there is no correlation and no identifiable causation between corporate tax rates and corporate profits” may be correct but it isn’t supported by the evidence you presented.

    1. Joachim Klement says:

      Thanks for your comment. I agree that one can also look at corporate profits directly instead of profits as a share of GDP. I redid the calculations and still can’t find any correlationor causation of corporate tax rates with corporate profits. I looked at corporate profit growth instead of corporate profits directly, since corporate tax rates are somewhat stationary and need to be compared with a stationary variable in order to avoid drawing th wrong conclusions. Corporate profits have a trend component so in order to fettend it one can look at corporate profits as share of GDP or simple annual growth rates. In both cases there is no correlation or causation.

  3. Mr. Klement’s article fails to mention that lower corporate tax rates also mean a lower cost of capital. Based on simple economics, I find it utterly improbable that a lower cost of equity capital does not correlate with higher economic growth (which does not NECESSARILY mean higher profits). But a lower corporate tax rate, plus taking a meat ax to all of the growth-stifling policies that Emperor Obama put in place through executive orders, should certainly increase economic activity and draw back into the job-seeking market some of the 95.1 million people (as of December 2016) who are not counted as being unemployed because they have quit looking for work.

    This is another reason that news outlets should report unemployment using the U-6 measure [which includes those who’ve given up] and the current U-3 measure [which makes the political class’s policies look a lot better than they actually are]. As of February 2017, the U-3 rate was 4.7% vs. the U-6 rate of 9.2%.

    It’s worth noting that Mr. Klement’s chart about the relationship between lower rates, expected CapEx, and actual CapEx omits the effect on CapEx of the significant rate cuts in the early years (1981, 1982, and 1983) of the Reagan Administration. Annual GDP growth per working-age adult rose from 1.15% under Jimmy Carter to 1.8% under Mr. Reagan. Therefore, the author’s assertion that lower taxes don’t increase economic growth looks questionable. . .unless the number of working-age adults fell under Reagan, which it didn’t.

    One thing is sure: Mr. Klement’s assertion and three bucks will get him a latte @ Starbucks. In the meantime, I’d like to see him back up what he said. . .if he can.

    1. Joachim Klement says:

      First of all let me state that I try to make an argument using data and analysis in a non-partisan way.

      I am not making any political statements and will not comment on current political events or the policies of current or former administrations.

      As for the relationship between corporate tax rates and economic growth I have linked to an analysis by the economic policy institute in my article (http://www.epi.org/publication/ib364-corporate-tax-rates-and-economic-growth/) that deals with this issue directly. No need to add something there.

      As for the assertion that the interest rate cuts in the early Reagan years created additional growth this is true, but these were monetary policy measures not fiscal policy measures. What I am interested in thus article is the isolated effect of fiscal policy measures. That monetary policy measures can stimulate investments and growth is a well-established fact that does not need to be discussed.

      1. Chuck t says:

        “Non-partisan”. Its really hard to self diagnose bias. I will take your word for it but we are living in a highly charged political environment.

      2. John Dewey says:

        Just because the Economic Policy Institute claims to be nonpartisan does not mean that it actually is nonpartisan. That organization’s board of directors is dominated by labor union executives and liberal academics. It is almost certain that any analysis of the impact of corporate taxes will support liberal views.

        1. Hear, hear, John. You’re dead-right.

          The only outfit in D.C. that has as big a megaphone as the Economic Policy Institute AND is as consistently loony-Left is John Podesta’s Center for American Progress.

          You remember Podesta: He’s the single-digit I.Q. genius who thought that ‘password’ was a great password for his email account. And then he wondered why it got hacked. . . .

    2. Shane says:

      You forget that while a decrease in tax rates is expected to decrease the cost of debit by an ever so slightly factor of x 1 – change in MARGINAL tax rate, decreasing tax revenues in the face of major deficits will in fact increase the real risk-free rate underlying both debt and equity.

  4. John Dewey says:

    “The United States currently has one of the lowest corporate tax rates in its history”

    Is that fact really that meaningful? As I understand it, the U.S. marginal corporate tax rate is the third highest out of 188 nations. The average of those 188 nations is 22.5%, much lower than the U.S. rate of 38.9%.

    When multinational firms make decisions about where to operate, the U.S. tax disadvantage of 16% certainly must be a factor. As I see it, the relative expense of U.S. taxes vs the world should be important. The very slight difference between current U.S. tax rates and historical tax rates – not so much.

    1. John Dewey says:

      One more important point: U.S. corporations do not use their current realized tax rate when making capital spending decisions. Rather, they use their firm’s expected long term marginal tax rate. Of course, any special tax avoidance features of an individual project proposal are considered.

    2. Shane says:

      Marginal tax rate is not the rate actually being paid. The average corporate tax rate in 2013 was just under 13%.

      1. John Dewey says:

        Shane,

        As I pointed out, the long term marginal tax rate is generally used for evaluating capital expenditure proposals or evaluate U.S. vs overseas operations. That’s the tax which the firm should expect to pay on additional profit realized over the long term. A high marginal tax rate will inhibit economic growth.

      2. John Dewey says:

        Shane,

        I do not believe the average corporate tax rate for all U.S. corporations is that low today. I think that number you are showing is the average for large corporations a couple of years after a severe recession. Here’s why it is not as meaningful as you apparently believe it is:

        1. Many large corporations have significant profits from overseas operations. If those profits are not repatriated, then no U.S. taxes are owed on those profits. Further, the taxes owed when overseas profits are repatriated are reduced by the amount of taxes paid to foreign governments.

        2. Any large corporations which had losses during the severe recession would be able to use tax-loss carryforwards in subsequent years. Those are temporary shields to corporate taxation which likely have little bearing on current taxes.

        3. Average effective tax rates are meaningless to the individual firm. As many as 20% of Fortune 500 firms may pay zero taxes in some years. But many others will pay much higher rates than the average rate.

        4. As I’ve pointed out in both the note you responded to, and in a subsequent note, it is the expected marginal tax rate which firms must use in deciding whether to invest further in the U.S.

  5. Brian Davidson says:

    Interesting, thanks for the article. I think the economy is to dynamic to be able to separate out all the cause and effects. In the eighties the tech sector was less than 10% of the economy. You eluded to profits didn’t take off until a decade later, that’s when the big gains in efficiencies from the tech revolution kicked in. I think it’s safe to say a dollar less paid in taxes is a dollar more in profit. From a stock valuation approach these are leveraged dollars of sorts, companies didn’t have to invest capital to get the return.

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