Cut that Rate ASAP

by Albert Meyer

Last month, we wrote about the negative impact of taxes on the market capitalization of corporations. The most recent edition of Barron’s addresses Donald Trump’s proposal to cut the corporate tax rate to 15%, and advocates limiting the rate cut to 22% and not 15%. At 22%, Barron’s maintain, the Treasury does not lose revenues. We propose that Trump sticks to the 15% goal. To address the revenue deficiency, cut the size of government and the myriad of agencies/departments.

If the corporate tax rate declines to 15%, all things being equal, corporations could report a more than 30% increase in earnings growth in 2017. The currently over-valued market will morph into a value play unless investors act quickly and re-price stock prices.

In addition, don’t expect the financial journalists and market commentators to fully grasp the nuances of a change in the tax rate on the “Deferred Tax Liabilities” line item in the balance sheet. Currently, companies provide for future tax liabilities at a rate of 35%. A future tax payment (described in accounting terminology as a deferred payment/liability) of, say, $245 million would have been calculated at a 35% tax rate ($700 million in future taxable income times 35% = $245 million). If the tax rate changes to 15%, the $245 million deferred tax liability would have to be restated at 15%, i.e., to $105 million ($700 million times 15%). This will result in an additional $140 million credit adjustment in the income statement, effectively boosting earnings by $140 million.

A material reduction in the corporate tax rate will provide a massive boost to corporate earnings and consequently stock prices.

Trump also wants to give corporations an incentive to repatriate approximately $2 trillion of foreign profits, currently held abroad, but subject to a 35% tax on repatriation. If corporations are allowed to repatriate these funds with little or no tax consequences, not only will this favorably impact stock prices, but for the economy, the impact would be profound.

If Trump succeeds in pushing through a cut in the corporate tax rate, the near- to medium-term future for investors in US stocks looks promising.



The Destruction of Wealth: The True Cost of Corporate Taxation

by Albert Meyer

Currently, the total market capitalization of the S&P 500 is approximately $10.6 trillion. Assume the index trades at a price-to-earnings ratio (P/E) of 20. Bear market pundits believe that the P/E on the S&P 500 is about 25, while the bulls use P/E’s as low as 16 to justify their bullishness. Earnings estimates come in various shapes and sizes as each constituency seeks to modify reported earnings as calculated and reported under generally accepted accounting practice (GAAP). A P/E of 20 is an acceptable compromise.

If we stick to our 20 P/E multiple then these 500 companies that make up the S&P 500 index currently generate earnings of approximately $530 billion ($10,600/20). The government collected $352 billion in corporate taxes in fiscal 2015. If we assume that about $212 billion pertains to the S&P 500 companies, this would equate to an effective tax rate of 28.5%. The statutory rate for corporations is 35%. If the government were to cut their tax burden in half it would add $2.120 trillion to the combined market cap of the 500 largest companies in the US, i.e., increase their market value by +20%. Libertarians would argue that the corporate tax rate should be zero (miracles take a little longer), in which case we could add approximately another $4.240 trillion to the market capitalization of these 500 companies.

How does this work on an individual level? Look at Charles Schwab, a company that generates all its revenues here in the US. The company earned $1.16 per share over the past 12 months. At the current stock price of $31.97, the company’s stock trades at a P/E of 27.5. It has a market capitalization of $42.3 billion. Schwab’s Federal taxes in 2015 amounted to $734 million, which equates to an effective tax rate of 32.2%, or 92% of the statutory rate of 35%. (The company also paid 2.6% of pre-tax income in State taxes.) If we assume a corporate tax rate of, say, 15%, all things being equal, Schwab’s effective tax rate would be 13.8%, and its Federal taxes would amount to $314.5 million, which would add $419.5 million to its bottom line. If we multiply $419.5 million by a P/E of 27.5 it comes to $8.390 billion. If we add this to the company’s current market capitalization, we get $50.690 billion, or a +19.8% increase in the company’s market value. This is more or less in line with our analysis above on the S&P 500 as a whole.

Corporate taxation destroys wealth. As most Americans have some exposure to equities, we are robbing ourselves when we tax these engines of wealth, jobs, innovation and progress. Don’t expect anyone in Congress to follow this logic.