Top stocks to invest in – Corporate Taxes Matter, But Not in the Way You Think

Top stocks to invest in


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


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


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

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