If there was one thing investors seemed to agree on after Donald Trump’s presidential election win, it was that lower corporate taxes would be good for stocks.
Shortly after the election, work out of Goldman Sachs showed that for each 1% the corporate tax rate was cut, S&P 500 earnings would grow by $1.50 per share.
And as stocks rallied to new highs after the election, Wall Street seemed to view Trump’s desire for lower corporate taxes and increased infrastructure spending as initiatives that would bolster corporate bottom lines and accelerate overall economic growth.
But a new analysis from Ben Inker, head of GMO’s asset allocation team, casts doubt on the idea that a tax cut would hit markets quickly, or that the impacts would be anything more than a quick sugar high.
“It is possible that [corporate tax cuts will be positive for the stock market], but it is neither theoretically clear that it should be nor empirically obvious that tax rate changes have been particularly important to profitability,” Inker writes.
Inker cites the following chart, which shows the relationship between US corporate profits and the statutory federal corporate tax rate. The correlation is, well, there’s not much to see.
“While tax rates are currently at about their lowest levels and corporate profits just off of their highest, tax rates did their falling in the 1980s and the profit spike was a good 20 years later,” Inker writes.
“Given that lag, it strains credibility to argue that the tax rate fall was an important driver of the rising profitability. What you would want to see is a relationship such that when tax rates fall over a period, profits rise. This does not seem to have been the case, as the correlation between tax rate change and profit change as a percent of GDP is positive over 3-, 5-, 7-, and 10-year periods. This means that tax rate falls have generally been associated with falling, not rising, profits.” (Emphasis added.)
Additionally, as Inker’s chart shows, the profit cycle looks largely in-step with business and commodity cycles and somewhat indifferent to the prevailing tax regime.
Trump proposed a corporate tax rate of 15% during the campaign, and the House Republican proposal targeted a 20% rate. Amid the flurry of news headlines we’ve seen since Trump’s inauguration, movement on tax policy has been sparse.
So far, we’ve seen Trump call the “border tax adjustment” proposed by the House Republican plan “too complicated.” While Kevin Brady (R-TX), who chairs the House Ways and Means Committee, told The Financial Times, “Our goal is to leapfrog America back into the lead pack” as one of the world’s most attractive countries for investment.
But Inker’s analysis casts doubt on whether tax cuts would really do much of anything at all to corporate profits, which is what underwrote the stock market’s positive view on lower taxes.
In a recent interview with Yahoo Finance, NYU finance professor Aswath Damodaran also outlined the problem with relying on the tax code as being able to anything meaningful to tweak corporate behavior.
“The tax code is a bludgeon,” Damodaran said. “When you change the tax code trying to make companies do the right thing, you almost always have a law of unintended consequences.”
Damodaran adds that, “tax codes have never been effective behavior modifiers. If you want companies to invest more in the US, you have to make it in their economic best interest, their operating best interest to bring business back to the US.”
And simply making the legal tax rate lower doesn’t necessitate the fulfillment of this condition.
“Your microeconomics professor probably would have taught you that corporate taxes should be a passthrough, just as sales taxes are,” Inker writes.
“Because corporations are interested in their after-tax return on capital, a change in corporate tax rates should generally affect output prices, not profits. That would make a fall in corporate tax rates at best a one-off windfall and possibly a wash.”
We recently highlighted commentary from Caterpillar, a US company that certainly stands to benefit from any changes to the government’s fiscal stance and any tweaks to the tax code. The company said that any changes out of Washington wouldn’t likely show up until 2018. And even if these positive impacts do show up, they might not be what the market has been betting on.
Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland
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