(MENAFN- ValueWalk) Every decade or two, the political class in the United States wakes up to the reality that the US tax code, as written, is an abomination that encourages and rewards bad behavior, and works on a tax reform package. In each iteration (and I have had a front row seat with the 1986, 1993 and 2001 attempts), the reformers start with the claim that the changes they make will make the system 'fairer' and 'simpler', with the added bonus of increasing economic growth. And with each one, the end result is that we end up with a system that is more complex and less fair. I am not a utopian and I understand that tax reform is a political exercise where different interests have to be balanced, but as we start to see the contours of the 2017 reform package, the big question becomes whether, on balance, it does more good than bad. As with prior tax debates, this one follows a predictable path, with support or opposition to the package, depending on who is initiating the reform. Since this version of tax reform comes from Republicans, Democrats are vehement that this reform will benefit the rich and devastate the middle class. The Republicans are just as assertive in their claims that this reform will help US companies compete better in the global economy, and increase economic growth. I would love to tell you that I am completely unbiased on this issue, but I cannot, because no one is objective when it comes to taxes. We all have our priors on taxes and look for data and evidence to back up those preconceptions. Nevertheless, my intent in this post is to start with a general assessment of how taxes affect value and to then look at both the current and proposed corporate tax models, with the objective of evaluating how the planned changes will affect value at companies.
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Taxes and Value
To understand how the tax code affects the value of a business, let's go back to basics, and link the value of a business to three component parts: the cash flows generated from existing assets, the value of future growth and a risk adjustment, usually taking the form of a cost of capital or discount rate.
Where does the tax rate show up in value? Everywhere, since each of these drivers is affected by not just the tax rate, but also by other provisions in the tax code.
Cash flows from existing investments: The cash flow from existing investments is estimated by starting with after-tax operating income and then subtracting out the reinvestment needed to sustain future growth. Since the cash flow is an after-tax cash flow, the effective tax rate paid by a firm will affect that cash flow, with higher effective tax rates resulting in lower after-tax cash flows. The statutory tax rate in the tax code is a driver, albeit not the only one, of the effective tax rate, but so are the provisions of the code that relate to the taxation of foreign income, as well as tax credits and special tax deductions that are directed at specific sectors. Cost of capital (or discount rate): The cost of capital is a weighted average of the cost of equity and after-tax cost of debt, with the weights reflecting how much of each is used to fund operations. The most direct effect of the tax code arises from its tilt being towards debt, in much of the world. In particular, the tax benefit of debt takes the form of tax deductible interest expenses and the benefits of borrowing will increase with the statutory tax rate (or the marginal tax rate). There are more subtle effects, as well, that come from how the tax code treats investment income in the hands of investors, since changing tax rates on dividends and capital gains can affect the price charged by investors for taking equity risk (i.e., the equity risk premium) and altering the tax rates on interest income earned by investors can affect the price charged by investors in the bond market (i.e., default spreads). Value of growth: The value of growth can be traced back to the amount that companies reinvest back into themselves (measured as a reinvestment rate) and the excess returns generated on those investments (captured as an excess return, or the difference between return on invested capital and the cost of capital). The tax code can affect both the reinvestment rate and excess returns, with provisions either encouraging or discouraging more investment and the after-tax earnings showing up in the return on capital and excess returns. It is on this dimension that the effects of changes in the tax code become most unpredictable, since they affect both returns and costs of capital. Lwering the statutory tax rate can increase after-tax cash flows and returns but also increase the cost of capital, by reducing the tax benefits from debt. The figure below captures the full picture of how taxes affect almost every input into value, and thus value.
The Current Tax Code
It is no secret that I think that the current US tax code is a mess, creating perverse incentives to under invest in the US and over borrow, and from that perspective, I welcome change. To see how the current tax code plays out in the numbers, I have taken the picture where I have connected taxes to value and looked at the tax code, as it exists today.
The US has one of the highest statutory tax rates for corporate income in the world, at 35% (and this is before state and local taxes, which push it up to 40%) and it combines this rate with a 'global' tax model, where it aims to tax foreign income earned by US companies, at the US tax rate, after allowing a credit for foreign taxes paid. In theory, then, a US company that earns income in a foreign market with a 20% corporate tax rate would first pay those taxes and then pay an extra 15% (the difference between the US marginal rate of 35% and the foreign country's tax rate of 20%) to the US government. In practice, this seldom happens because the US also has a provision in the code that specifies that this extra tax is due only when foreign income is remitted back to the US. The result is no surprise. US multinationals have held off on remitting foreign income back to the US, resulting in 'trapped cash' of $2.5 trillion or more, 'trapped' because this cash cannot be invested back in the US or used to pay dividends or buy back stock. This behavior also, in large part, explains why
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