Intro: With the advent of fake news, underlain with politician’s gifts for selling legislation, I wanted to personally investigate the impact of lower business tax on each company in the S&P500. Most importantly, I wanted to see which industries and companies would increase in value, since most companies don’t pay the prevailing corporate tax rate anyway.
Since there are too many variables to account for in such a complex tax system, I’m not going to address every tree in the forest, but instead, focus on the prevailing corporate tax rate and its impact on your stock portfolio. Our first stop is an analysis of this special number: 25%.
Preface: I’ve simplified one of the most complicated tax codes in the world to show some interesting insights about company values and the US tax system. If you like this post, don’t forget to rate my LinkedIn skills for value investing and financial modeling. Enjoy the post.
What does 25% mean? 35% is the official federal tax rate. States charge taxes as well, but we can simply say this adds 5% to overall rates. Grand total? 40%! That feels high, but there is a catch. Since the US tax code is full of loopholes, 25% is the actual tax rate that an average big company pays. Simply closing loopholes would significantly raise business taxes to equal the number (35%) that politician’s debate in the news. Politician’s want to lower the tax rate and close loopholes for a target rate of 20%.
Do we pay the most taxes in the world? Out of the 34 large economies I analyzed, that statement could be true if you only look at the headline rate for US corporate taxes. When you look at the “actual” rate US companies pay, then the tax rate is a lot more reasonable.
In essence, US companies are competitive. Side note: Since I had the data, I regressed tax rates against the recently-reported happiness data published by Gallup. I didn’t find any correlations between tax rates and happiness. Low or high taxes, countries are happy for other reasons.
What’s the tax plan? The debate starts with a 20% federal corporate tax rate. States add 5%, which equals our 25% magic number…
the same number companies already pay. If passed, politicians can gleefully claim a ~40 drop in business taxes without sacrificing much government revenue. The real benefit is the simplification of taxes for all businesses due to the closing of tax loopholes. A more ambitious, but unnecessary budget crunching effort would focus on a 15% federal tax rate, which might be the target of negotiations before everyone compromises at 20%. Position the mirrors and queue the smoke.
How does this impact my stock portfolio? Holding all else constant, lower taxes help stocks, because a stock’s price works off a methodology called valuation. In summary, valuation says that if you have a business open for one year and plan to make $100, then your business is worth one hundred dollars. If the government lowers taxes and you make $150, then your business is now 50% more valuable.
When is the stock market going to double? After President Trump’s election, the stock market went up in anticipation of tax and regulation relief; therefore, the benefits may already be in stock prices, but this was a broad-based rally, which means that individual companies may still benefit. When tax details eventually come out, individual sectors will move higher or lower. See the chart below for a breakdown by industry.
Broadly speaking, consumer staples, utilities, and industrial sectors should do better if corporate tax rates dropped, while the real estate and information technology industries would do worse. This insight will help your investments, but what about individual companies? We’ll get to that next.
Who are the winners and losers? That’s hard to say, but one clear loser could be accounting firms, because they profit from tax complexity. Winnings go to firms that pay the most taxes now, because their rates should drop. The problem is most companies don’t pay taxes anywhere near 40%; a lot don’t pay taxes at all. For example, the average real estate company only pays 5% of their earnings in taxes. Will the government make a special exception for them? I’m not sure. We can best diagnose tax benefits on a case by case basis, which brings us back to valuation.
Valuation, it gets a little more complicated: When deciding to buy, or sell stocks, it’s important to understand that everyone has an opinion. Using our above example, a company can make $150, but there is a risk that tax reform may not happen. In that scenario, a person may only pay $140 for shares in our company due to higher perceived risks. Other investors may say that tax rates can fall more than expected, so they would pay $160 per share for our company. In general, the laws of math prevail, but not over the short term and not for every stock. The best way to tell what happens to an individual stock is a do a discounted cash flow (DCF) analysis and project out some numbers, but that’s boring, so I did the work for you. I also ran scenarios with different tax rates. [Note definitions: Return potential is how much money you can expect to make on this investment. Potential: XX% Tax is how much money you can expect to make given the tax rate.] See below:
Wait, but why are we lowering taxes anyway? If we ran the country like a corporation and the tax rate equated to our profit margins, then the US government should have a higher tax rate than the rest of the world. For example, does Apple eagerly lower the price of their iPhones to attract more customers? Not really. Apple wants to maximize profits. Higher profits also feed innovation through additional R&D and attract top talent through better pay. USA Inc. works broadly the same way. US citizens get better roads and schools… in theory. Going further with this example, the rest of Apple’s competition might operate like tax havens, because tax havens compete more on price (aka low taxes). A simplified competitive analysis gives three options for companies looking to stand out: 1. high cost/high quality (USA and Apple), 2. low costs/low quality (tax havens and cheap phones), or 3. some differentiating factor (AI, large population).
Conclusion: Companies don’t pay the prevailing corporate tax rate due to a proliferation of loopholes. If the US government were to close loopholes and lower the corporate tax rate to 20%, it’s conceivable to see this as a revenue neutral option that has some political benefit. The real benefit to companies is the simplification of taxes and the level tax playing field between companies. In the end, individual stock valuations still determine if stock prices will go up or down, so you must do your homework if you want to invest.
What should the US government do to corporate taxes? Write your response in the comments below.