Most of the time tax reforms are well-intentioned, but they invariably open the Pandora’s Box. Once governments start making changes to the tax code, it is difficult to figure out the final outcome given the many interrelationships, interactions, and incentives that tax reforms afford various players in the financial markets. And the more extensive and pervasive tax reforms are the more complicated it gets to understand the direct and indirect effects on the economy and financial markets.
A case in point is the last major U.S. tax reform of our generation that took place in 1986. The Regan administration and its supply side economics advisors aimed to reduce taxes in an effort to make the economy more efficient and productive.
Some key aspects of it were the following: The corporate tax rate was reduced to 34% from 46%. The top personal tax rate was reduced from 50% to 28%. The average top dividend and realized capital gains tax rate was reduced from 35% to 28%.
Other tax changes were related to the elimination of Investment tax credits and the reduction of related subsidies to capital investments by extending the depreciation life of assets, as well as allowing losses to be carried forward up to 15 year as opposed to only 5 years before the tax reform.
On paper it looked great. What can go wrong with such well thought of tax reform that reduced taxes both at the personal and corporate levels?
The 1986 Tax Reform contributed the missing piece to the U.S. tax, legal, regulatory and government policy institutional framework to make it approach that envisioned by the Noble Prize winners Franco Modigliani and Merton Miller. The theory the pair developed in 1958 and 1963, as well as their extensions, demonstrated that under certain tax and legal/regulatory conditions, corporations would have an incentive to use extreme amounts of debt – as the advantage of debt over equity increased over and above that provided by interest expense deductibility.
These conditions were as follows:
First, that realized capital gains are taxed at the same rate as dividends and interest income.
Second, that the top personal marginal tax rate is below the corporate tax rate.
Finally, that other ways to shield income from taxes are eliminated or reduced thus making interest expense-related tax savings the most important source of reducing taxes.
In addition, there were also other legal, regulatory, and government policy changes that took place around that time that were aligned with the conditions necessary for the Modigliani-Miller theorem to work.
And indeed this is what started to happen in the U.S. in the late 1980s. The debt-to-equity ratio for non-financial corporations rose from about 70% in 1984 (i.e., the year of the announcement of the changes) to well over 100% by the end of the decade. A control country, similar to the U.S. that had no such tax changes, i.e., Canada, saw no change in the debt-to-equity ratio over the same period.
And then recession hit in early 1990s. The U.S. financial system came under severe strain as bankruptcies rose sharply. As a result, a well-intentioned tax reform almost ended in a disaster. The tax system is a dangerous implement to play with as no one knows how the various agents of economic activity will respond to the incentives and the collateral interrelations.
And this brings me to the current Tax Reform proposed by the Trump administration in the U.S. What is the Trump administration proposing? And what can we conclude given the above analysis and the experience with the 1986 Tax Reform?
It includes, among other things, significant cuts in federal tax rates at both the individual and corporate level.
First, the highest corporate tax rate will be reduced from 35% to 15%.
Second, the top personal tax rate will be set at 33%.
Third, the top capital gains tax rate will be set at 20%.
Fourth, companies in the manufacturing sector will be allowed to elect to immediately expense capital investments, effectively reducing to zero the depreciation time for such assets.
Fifth, deduction of interest expenses from income for tax purposes will be disallowed in such cases, eliminating the advantage debt has had over equity throughout history.
Finally, the tax loss carry forward period was extended to infinity.
Notice the dissimilarities with the 1986 tax Reform. The proposed Tax Reform negates many of the Modigliani-Miller conditions that made debt an unambiguously attractive source of raising capital. It will dissuade companies from issuing large amounts of debt; in fact we may see a surge in equity issuance. It will be good for the long-term viability of the financial system in light of the elevated leverage experienced at all personal, corporate and government levels in recent years.
But is this good for stocks?
In general, in terms of demand-supply, if the stock supply is increased without a commensurate increase in stock demand, this will adversely affect stock prices.
However, at a company-specific level, there will be winners and losers depending on a company’s industry and the industry’s business risk. Winning industries will be those that have high business risk — that is, industries that optimally tend to issue little or no debt, and/or have high needs for capital expenditures and/or have very volatile profits that will benefit from the ability to carry forward losses indefinitely into the future.
Losers will be industries with low business risk that optimally issue a lot of debt, and/or those that have little need for capital expenditures.
Nevertheless, at the end of the day, it will all depend on whether the tax savings from writing off capital expenditures is higher or lower than the tax savings companies forgo for not been able to deduct interest expenses for tax purposes.
In my opinion, the tax reform will reduce financial risk and the probability of bankruptcies, but at the same time, offsetting the reduction in financial risk, may increase business risk if the higher risk companies are benefitting the most and the lower risk companies the least.
We have to wait and see.