"Kee" Points with Jim Kee, Ph.D.

  • Hammering out the Tax Plan
  • How to Think About Corporate Cash
  • Important Point on the Federal Reserve

Markets were down slightly last week as Senate Republicans outlined their version of a tax bill which proposed, among other things, a one year delay in cutting the corporate tax rate. They also proposed rethinking some tax breaks (charitable deductions, mortgage interest deductions, medical deductions). Other points of contention are state and local tax deductions. I think this highlights the inevitable conflicts between tax simplification, on one hand, and key tax deductions or incentives, on the other.

Hammering out the Tax Plan

Another trade-off is the loss of federal revenue to the US government. Individual income taxes currently account for about 80 percent of government revenues, corporate income taxes account for about 9 percent, and the rest comes from miscellaneous taxes. In general, capital is more responsive to tax changes than labor, and a large cut in the corporate rate would have the biggest bang-for-the-buck, particularly as it affects business investment spending. This includes reducing taxes on repatriated income, or income earned overseas. It also includes accelerated depreciation schedules, as immediate expensing of capital expenditures lowers tax burdens relative to depreciating them over time. That is because expensing lowers immediate taxable income more, while depreciating investments over a time schedule spreads the “tax shield” over future periods, thus making the present value of taxes paid higher under depreciation (versus expensing). Lowering the corporate rate permanently also has a bigger impact than a temporary reduction. For these reasons, we still believe that the highest probability of impactful reform will take place at the business level, where revenue losses are smaller and growth impacts are larger, than at the individual level (where revenue losses are greater and growth impacts are smaller). The higher the existing rate, the stronger the impact of tax cuts, and here again corporate rates are relatively higher than individual rates. That’s as simply as I can lay it out without 10 pages of detail!

How to Think About Corporate Cash

What should companies do with higher after-tax income and with earnings brought back (repatriated) from overseas? The way to think about it is in terms of wealth redistribution versus wealth creation. If companies are profitable, that is, if they are earning a return on their investments that is higher than the cost of those investment funds (called “the cost of capital”), then more wealth is created by reinvesting in the business, which includes spending on plant and equipment, building or leasing more space, and - increasingly in a high tech world - spending on research and development (R&D). These are actions that result in wealth creation. If profitable reinvestment opportunities aren’t available, then firms should give excess earnings back to investors, which takes the form of paying down debt, buying back shares, and paying out dividends. These are best thought of as wealth redistribution strategies. This is also where regulatory morass comes in to play, which is difficult to quantify but no less important than taxes. Streamlining the myriad layers of regulation and clearing up regulatory uncertainty would go a long way toward maximizing the growth impact (i.e. business investment spending) of any given tax cut, so the two - taxes and regulation - should be looked at in tandem, and I believe they currently are. Of course, regulatory safeguards with respect to workers and environmental impacts are important, but at issue here is accomplishing these laudable goals in as straightforward a way as possible.

Clearing up uncertainty goes a long way toward inducing companies to reinvest for wealth creation, which is risky, versus returning cash to investors, which is not (really). The safest thing a company can do with cash is to sit on it, but that doesn’t help anybody. The next safest action is buying back shares, more so than increasing dividends, as a later decision to have to cut dividends is frowned upon by investors. General Electric’s recent decision to cut its dividend for the first time since the Great Recession and, before that, the Great Depression era, is an excellent case in point (the stock sold off almost 8%!). A corporate tax cut combined with regulatory reform or simplification results would be the ideal reform package.

Important Point on the Federal Reserve

Lastly, I have made the point in several webcasts that, overall, the Federal Reserve has done a pretty good job at maintaining price stability in the face of numerous crises over the past several decades. In his recent blog, “The Grumpy Economist,” University of Chicago economist John Cochrane made the point that Fed Chair Janet Yellen has continued this performance. True, she didn’t face any monumental events during her tenure, but Cochrane points out that she didn’t mess anything up either, and she maintained the basic Fed mandates of promoting maximum employment, stable prices, and moderate long-term rates. My expectation and hope is that, in future years hence, we will be able to say same the same thing about incoming Fed Chair Jerome Powell.