Corporate tax reform is here. But will the changes cause corporates to substantially shake up their investment plans, using some of the extra cash they have on hand to expand and hire more people?
Cutting the corporate tax rate
The tax bill reduced the corporate tax rate to 21 percent. While proponents of the bill posit that lowering the rate on repatriated earnings would cause corporations to invest that money in the United States, there has been speculation that companies are much more likely to return money to shareholders. Wells Fargo CEO Tim Sloan even said at a Goldman Sachs investment that’s exactly what his organization plans to do, and a much publicized video of National Economic Council Director Gary Cohn speaking to a room full of Wall Street executives indicates a similar outcome.
A corporate treasurer who spoke under condition of anonymity said that his organization is likely to follow this path. “I just don’t see any change on my investment policy based on the tax bill, primarily because it doesn’t change my pre-tax ROI,” he said.
However, Marko Papic, senior vice president and chief geopolitical strategist for BCA Research, cautioned that these incidents shouldn’t necessarily be used as barometers for gauging what corporates might be poised to do with any extra money this bill affords them. He stressed that the Cohn video in particular is “not empirical, it’s not data—it’s just a room full of dudes. We don’t really know what companies will do.”
However, what we do know is that previous efforts to repatriate foreign earnings went into stock buybacks and not investment, with the most recent example being the Bush tax cuts of 2004. “We also know that the marginal tax rate for corporates is already fairly low,” he said. “So it’s unclear to what extent that will stimulate the economy.”
Jeff Johnson, CTP, CPA, chief financial officer for Amesbury Truth and Chairman of AFP’s Board of Directors, sees many companies utilizing the tax cuts primarily to pay down debt or buy back shares. “The question is, how much will be used to invest in individuals or capital,” he said.
Johan Nystedt, vice president, treasury for IR Conagra Brands, doesn’t expect a big shakeup; he sees most companies adhering to the capital allocation plans that they already have in place. And if companies do make any changes as a result of the tax bill, he doesn’t anticipate anything radical. “It’s going to be a mix of investment in the business, capex, etc., he said. “And there will be things that benefit shareholders directly, like dividends and share repurchases.”
There is one provision in the tax bill that could potentially spur U.S. corporates to spend more money at home, and soon—for the next five years, companies can fully deduct their capital expenditures. “Unlike the reductions in tax rate, U.S. firms only benefit from this change when they deploy capital on qualified property and equipment at home, an unambiguously stimulative change,” Papic wrote in a note to clients.
The IRS already allows accelerated depreciation of capex; the new tax bill just brings it forward. BCA’s analysis suggests that this could lead to a change in corporates’ spending behaviors in 2018. “We are already seeing capex recovery in some sectors, and we think this could stimulate further capex recovery,” Papic said.
For example, a company’s 20-year capex strategy might include plans to build a factory or do some natural resource exploration. “You might want to just accelerate those plans over the next five years,” he said. “One company’s capex is another company’s incentive to hire. So it’s a virtuous cycle.”
Papic noted that the risk of introducing a tax plan that is fiscally profligate in the late stages of an economic cycle can stimulate the economy considerably, prompting the Federal Reserve to raise interest rates. “This is a stimulus that is not really necessary, so it could bring forward a recession that was going to come anyway,” he said. “We’re going to have a recession at some point; it’s natural to do so. The question is when.”
An early indicator that a recession is brewing is the Treasury yield curve, which has been flattening significantly. “The 10-year yield is being kept fairly stable, whereas the short-term interest rates are rising, in expectation that Federal Reserve will raise interest rates,” Papic said. “The yield curve usually leads a recession by 12 to 16 months and if the tax bill does prompt the Fed to tighten rates faster, because you have this late stage stimulus, then those interest costs become a burden on households and corporates, and we’ll have a recession.”
Nevertheless, Papic stressed that this looming recession is not an “apocalypse”; currently, there aren’t the kinds of imbalances in the economy that existed in 2007-2008. “So this recession could actually be quite mild, and relatively tame,” he said.
Nystedt agreed. “There were so many factors that contributed to the 2008 recession,” he said. “My sense is that we are in a better spot than we were back then. I think a lot of people are going to say that the equity markets are very highly valued, and there is going to be a correction to that at some point. But a market correction and a recession are two different things.”
But Papic warned investors and corporates against misjudging the Fed. “We could see nominal GDP growth this year, between 4 and 5 percent. That wouldn’t be completely crazy,” he said. “And if that happens, the Fed will raise rates four times. That’s a certainty. And that, I think, would bring forward a recession in 2019.”