We have heard the drumbeat for months. Interviews with CEOs and politicians repeat the same mantra: “We must cut corporate taxes to make our corporations competitive in world markets”. This mantra has now become the core of both Republican tax bills. As a soundbite this is convincing, but the whole initiative is just a well-orchestrated scam.
The most obvious question, of course, is “who is not competitive?” Apple seems to have no problems selling in foreign markets. GM just hit records selling cars in Canada and is well positioned in China and other foreign markets. Tech companies have skyrocketed based on both foreign and domestic sales, and positive earnings reports across all sectors have driven stock prices to record highs. Corporate tax cuts are a solution in search of a problem.
The bigger problem is that income tax cuts will not make U.S. Corporations more competitive or spur investment. To understand this, consider a sector that is struggling to compete. Suppose a plate steel manufacturer has costs of $750 per ton, when the world market price is $700. That company cannot compete and make a profit. If we create a profit tax cut of 40%, how does this improve its competitive position? The cut does Nothing at all for struggling companies. It still costs $750 to produce a ton of steel. Investments that are not profitable before the cut are still not profitable. Competition is driven by cost and revenue structures, but tax cuts on profits will affect neither.
Though it is clearest in this simple example, the same applies to all corporations. Investments are driven by expected costs and revenues, and corporations consider their profit margins when making investment decisions. For example, when I was evaluating investment options for a large medical services corporation we had an alternative that had an estimated return on investment of 16%. This seems very good when the corporation could borrow at 5%. But my clients pointed out that their operating margin – the profit rate after operational costs – was over 20%. A project that returned less than 20% would lower operating margins. Falling profit margins are negative signals to stock analysts and can threaten stock prices, executive bonuses and stockholder support. In short, most corporations invest in projects because they can return a target profit level, not because they have idle funds. Income tax rates affect what is left after taxes, but not the basic profitability of investments. Given the current plethora of cash and credit, If a viable opportunity exists it has already been taken. Cutting corporate tax rates will add more cash to companies that already have plenty of cash, but will not create better opportunities.
Republicans claim that if tax rates are lowered, corporations will lower their expectations for profitability, pay higher wages, and invest more. This scenario is very unlikely. Corporations are already maximizing profits. Stock prices will rise quickly to reflect the higher after-tax earnings. This has already begun and accelerates each time the tax cut prospects improve. Once stock prices have risen, any decline in profitability can cause a fall from these peaks, damaging the increased wealth of stockholders and corporate executives. Why would executives reduce their own wealth? Why would stockholders who paid premium prices expecting increased earnings accept lower profit margins?
This is what Gary Cohn found when he asked a gathering of CEOs how many would use the increase in retained earnings to re-invest. (https://www.cnbc.com/2017/11/15/ceos-raise-doubts-about-gary-cohns-top-argument-for-cutting-the-corporate-tax-rate-right-in-front-of-him.html) Very few indicated they would. The only surprise is that someone with experience in investment banking would expect a different answer.
Other provisions in the bills will work against growth, including the use of a territorial tax structure. In a leap of fantasy, the architects of the tax package believe that if we tax domestic profits at 20% but exempt foreign income, investment will rapidly flow back to the U.S. Let’s see, I can invest abroad and keep everything I earn, or invest in this country and keep eighty cents on the dollar. What’s the incentive here? We have deferred taxes on profits held outside of the country, causing corporations to invest abroad and funnel profits to foreign subsidiaries. The solution is not to permanently institute differential tax rates which are the root cause of our current problems, but to tax all profits equally regardless of their source. That would end the existing tax incentive for foreign investment.
As an alternative to reduction of corporate rates, Payroll taxes could be cut and the revenue replaced by general funds. This would immediately cut operating costs for all corporations and improve their competitive positions. Lower production cost would make our goods more competitive in foreign markets, reduce the advantage of foreign investment, and provide incentives to invest domestically. A payroll tax cut would also provide an immediate increase in take home pay for every working American. What it would not do is provide a massive wealth transfer to the richest 1% of Americans, so it is obviously not a candidate for Republican tax policy changes.
The House and Senate tax bills as drafted will not produce significant economic growth, keeping with failure of past trickle-down schemes Republicans have championed. They will create an enormous transfer of wealth to the super rich, which is the purpose of the corporate rate cuts. The bills will also damage middle class families in high tax states and those with exceptional medical expenses or student debt. But worst of all, this gift to the wealthy will create a massive deficit, adding to the future burden of middle class taxpayers.