Who will pay for a rise in US corporate taxes?

Joe Biden intends to increase taxes on corporate profits and will probably succeed. He may not get the rate all the way from 21 per to a planned 28 per cent, but some increase is likely.

Who will bear the heavier tax burden: companies, employees or shareholders?

Higher corporate taxes mean lower earnings per share. Naively, and all else being equal, that would suggest that stocks should be worth less. A stock’s value is the present value of its future cash flows. If the discount rate applied to future earnings stays the same, and earnings go down due to tax, the price should fall. So shareholders pay.

Yet the US stock market has only gone up since Biden became the frontrunner, won the election and finalised his tax plan (which was clear in outline all along). 

Not all else is equal though. Perhaps exuberance attending the end of the pandemic outweighed the drag from the tax news. But the point can be generalised. The corporate tax rate has fluctuated wildly, from near zero before 1917 to the teens until the second world war, to near 50 per cent in the middle of the century and then down to between 30 and 40 per cent from the 1980s until Trump cut it to 21 per cent in 2017. But long-term data about earnings, earnings growth and valuations show no step changes accompanying changes in the rate. The market doesn’t care. 

The economist Paul Krugman used to think the tax came out of corporate investment. That view makes sense. The market sets the global rate of return investors expect. That is the hurdle rate corporate investments must surpass. Higher taxes decrease companies’ return on investment, so fewer potential investments pass the hurdle. So there is less investment and less economic growth.

That is why, as Krugman recently wrote, the corporate rate cut was the part of the 2017 Trump tax cut he disliked least. Now he thinks he was wrong, because corporate investment has not budged in relation to gross domestic product. 

Why not? First, he says, most corporate investment is funded by debt, which is tax-deductible anyway. Next, most corporate investments in software and equipment only last a few years, so the cost of capital is less important (in the same way that a mortgage rate is more important to an individual that what they pay on a car loan). Finally, companies such as Apple, Amazon and Google are quasi-monopolies with huge market power. Monopoly profits are free money, not a return on investment, so they ignore taxes.

Andrew Smithers — venerable City economist and sometime contributor to the Financial Times — disagrees. On the issues of debt and the lifespan of investments, he points to data from the Bureau of Economic Analysis and the Fed, which show that the average lifespan of corporate fixed assets is 16 years, and net debt is just 30 per cent of corporate capital employed. On monopolies, the profit share of output has not gone up in recent years and is near historical averages, inconsistent with claims of growing monopoly power.

But Smithers’ rebuttal is as much logical as factual. Corporate tax must be taken out of the private sector’s ability to consume or invest. If it comes out of consumption, there are three groups it could hit: companies’ shareholders, debt holders or employees. We know that shareholder return from stocks has been consistent through time regardless of the corporate tax rate, so shareholders don’t pay. We know that lenders don’t charge less interest when taxes rise, so debt holders don’t pay. And Smithers argues that wages relative to the output of companies have been stable through time, mean-reverting regardless of the corporate tax rate. So employees don’t pay. Private investment is the only thing left for the taxes to come out of.

Smithers thinks the reason investment didn’t rise more after the tax cut is because of skewed executive incentives. In a “bonus culture”, execs would rather buy back shares to boost earnings per share, and their share price, than invest for long-term growth.

I will let better economists than myself call the winner here. But my experience working for an investment fund makes me lean heavily Smithers way. What we looked for were companies that were increasing free cash flow, that is profit after investment and taxes, which could be handed back to shareholders. Companies know this is what investors want, and promise to deliver it. If taxes go up, something has to be cut to keep giving investors what they want. Long-term investment is a natural place to look.

robert.armstrong@ft.com