In the first part of this series, we looked at the motivation behind tax reform, which essentially amounts to giving significant tax breaks to corporations. Our piece discussed the fact that U.S. corporations are not in fact heavily taxed compared to their counterparts abroad.
In this piece, we examine the second assumption driving tax reform i.e. corporations will use tax savings to raise investment spending, which in turn will raise productivity and wages. We start by looking at what corporations choose to do with their excess profits, especially in recent years.
As we discussed in the first part of the series, companies have used a variety of strategies to keep their effective tax rates far below the marginal rate of 35 percent, and profits have soared. Corporate profits as a percentage of GDP fell from 7.6 percent in 1980 to as low as 3.3 percent by 1986, which was likely due to the recession in the early 80’s. However, by 2004 corporate profits surpassed 8 percent and reached as high as 10.8 percent of GDP by 2012. That figure has stayed relatively constant since, slowing to 9.2 percent of GDP in the second quarter of 2017.
Exhibit 1. Corporate profits as a percentage of GDP, historical tax rates Source: St. Louis Federal Reserve FRED Economic Data, Tax Policy Center
Rising corporate profits can be good for an economy since it allows companies to spend more on investments that can spur growth (like automation), boosting productivity. Problems arise if companies choose not to spend more on productivity-enhancing investments.
More generally, companies have three choices to decide where to allocate their excess capital: increase capital investment, increase employee wages, and/or return capital to shareholders (dividends, buy-backs, paying off debt). Historical data shows us that the latter has been the case over the past 25 years. Returning capital to shareholders is not necessarily a bad thing, but it does tell you that corporations cannot find more productive uses for their excess capital.
Despite corporate profits rising to record levels, non-residential fixed investment (capital spending) has fallen since 2000. In 1990, non-residential fixed investment accounted for approximately 12.5 percent of GDP and rose to almost 15 percent amid the tech boom. That figure has fallen back to 12.5 percent of GDP, as of the second quarter of 2017. This is despite corporate profits rising from 4.4 percent of GDP at the end of 2000 to 9.2 percent today.
Exhibit 2. Non-residential fixed investment as a percentage of GDP Source: St. Louis Federal Reserve, FRED Economic Data
U.S. corporations clearly started to save a lot more after the tech bubble burst in 2000. Instead of spending excess profits on capital expenditures, many U.S. companies have built up significant cash holdings (including short-term investments and other liquid long-term investment). In total, Moody’s estimates that total corporate (non-financial) cash held by U.S. companies totaled $1.84 trillion at the end of 2016, compared to $1.24 trillion in 2010 – a 48 percent rise in 6 years. Five companies hold nearly a third of the non-financial cash holdings: Apple, Microsoft, Alphabet, Cisco Systems, and Oracle, totaling $594 billion (over 32 percent of 2016’s total).
Companies simply do not let cash sit in a bank account. Instead, many companies have a significant amount of funds held in investment securities. Out of the five companies with the largest cash holdings, Apple tops the list, with cash holdings of nearly $270 billion (as of the latest fiscal year), and Microsoft is just shy of $140 billion. Apple and Microsoft’s share of marketable securities (which includes fixed income and equity investments) to total investment securities surpassed 90 percent.
Exhibit 3. Total value of assets allocated to investment securities and cash by the top 5 largest cash holders; share of marketable securities and cash investments to total investments Source: Apple , Microsoft , Alphabet , Cisco , and Oracle investor relations webpages
A large portion of these marketable securities and cash figures are likely invested in U.S. government debt, effectively helping fund the U.S. government and keeping interest rates low. In the 2017 fiscal year, over 80 percent of Microsoft ’s $139 billion investments into cash, cash equivalents, short-term security investments, and equity investments went to U.S. government and federal agency securities.
Looking more specifically at the companies’ latest cash flow statements, all of them spent more on security investments – mostly debt, but also some equity – than capital investments. Of the five companies, Apple had the largest net purchase of investment securities, over $33 billion, versus nearly $13 billion spent on capital, which translates into a securities investment to capital expenditure ratio of 2.6. The company with the highest ratio out of the five is Oracle, which spent over $8 billion (net) on various investment securities, while spending only $2 billion on capital expenditures– putting the ratio of securities investment to capital expenditure just above 4 for the latest fiscal year.
Exhibit 4. Millions of dollars spent on investment securities versus capital expenditures. Source: Wall-Street Journal
As companies’ profits have surged, the financial data points to companies saving much of their excess cash by means of lending it to others (like the U.S. government), as opposed to using it for capital investment, or even wage increases for employees.
The last time corporations had an incentive to boost capital spending was in 2004, with the Homeland Investment Act (HIA). HIA allowed for a one-time tax holiday when companies could repatriate foreign earnings at a discounted rate of 5.25 percent, far lower than the 35 percent marginal rate. Corporations returned an estimated $312 billion , avoiding over $3 billion in taxes.
The Bush administration and Congress required that the repatriated money be spent on capital investments or job creation. At the time, Congress argued the tax holiday would create over 500 thousand jobs over 2 years, and financial institutions estimated that capital spending would rise by 2 to 3 percent over the same time period. However, according to one study on the effect of the HIA, they found that for every $1 increase in repatriations, there was an increase of nearly $1 ( $0.92 to be exact ) in payouts back to companies’ shareholders.
Companies found ways to skirt around HIA requirements by disclosing possible uses of the repatriated funds, without actually committing to specific investments. For example, Dell lobbied for the HIA by saying that the repatriated funds would be used to build a new plant in North Carolina. They returned $4 billion from abroad and spent $100 million on the new plant, which, as it turns out, was already in the company’s plans from the start. Shortly thereafter, the company initiated a share-buyback program worth $2 billion.
In addition, some companies took advantage of the initial confusion over the law, which forced the U.S. Treasury to release various documents for clarification – companies sold assets to foreign subsidiaries that were subsequently repatriated and taxed at a discounted rate ( known as roundtripping ). In short, corporations successfully took advantage of the tax code to boost their profits, and promptly returned those profits to shareholders.
As stockholders will likely benefit from share-buybacks, another winner of the current tax bill is likely to be corporate bond holders. For decades , business have been able to deduct interest expenses, which was supposed to encourage credit growth for capital investment. Over the years, this tax incentive has not changed, allowing companies to take advantage of the historically low interest rate environment.
As the Federal Reserve (Fed) cut rates to near zero percent and introduced three quantitative easing programs to keep the economy afloat after the 2008 financial crisis, businesses increased their debt load. Prior to the Great Recession, non-financial corporate debt reached over 27 percent of GDP in the fourth quarter of 2001, the highest rate at the time. By the third quarter of 2015, corporate debt amassed 30 percent of GDP and has stayed above that rate since.
Exhibit 5. Non-financial corporate debt as a percentage of GDP, in billions of dollars Source: St. Louis Federal Reserve, FRED Economic Data
However, as the economy has continued to improve, the Fed has slowly begun to normalize rates. There have been five rate hikes since 2015, with one rate hike that year, one in 2016, and three in 2017. Despite rates rising at the short end of the yield curve, corporate bond yields have remained close to historical lows, indicating that firms are not constrained when they want to borrow. Yet, as we saw earlier, investment spending has barely budged.
Exhibit 6. Bank of America Merrill Lynch U.S. corporate master effective yield Source: St. Louis Federal Reserve, FRED Economic Data
In addition, the new tax bill caps interest rate deduction for businesses at 30 percent of gross income (in this case, earnings before interest, taxes, and depreciation/amortization). This, in addition to the fact that cash-rich multinationals are likely to use repatriated cash to pay off outstanding debt, means that the future supply of corporate bonds is likely to be constrained, raising the price of existing corporate bonds. As a result, corporate bond holders could be the ultimate winners.
What makes the current tax reform bill strikingly different from previous reforms is that there is no specific mandate on corporations to use tax savings for capital investment. The hope is that corporations will use excess profits to increase investment spending, as opposed to simply returning it all to shareholders. Policymakers could have learned from the policy mistakes in 2004. For instance, they could have provided targeted incentives to companies that increase investment spending and promote job creation within the U.S. Instead, we are likely to see a continued rise in corporate profits as corporate tax rates are reduced, and corporate savings increase further.
Since there is no impetus for corporations to increase investment spending, we do not believe the reform will, at best, provide a significant boost to output. Large corporations already have significant cash on hand, not to mention the ability to borrow money at low rates. Yet they have not used it to make productivity enhancing investments. It seems highly unlikely that increasing their cash pile via tax cuts will induce them to do so. If anything, corporations will simply return those excess profits to shareholders.