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Feb 23, 2017

Corporate Tax Incentives and the Unintended Side Effects

By Gene Balas

We don’t yet know what, if any, forthcoming tax proposals will become law. However, one potential idea that might be included in such a plan could be to encourage businesses to invest more in their property, plant, equipment, and technologies. After all, in the long run, that would likely help the economy, as it may boost productivity – an essential ingredient in the potential growth rate of the economy. And in the short term, the very investment itself is a direct addition to GDP.

But, as with many things in life, it really isn’t so simple to magically make money appear by legislation. There are complicated side effects and interactions. So, let’s take a walk through the data and connect some of the dots along the way to see how (or if) this could actually negatively impact consumer spending.

  1. Funds for investing in capital expenditures (capex) will have to come from somewhere else. Corporations can’t simply print money, so the likely source of those funds may be from monies companies had been using to buy back shares.
  2. Share buybacks help the stock market for two reasons. First is the obvious demand for those shares in the stock market. Companies in the S&P 500 have spent more than $2.5 trillion on share buybacks in the five years through 2016’s third quarter, according to FactSet. But the second reason buybacks help the market, though, is just as important: By reducing the number of shares outstanding, then, presto, earnings per share is then higher. In fact, the 5.3% in annualized, cyclically-adjusted earnings per share growth since 2009 would be less than half as much if not for the effect of buybacks, according to data from FactSet.
  3. While we can’t predict actual market outcomes, some may argue the market could be considered pricey, as measured by the ratio of the S&P 500 to sales. Sales, unlike earnings, are not distorted by accounting policies (or indeed, the number of shares outstanding). That provides a cleaner look at the valuations of the market over time. As seen in the nearby graph, the market may arguably be rather expensive.SP 500 Price to Sales Ratio.png
  4. If companies invest funds in things that benefit the economy, they may correspondingly invest less in things that benefit the stock market, like their own shares. The stock market is like any other market: Prices are set by supply and demand. If there is less demand for shares coming from the issuer of said shares, the market may not go up.
  5. Without an ever-rising (or possibly even declining) market, then theoretically, at least, investors might feel a need to save more for retirement or other goals out of their paychecks instead of relying on the courtesy of corporations to buy their stock from them. If this is true, then that could be a drag on consumer spending.

The economy and markets are complex organisms

So, this much might make intuitive sense. But it comes with a huge caveat: there are many other factors besides the stock market that can influence consumer spending and saving. Indeed, there have been times when consumer spending has fallen along with the value of the market – just as consumer spending had also risen after sharp drops in the market. The October 1987 stock market crash did nothing to stop the 1980s economic expansion. It’s hard to pin down the relationship of one variable to just one other variable.

Our main point, though, is not to make a forecast of the direction of the market or the levels of consumer spending or saving. Instead, this discussion is intended to illustrate just how complex the economy is. It rarely responds to just one factor, like tax incentives or the level of the stock market. In our example above, we’ve walked through unintended side effects of just one pathway. Multiply this by hundreds of other variables, and you can see where it is far from a slam-dunk case that one lever – tax policy – can influence markedly the economy or the market as a whole.

Indeed, former president Ronald Reagan cut taxes, and the market went up and the economy expanded in the 1980s. Former president Bill Clinton raised taxes, and the market again rose while the economy grew in the 1990s.

The bottom line is that investors would be wise to consider many more factors when investing than a single variable. Often, staying the course instead of responding to either fear or euphoria might be a better course of action. Recognizing the tendency of investors to respond to just one variable and the historical examples of why this hasn’t yielded results is proof of the economy’s complicated nature. Avoid the temptation to have selective attention.

Disclosure: Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change, and they reflect those of the author and not necessarily United Capital. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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United Capital Financial Advisers, LLC (United Capital) provides financial guidance and makes recommendations based on the specific needs and circumstances of each client. For clients with managed accounts, United Capital has discretionary authority over investment decisions. Investing involves risk and clients should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this blog is intended for information only, is not a recommendation, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. This blog is a sponsored blog created or supported by United Capital and its employees, organization or group of organizations. This blog does not accept any form of advertising, sponsorship, or paid insertions. Certain authors of our blog posts may be influenced by their background, occupation, religion, political affiliation or experience. It is important to note that the views and opinions expressed on this blog are that of the owner, and not necessarily United Capital Financial Advisers. As a Registered Investment Adviser, United Capital does not allow any testimonials on their blog, and any comments deemed as such United Capital will remove.

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