May 03, 2017

Why Tax Cuts May Not Stimulate Economic Growth

By Gene Balas

President Trump has proposed cutting the corporate tax rate to 15%, from a top marginal federal tax rate of 35% per KPMG plus an additional 5% for state and local taxes. (The effective tax rate may be lower.) That sounds great: At least on first glance, it would argue for buying stocks because presumably more profitable companies would conceivably drive the market higher.

However, before we get carried away, we can look to the example of Germany, which lowered corporate taxes, with the effective tax rate dropping to 29% currently from about 39% at the end of 2007, according to KPMG. A curious thing happened to corporate profitability: absolutely nothing. In fact, in the years from 2000 to 2007, the average profit margin for companies in the DAX index was 3.82%, according to Bloomberg. Then, from 2008 to 2016, profit margins were 3.94%. Similarly, ROE in the earlier period was 9.17%, and a slightly less 8.45% in the later period, according to Bloomberg.

Do Changes in the Tax Rate Affect Profit Margins or ROE.png

Was the Great Recession to blame?

I know, I know - you're going to make the argument that the Great Recession may have impacted German corporate profits. But that belies the whole argument that taxation drives growth: If taxes were a major driving force in economic growth, then the Great Recession theoretically might never have crossed the German border. To that point, note that the tax cut was made effective at the beginning of 2008, just as the recession was beginning. And both the earlier and the later period include both expansions and recessions.

So, having stated the conclusion already, let's now delve into the forces that conspired to restrain return on equity and profit margins.

The mechanics of the economics

To set the stage: Textbook economics states that, outside of monopolies and certain other exceptions, competition drives down "excess" corporate profits to zero, with the remainder of profits covering a firm's cost of capital. (That's why the average return on equity didn't budge from one period to the next.)

The question is why.

Well, if a company is suddenly handed additional funds, so to speak, it must find a use for them (aside from the obvious share buybacks and dividends). One potential avenue for deployment is capital expenditures, which would be depreciated over time, cutting into profits. At this point, I would interject that there actually has to be a need for more capex for such business investment to make sense.

We can assess the need for capex by looking at capacity utilization, which, as seen in the nearby graph, is notably low in the U.S., especially compared to history, according to Federal Reserve data. What, precisely, would be the motivation be for a company to add another machine when a quarter of their capacity is idle?

Capactity Utilization.png

But let's hypothetically say they did invest more. That business investment would show up in economic growth, such as measured by GDP. Again, we can turn to Germany, and what we find is that GDP growth in real terms showed no discernible trends from before the tax cut vs. afterwards, according to Eurostat. Certainly, other factors were at play in suppressing economic growth - but that is precisely the point of this exercise; to see if tax policies, by themselves, are a path to riches.

Lower prices, not more economic growth, may be the result

Instead of boosting economic output, perhaps instead tax cuts lead to lower prices, as companies find themselves able to attempt to grab market share by being the first mover in what might turn out to be a price war (or perhaps just a skirmish). Obviously, there are many factors that feed into inflation, but one might observe that the average of annual consumer price inflation in Germany fell to 1.35% in the 2008 to 2015 period from 1.65% in the 2001 to 2007 period, according to Eurostat. Companies having extra ability to withstand lower prices and still keep stable margins meant that companies may have opted to choose maintaining market share over maximizing unit prices.

After all, once one company in a competitive industry cuts its prices, its competitors are often forced to do so. And those lower prices don't just affect their home market: Companies can "export" lower prices to other economies as well. (Currency translation and many other factors also can play a role in price setting of a company transacting business across borders.)

As companies battle over market share, prices are kept lower than they otherwise would be. Companies may increase their labor force utilization if demand for their goods and services increases as a result of lower prices. Even if companies don't raise an individual worker's wages by much, they may need to hire more workers, driving total labor costs higher - especially when productivity is low, as it is now. With prices that don't rise (or even fall a bit), and labor costs that increase as a percentage of revenues, then voila, margins and ROE remain the same as before the tax cut.


That's one theory. Of course, it may turn out differently, as every situation is at least somewhat unique. But it is hard to envision that money just magically appears and stays forever. Eventually, a tax cut must be paid for. And if corporate profits don't grow the way some predict they will, what goes down must come up, because a tax cut might not, in fact, pay for itself, as we saw with German profits before and after their tax cut. Tax cuts today could become tax hikes tomorrow - and that is the key factor that may limit corporations' desire to make permanent investments.

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Gene Balas

Gene Balas

United Capital Financial Advisers, LLC (“United Capital”), is an affiliate of Goldman Sachs & Co. LLC and subsidiaries of the Goldman Sachs Group, Inc., a worldwide, full-service investment banking, broker-dealer, asset management and financial services organization. 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.

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