David Rosenberg: Raising money to support pandemic spending is critical, but corporate tax hikes would be a fool’s errand

Article content

By David Rosenberg and Ellen Cooper

It is truly a fool’s errand for United States President Joe Biden’s administration to play with the corporate tax rate in an effort to fund its massive infrastructure proposal. The efforts to slow the “race to the bottom” in taxation policy internationally are commendable, but there is a risk that the proposed tax hikes will make the U.S. less competitive and reduce incentives to hire workers and invest. Even if the damage isn’t too significant, these tax hikes likely won’t raise much revenue.

It helps to understand where things were before the 2017 Tax Cuts and Jobs Act (TCJA) was passed. At 35 per cent, the headline U.S. corporate tax rate was much higher than the Organisation for Economic Co-operation and Development average of 24.2 per cent. Just as important was the unique absence of an exemption for repatriated foreign business income: U.S. multinationals were keeping billions of foreign profits offshore.

Article content

President George W. Bush had a temporary holiday on repatriations, but what was needed to normalize their system was a general exemption, like we see in Canada and Europe. With this incentive structure, there was a wave of “inversions,” where a non-U.S. foreign parent is sandwiched between the (former) U.S. parent and shareholders. This posed a huge threat to the U.S. tax base. It had to be fixed and it was through Donald Trump’s tax reform legislation, which instituted a general exemption from U.S. tax on repatriation of foreign business income.

Article content

Now the Treasury Department has proposed to amend corporate tax law in an effort to raise US$2 trillion over 15 years to cover the costs of the infrastructure package.

It’s important to remember that corporate income tax contributes a relatively tiny amount to governments’ bottom line — maybe five to 10% at best

Looking for responsible ways to raise revenue to support all the recent spending is critical. However, the problem with tinkering with corporate taxes is that it creates uncertainty for businesses embarking on multi-year projects. What business is going to embark on a major multi-year spending project without knowing what the after-tax rate of return on the capital invested is going to look like?

As well, the proposal, as it stands, would raise the U.S.’s combined corporate income tax rate to 32.3 per cent from 25.8 per cent, positioning the country as the highest tax jurisdiction among OECD countries and decreasing U.S. competitiveness. The impact could be a short-term freeze in capital expenditures, particularly as companies hold off during the months of negotiations that will no doubt ensue as G-20 countries work towards a harmonized tax plan.

Article content

We know that following the Trump tax cuts year-over-year capital spending rose eight per cent in 2018, one of the best years of the past cycle for capital deepening. A reversal of the cuts could have the opposite effect. However, the impact of the TCJA was temporary (many tax planners knew even at the time that the 21-per-cent corporate rate was unsustainable), with capex fading the following year even before the onset of the pandemic, to just two per cent in 2019. Some of the windfall also went to share buybacks, which skyrocketed temporarily to a high of US$223 billion for the S&P 500 in Q4 2018 from US$137 billion in Q4 2017.

The previous tax changes may not have spurred a long-term capital deepening cycle, but what is important here is the uncertainty, particularly if Biden is a one-term president and the U.S. embarks on further dramatic tax changes again in just four short years.

There is still quite a bit of negotiating to be done on this file, even within the Democratic party, but the Treasury’s estimate of raising US$2 trillion from the final package of reforms seems far fetched and, of course, will be affected by unknown behavioral effects. It’s also important to remember that corporate income tax contributes a relatively tiny amount to governments’ bottom line — maybe five to 10 per cent at best. History shows that to be very stable whatever the rate and whatever the base. There is no way the corporate tax changes will pay for much in the way of infrastructure.

Article content

How should the U.S. pay for its infrastructure plan? We are not prescribing any policy advice, but it seems the country needs to have a debate on revamping the tax system in a way that doesn’t distort the incentives to work and invest. That could mean adopting a value-added tax or a type of goods-and-services tax system as many other countries have done, which could raise revenues progressively (with generous credits for low-income households) and do very little to distort investment decisions. However, the political price would likely be too high. In Canada, implementing a GST was a smart choice, but came at the expense of Brian Mulroney’s federal conservative party popularity. There are also user fees, public-private partnerships, carbon taxes, etc., which have a place, but would not move the revenue needle as far as necessary to fund the intended spending ahead.

Bottom line: the proposed changes to corporate income taxes will likely not do too much damage, but the rates that ultimately get passed will be far below those in the current plan, and probably won’t lead to significant revenue generation, either.

Join me on Webcast with Dave on May 19 when I will be hosting my long-time mentor and legendary market strategist Don Coxe.  Learn more on my website:rosenbergresearch.com.