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Tariffs, Protectionism Might Hinder Corporate Spending

Tariffs, Protectionism Might Hinder Corporate Spending

Tuesday, 05 June 2018 08:32 AM Current | Bio | Archive

Corporate Finance 101: Repatriated Earnings. Put on your diving suit. We are going to see how the 2017 Tax Cuts and Jobs Act (TCJA) affected corporate finance developments during Q1-2018. We will take a deep dive into the latest data. On May 30, along with the first revision in Q1 GDP, the Bureau of Economic Analysis (BEA) released lots of pertinent data showing the impact of the TCJA on corporations. Here are the key takeaways:

(1) Tax rate on repatriated earnings. Let’s start with the BEA’s explanation of “How does the 2017 Tax Cuts and Jobs Act affect BEA’s business income statistics?” Despite its broad title, it focuses only on the taxation of repatriated earnings under the TCJA.

The BEA reports: “The tax rate is 15.5 percent on earnings held in cash and cash equivalents and 8.0 percent on earnings held in illiquid assets. Parent corporations may elect to pay this tax in prescribed installments over a period of eight years.” It’s a one-time tax on foreign earnings built up since 1986 that applies whether or not earnings actually are brought back home.

(2) No impact on NIPA current accounts. The BEA observes that in the National Income and Product Accounts (NIPA), the tax is classified as a one-time capital transfer from business to government. The BEA explains: “It is effectively a wealth tax in economic accounting terms. The one-time capital transfer affects net lending/borrowing of business and government, resulting in a redistribution of net worth from business to government but not affecting any measures in the current accounts.” (See NIPA Table 5.11U Capital Transfers Paid and Received by Sector and by Type.)

(3) Recorded during Q4-2017. The BEA currently estimates that the one-time tax amounts to $250 billion at a quarterly rate. It was all recorded (in its entirety) on an accrual basis in Q4-2017 (though at an annual rate of $1.0 trillion, which confounds us). Melissa and I reckon that this tax estimate implies that repatriated earnings amount to around $1.5 trillion, assuming that most of them are held in liquid assets.

(4) New territorial system. Prior to the TCJA, the overseas earnings of US multinationals were taxed under a “worldwide system.” They were taxed at the statutory US corporate tax rate. However, the taxes were deferred until the profits were repatriated to the US.

Under the new modified “territorial system,” the good news is that profits earned abroad are no longer subject to the statutory rate (which was slashed from 35% to 21% by the TCJA). The bad news is that you need an international tax accountant to decipher the BEA’s oh-by-the-way explanation of what the ongoing taxation of future earnings derived from abroad will look like, as follows: “The Global Intangible Low-Taxed Income tax (GILTI) is a minimum tax on the excess income of foreign subsidiaries over a 10 percent rate of return on tangible business assets. The Base Erosion Anti-Abuse Tax (BEAT) is effectively an alternative minimum tax applied to companies with excessive interest or services payments to related parties.”

(5) Welcome home. While the BEA jammed the wealth tax transfer effect of the TCJA on repatriated earnings into Q4-2017, the actual estimated amount of those earnings showed up in NIPA as “dividends receipts from the rest of the world.” It shot up from $349.0 billion during all of last year to $1.36 trillion (saar) during Q1-2018 (Fig. 1). Dividend payments received from abroad less paid abroad has been running between $100 billion and $200 billion (saar) in recent years (Fig. 2). It jumped to $1.19 trillion during Q1. (See NIPA Table 4.1 Foreign Transactions in the National Income and Product Accounts.)

Corporate Finance 102: Profits & Taxes. The cut in the corporate tax rate was reflected in the latest NIPA data. Pretax book profits (as reported to the IRS) edged up slightly during Q1-2018 to $2.14 trillion (saar) (Fig. 3). Interestingly, they’ve actually been stuck around this level since early 2012. After-tax book profits rose more as a result of the tax cut, yet also remain remarkably flat since 2012.

In any event, corporate profits taxes fell $117.3 billion from $445.5 billion (saar) at the end of last year to $328.2 billion during Q1-2018 (Fig. 4). That’s a 26.3% drop, reflecting the 40% cut in the federal corporate statutory tax rate. (The NIPA tax series includes taxes paid to other government entities in the US and abroad. The profits series includes profits of solely owned corporations but excludes their taxes, which are reflected mostly in personal income taxes!)

The BEA also computes a series called “corporate profits from current production” (Fig. 5). It includes two adjustments. The Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj) restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP (Fig. 6).

Profits from current production have been relatively flat on a pre-tax basis since 2012, much like pre-tax book profits. On an after-tax basis, they rose to a record $1.87 trillion (saar) during Q1-2018, thanks to a big jump in the CCAdj from -$97.6 billion during Q3-2017 to $152.2 billion during Q4-2017, and held steady around there during Q1-2018. Of course, the tax cut also boosted after-tax profits from current production.

Corporate Finance 103: On the Margin. Meanwhile, both S&P 500 aggregate reported and S&P 500 operating earnings rose to record highs during Q1-2018 (Fig. 7). Historically, there was a reasonably good correlation between the after-tax S&P 500 profit margin using operating earnings and the comparable NIPA profit margin (Fig. 8). However, they’ve diverged significantly since 2015, with the former rising to a record 11.9% during Q1-2018, while the latter has been volatile around 9.0%. We aren’t sure why this is happening, but we would put our chips on the S&P measure of the margin.

Corporate Finance 104: Cash Flow. Since NIPA is based on current production, the massive increase in dividends received from abroad (i.e., repatriated earnings) during Q1-2018 has no impact at all on net dividends paid by US corporations (Fig. 9). In another note, the BEA explains: “There is only a small net effect on the current account balance and no net effect on receipts of direct investment income because the full amount of U.S. direct investors’ share in the earnings of their foreign affiliates is reflected in direct investment income at the time that these earnings are earned, not when they are distributed to stockholders as dividends. Payment of dividends affects only the form in which direct investment income is received (i.e., as distributed versus as undistributed earnings) and not its overall amount. As the accounts are constructed, the change in form is almost entirely reflected as changes in financial account flows that are largely offsetting.”

In any case, NIPA dividends in corporate profits remain remarkably flat around $950 billion (saar), as they have for the past few years. As a result, undistributed corporate profits (including the IVA and CCAdj) rose to a record high of $888.7 billion (saar) along with after-tax profits from current production during Q1 (Fig. 10).

Corporate cash flow rose to a record $2.56 trillion (saar) during Q1-2018, boosted by undistributed profits as well as the CCAdj, which boosted tax-reported depreciation significantly, as noted above (Fig. 11).

Corporate Finance 105: TCJA & Capital Spending. Previously, Melissa and I have noted that the increase in capital spending in GDP over the past year through Q1-2018 has been remarkably unremarkable. It is up 8.1% in nominal terms and 6.8% in real terms (Fig. 12). Those are solid gains, but not as strong as suggested by the record high in the CEO Outlook index compiled by the Business Roundtable. More in tune with this index are the data for large public companies. As noted below, they suggest a much higher rate of increase in capital spending than the BEA data.

The TCJA certainly should boost capital spending now that much of it can be expensed immediately rather than depreciated over time for tax-accounting purposes. Melissa points out:

(1) 100% bonus depreciation. The TCJA includes two key provisions for businesses intended to encourage business investment. One is called the “100 percent bonus depreciation,” as a 5/30 Tax Foundation article discussed. It provides for the full and immediate expensing of short-lived capital investments, excluding some categories, for five years. Prior rules dictated that “short-lived” assets with a lifespan of 20 years or less were eligible for a 50% bonus depreciation. The act also increases the cap on Section 179 expensing to $1 million from $500,000, according to a 12/18/17 Tax Foundation analysis. Further lowering the cost of capital for businesses was the drop in the US corporate statutory income tax rate to 21% from 35%. J.P.Morgan observed in a note that allowing businesses to immediately deduct the full value of their capital expenses—instead of a years-long depreciation schedule—may encourage them to accelerate planned expansions and acquisitions.

(2) Big increase for big companies. Data from the S&P’s Howard Silverblatt including 94% of S&P 500 companies, according to a 5/17 Reuters article, showed that the growth in capital spending for Q1 was 21% y/y. That’s on track to be the highest y/y growth since Q3-2011. Silverblatt said: “These numbers are high, and I would expect higher numbers in capex this year. It takes a little bit longer for companies to plan and to execute.”

(3) More capex to come? In testimony before the House Ways & Means Committee on 5/16, in a panel on the effects of the TCJA, Emerson CEO David Farr discussed a recent survey of National Association of Manufacturing members. It reported that 86% of those surveyed were planning to increase investments because of the tax reform.

Corporate Finance 106: Protectionism & Capital Spending.

Of course, it may be that President Donald Trump’s protectionist saber-rattling is offsetting the stimulative effect of the 2017 Tax Cuts and Jobs Act (TCJA) as some companies hesitate to spend on big-ticket items with tariff threats hanging over their heads.

The Fed’s latest Beige Book implies that tariff concerns are affecting capital spending, although capital spending wasn’t the focus of most of the commentary. For the districts that did discuss capital spending, the impact of the tariffs on current projects and plans was quite mixed.

Let’s review:

(1) Atlanta. For the contacts in the Atlanta district’s transportation industry, “uncertainty over trade policy had not negatively impacted capital projects already underway.” However, “a number indicated that they have tapped the brakes on projects in the planning phases.”

(2) Boston. No manufacturing contacts in the Boston district “cited revisions to their capital expenditure plans.”

(3) Chicago. Imports slowed for manufacturers in the Chicago district “after the steel and aluminum tariffs were enacted.” Further, “contacts noted ongoing uncertainty about whether there would be further changes in tariffs policy.” Chicago agriculture contacts “expressed unease over the potential impact of international trade policies on the farming sector.”

(4) Cleveland. In the Cleveland district, contacts were concerned about future demand due to the tariffs. District manufacturers cited “uncertainty about future prices” as a reason that “finished goods inventories were down.” Further down the supply chain, some Cleveland district retailers noted that the “uncertainty surrounding tariffs on Chinese imports is a source of concern,” primarily for some retailers “that have operations overseas or use imported goods as inputs.”

(5) Dallas. Outlooks in Dallas “remained fairly optimistic, but tariffs and trade-related concerns were creating uncertainty.”

(6) Minneapolis. In the Minneapolis district, contacts in services industries “reported major disruptions in international supply-chain management” and in global import-export banking “due to uncertainty over trade policy.”

(7) Philly. The percentage of Philadelphia district manufacturing firms expecting increases in future capital expenditures is less than one-third. One primary metal manufacturer in the Philadelphia district attributed the current slowdown in orders to “customers waiting for clarity on the issue of steel tariffs.”

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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The Fed’s latest Beige Book implies that tariff concerns are affecting capital spending, although capital spending wasn’t the focus of most of the commentary
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Tuesday, 05 June 2018 08:32 AM
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