A lot of the latest puff in the US stock market is based on the expectation of a big cut to US corporate taxes. But in a competitive capitalist economy any profit boost should be short-lived, with benefits passed on to customers. Or should it? A look overseas and at the top companies in the S&P 500 gives some insight into what to expect.
I’m not going to go into how much US corporate taxes may, or may not, be reduced once Trump and co. have wrestled with Congress. That’s been covered extensively by others. I’ll just note that the plan is to reduce the top (federal) rate from 35% to 15%.
Instead I want to look at whether lower corporate taxes actually lead to higher corporate profits. Specifically, whether they boost either post-tax profit margin or return on equity.
That may sound counterintuitive. Surely lower taxes mean higher profits? And yes, they probably do in the short term. But in the end good business is all about making an acceptable return on invested capital, in competition with others.
Any decent CFO of a large company knows this, and if he doesn’t he should be fired. And if he can’t persuade the CEO of its importance then he should resign. Top management’s main job should be getting the best return on capital for shareholders, over time.
For their part shareholders have an idea of how much return, as an annual percentage, they want to make on their investment. In financial jargon this is known as the “cost of equity”, and amounts to the combination of capital gains (stock price rises) and dividends. It’s what they want to make for the risk they take.
Corporate managements – sometimes assisted by consultants – usually have a fairly good idea of what returns they need to make to keep the markets happy. This applies to both existing businesses and new projects.
And here’s the crux of it. If the tax rate falls, and nothing else changes, the profit rises, lifting return on capital with it. But XYZ Inc.’s cost of capital hasn’t changed, and neither has that of its competitors, each hungry for more market share.
In other words the prices of products can fall after a tax cut and companies will still make a sufficient return. In a competitive capitalist economy this is what you’d expect to happen. It’s the customers who should benefit from the lower taxes, not the companies.
Of course the competitive price adjustments would take a bit of time, perhaps several years. But they’ll only happen at all if there’s plenty of competition in the first place.
What happens if you’re living in an economy dominated by monopolies where one company controls each sector, and oligopolies where a small group of companies controls each sector? Won’t the lack of competition mean unaffected customer prices, and a big lift to the bottom line from the tax cuts? Is this the situation in the USA today?
I’ll come back to that. But first I want to look at other countries. After all, at 35% the US has one of the highest corporate tax rates in the world.
How do tax rates affect profits in other countries?
As I’ve pointed out before: “The US’s federal corporate tax rate of 35% puts it in a country club that includes these members: The Democratic Republic of Congo, Chad, Argentina, Equatorial Guinea, Zambia, India, France, Brazil, Belgium and Venezuela.”
That’s not exactly auspicious company, to say the least. And I haven’t even included US state level taxes. But anyway, to try to see if tax rates matter I compared profitability levels of companies in the US stock market with a range of other places in the world.
The list isn’t comprehensive, but they’re all wealthy places. Tax rates range from 35% in France down to just 12.5% in Ireland. Note that these aren’t the actual rates paid after deductions, just the top marginal rates.
Below is a chart that compares tax rates with return on equity, or RoE.
I don’t know about you, but I can’t see much of a relationship there. Hong Kong and Singapore have low taxes but similar RoE to high tax France and Germany. Sweden pays higher taxes than Switzerland, but Swedish companies make a much higher RoE.
About the only thing that stands out is the USA. It currently has a really high RoE, despite its high tax rate. It’s not down to low interest rates in the US, as debt is even cheaper elsewhere. But it could be down to extra leverage being used to goose up returns on equity. However, in a market economy those excess returns should be competed away.
Next is a chart that compares tax rates with net profit margin.
It looks like there’s a clearer relationship here. Lower tax countries tend to have higher profit margins, at least in this group. This makes sense in a global economy. If a Swiss company paying Swiss taxes can sells its Swiss made products in Germany, at German market prices that reflect taxes on German companies, then profit margins will be boosted.
Lower corporate taxes shouldn’t do much for domestic profits, but can add competitive edge when up against foreign competition in global markets. This is when products are exported from low tax to high tax jurisdictions, to compete with high tax producers.
But again, the US is an outlier here. Its profit margins are similar to low tax Ireland’s even though its taxes are above low margin Japan’s. So what’s going on, and is it likely to last?
Obviously each country’s stock market has a different mix of businesses. Is there something that makes the US unique, apart from its size? Most obviously it has a very successful technology sector that has taken a bigger share of stock market capitalisation over time.
This next chart shows how much of the S&P 500 index’s market capitalisation came from each sector since 1991. It’s a little difficult to read, but you can see that technology is now the largest sector, at around 20% of the market’s value.
A lot of tech companies – especially online ones like Alphabet (Google) and Facebook – need relatively little capital. And if they get to scale ahead of competitors they can find themselves with a strong protective moat and the fat profit margins that follow.
Big company profits up close
I can’t look at profit margins for all of the S&P 500 index, let alone the whole US stock market. But I reckoned that a close look at just the top 10 companies might shed some light. After all, just these 10 giants make up over 20% of the S&P 500’s market capitalisation.
Here’s a list of those companies, a brief description of their main businesses, and their weightings in the S&P 500.
And here are their post-tax profit margins in 2016, from largest to smallest.
Add together all the 2016 revenues of these 10 companies and you get just shy of US$1.3 trillion. Net profits were US$174 million. In other words the post-tax profit margin of this group was 13.5%, well above the 8.8% for the market as a whole. This lends weight to the oligopoly/monopoly thesis.
But clearly they’re not all getting storming results. Amazon, after all this time, doesn’t really make any money at all. Facebook makes gobs of it. Apple, due to its sheer size, makes 26% of the net profit of this group of 10.
Because it’s so big Apple is worth a quick comment. The maker of fashionably fruity phones continues to defy the typically tight margins of hardware producers. That said, it’s worth noting that net margin was 15% in 2007, peaked at nearly 27% in 2012 and has since slipped back to 21%.
(The net margin at Samsung Electronics is 10%. And the less said about cell phone wonder stocks of the past, such as Nokia and RIM/Blackberry, the better…Oh, and Apple stock did very little between 1980 and 2003, but everyone has long forgotten about that…)
Can these mega-profitable companies keep it up, with or without tax changes? Will lower taxes give them anything more than a short term boost? Or will market forces eventually get the better of them either way?
Each company merits a long discussion in its own right. So I’ll just leave you with a table that (very) briefly outlines what I think gives these companies a moat against competition, and where potential threats could still come from.
Corporate tax cuts have offsetting factors, but evidence from looking at markets outside the US suggests there is some benefit. At the same time US companies already have unusually high profitability, both against their history and versus other countries.
Can it go on? We will see. But I have my doubts.
Stay tuned OfWealthers,
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