Key points

Introduction

The slump in global business investment growth over recent years has been particularly evident in advanced economies.


Source: Reuters, AMP Capital

In the US, business investment growth has been poor over the past two years. Over the long-term, business investment (as a share of GDP) is still tracking at moderate-high levels, but has recently fallen to its lowest level since 2012. Non-defence government investment is also running around record low levels (see chart above).

The need to lift business investment is around the requirement to replenish the capital stock as it becomes depleted, to improve growth in productivity and living standards.

An improving growth backdrop should provide a favourable environment for stronger business investment growth, but concrete signs of higher business spending are still mixed. Perhaps businesses are still waiting for even better growth outcomes before committing to large capex programs.

In the absence of improving business capex, there have been calls for corporate tax reform, with the argument now particularly prominent in the US. Theoretically, a cut to the corporate tax rate increases disposable income and therefore purchasing power. What is the empirical evidence around the impact of corporate tax reform? Does it indeed lift business investment?

Corporate taxes and business investment

We collated the statistics around OECD corporate tax rates and levels of business investment in 2015 (see chart below):


Source: Reuters, AMP Capital

At face value, there does appear to be some negative relationship between the corporate tax rate & business investment. Therefore, counties (like Ireland and Switzerland) that have low corporate tax rates have high levels of business investment. And countries with a high corporate tax rate (US and France) have lower levels of business investment.

Empirical studies around the impacts of tax rate changes are limited because of the difficulty in isolating tax reform from broader economic events. For example, good economic outcomes may lead the government to cut the tax rate because of a better revenue position. At the same time, a recession could prompt a cut to the tax rate to spur spending.

A 2016 Federal Reserve Board paper analysed the impact of state tax changes in the US between 1970-2010 and found that tax increases hurt employment and income but tax decreases have little effect generally on employment and income, expect for times during a recession.

A recent argument against a corporate tax cut is that the additional earnings will be distributed through dividends, as shareholders have become accustomed to higher dividend payouts over recent years.

The US tax system

The latest OECD corporate tax data indicated that total US profits are taxed at 39.9% at the headline level, which includes both federal (35%) and state & local taxes. Average OECD taxes are lower, at 24.7%, in 2016. In reality, the effective rate of tax paid by companies tends to be lower because of business write-offs and allowances, with estimates suggesting an effective tax rate of 25% for the S&P500.

Corporate tax reform is a key “to do” item on the agenda for US President Trump and for the Republican Party. The key items that have been discussed include:

  • A cut to the Federal corporate tax rate (currently at 35%). The initial Republican Party proposal suggested a 20% tax rate and Trump is now suggesting a tax rate “between 15% to 20%”. Currently, it appears that this policy has the best chance to be pass in Congress
  • Introduce immediate write-off of capital investments, rather than capitalising and depreciating these investments over time
  • A change in net interest expense deductibility to equalise treatment of debt and equity financing
  • Cut the taxation of US offshore earnings brought back onshore and introducing a one-time transition tax of “up to 10%” on these repatriated funds, payable over a number of years
  • A border tax adjustment which is an additional tax on importers and (ultimately) a tax rebate to exporters to encourage domestic production
  • Lower regulation, but the actual details on this are less clear with Trump saying he would get rid of “75% of regulation”

A number of these policies could push up the value of the US dollar as investors price in higher expectations for inflation and US exports which would offset some of the positive impacts to exports. Impacts of the border tax adjustment are suggesting that the US dollar could appreciate by around 25%, if the corporate tax rate is cut to 20%.

The other key issue is around how much debt will lift on the back of these taxation changes. The US Tax Policy Center have estimated that the corporate tax policy changes would decrease government receipts by ~$890bn over the next decade which equates to around 0.3% of GDP per year. This doesn’t include any potential changes to personal income taxes and infrastructure spending, which are also key priorities for the new US administration.


Source: Reuters, FRED economic data, AMP Capital

A large increase in government debt (which is already elevated) could lead to higher interest rates and therefore a tightening in financial conditions, which would be detrimental to private investment.

What else is needed to lift business investment?

The uptick in global manufacturing PMI’s is a positive sign of an improving outlook for business investment and it appears that the worst is now behind us for the capex cycle. Corporate tax reform is one tool to lift long-term business investment. But, there are also other factors which may be required for better business investment:

  • Better corporate earnings. Earnings growth and earnings expectations are lifting, at least in the US and in Australia which is a positive sign that the nominal income recession is over. Rising inflation tends to be a good sign for corporate earnings
  • Lower business hurdle rates which haven’t dropped by as much as expected, given how low interest rates are
  • Better confidence about the economy, with businesses normally citing better consumer spending as a sign of better future growth prospects

Another point to keep in mind is that business investment in the advanced economies may be stuck in a structurally lower level for a while because of the increased significance of the service sectors. Service sectors tend to require less investment, compared to the traditional industrial sectors of an economy.

Implications for investors

Markets have priced in an expectation that US corporate tax reform will be positive for US growth and will lift inflation. While the evidence on the actual short-medium term impact of corporate tax cuts is still mixed, any backing away from this will be detrimental to equity markets and growth expectations.

Trump’s focus on improving production and income for US domiciled companies means that investors would benefit from being overweight to corporates with sizeable US earnings or above-average effective tax rates. Investors could also maintain exposure to sectors that benefit the most from a corporate tax cut (see chart below). Banks, consumer staples, consumer discretionary and telecommunications companies currently incur above-average tax rates and could therefore benefit the most from a lower tax rate (see chart below).


Source: BofA Merril Lynch Global Research, company data, Bloomberg

It is also important to keep a close eye on the US dollar. A significant appreciation in the US dollar, because of expectations for higher growth, inflation and interest rates, could put a halt on a rebound in earnings and growth for exporters.

By Diana Mousina
Economist, AMP Capital

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