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How Obama's Balanced "Tax-Loophole" Closing Will Crush S&P Earnings

Following today’s sequester-delay-seeking, tax-hiking, close-the-loophole speech by the President, it would appear that fiscal policy debates will be balanced a little more to raising effective rates on corporates (as opposed to the ‘statutory’ rate so many discuss). The US has the second highest global ‘statutory’ tax rate but less than 10% of S&P 500 firms have paid this rate over the last decade. Somewhat shockingly, since 1975, taxes have had the largest cumulative impact on S&P 500 ROE as effective rates fell from 44% to 30%. They estimate each percentage point rise in effective tax rate would lower S&P 500 ROE by 22 bp and EPS by $1.50, all else equal. Closing all the loopholes would smash year-end 2013 expectations from Goldman’s 1575 to around 1300 with Staples and Tech the hardest hit. With the ‘market’ the only policy tool left, it would seem not even the Fed could monetarily save us from this fiscally fubar action. 

 

Via Goldman Sachs,

Political dialogue in Washington, D.C. has turned squarely to the nation’s fiscal health. The temporary resolution of the ‘fiscal cliff’ focused mainly on raising revenues through changes to personal tax rates, but delayed decision-making deadlines on the sequester and the long-term path of Federal spending.

Corporate tax rates will likely receive scrutiny as the debate continues. Corporate taxes contributed 8% of 2012 federal revenues. A recent Congressional Budget Office report suggested that policy adjustments such as eliminating foreign tax deferrals could increase US tax revenues by as much as $100 billion over the next decade.

President Obama and Democratic leaders continue to focus on raising revenues. Corporate tax rates represent a logical next step following successful year-end negotiations that raised personal taxes. In his January 5th radio address, President Obama maintained that “spending cuts must be balanced with more reforms to our tax code. The wealthiest individuals and the biggest corporations shouldn’t be able to take advantage of loopholes and deductions that aren’t available to most Americans.”

The debate will be fierce as Republican leaders emphasize spending reductions. In an attempt to focus on cutting mandatory government spending through entitlement reform, Senate Republican Leader Mitch McConnell recently summarized the right’s view, stating “The tax issue is finished, over, completed. That’s behind us. Now the question is, what are we going to do about the biggest problem confronting our country and our future? And that’s our spending addiction. It’s time to confront it.”

The United States has the second highest statutory corporate income tax rate among OECD countries, at 39%. This rate combines the 35% federal rate with a weighted average of state corporate marginal income tax rates. Among developed countries, only Japan has a higher statutory combined rate (40%). Furthermore, although most developed countries primarily employ a territorial system, levying corporate taxes on income earned within their borders, US tax policy includes all income of domestically-incorporated multinational companies, regardless of origin, while allowing deferrals and tax credits in certain cases.

However, statutory rates do not reflect the effective taxes paid by large-cap US firms. For the last 45 years, the median S&P 500 firm has paid an effective tax rate averaging more than 5 percentage points below the statutory rate. Despite statutory rates hovering near 39% for the last 25 years, effective tax rates have been gradually decreasing (see Exhibit 2). At 30%, the current S&P 500 median effective tax rate is almost 10 percentage points below the statutory level, and close to the global statutory average. The aggregate tax rate has averaged 33% over the past 10 years and was 26% over the past four quarters.

The distribution of S&P 500 company median tax rates over the last 10 years indicates that fewer than 10% of firms pay at least the statutory rate. Exhibit 3 shows the median ratio of taxes paid to pre-tax income over the last 10 years. The average firm paid an effective rate of 31% with a standard deviation of 7 percentage points. The median tax rate over the past three and five years equals 31% and 30%, respectively.

The tax preferences that create the gap between effective and statutory rates will likely receive scrutiny from policymakers as they attempt to reform the tax code. By closing the gap between effective and mandated tax rates, the government could raise revenues while lowering the statutory rate, thus presenting the change as a tax cut. Democratic leaders, including President Obama and Minority Leader Pelosi, have specifically mentioned targeting corporate tax strategies that create this gap.

Changes to tax rates could have meaningful implications for corporate profitability. Since 1975, tax rates have had the largest cumulative contribution of the five DuPont factors to S&P 500 index ROE (ex-Financials). The majority of this 551 bp contribution was generated in the 1980s when President Reagan cut statutory rates from 50% to 39%. In the last decade, taxes have had a positive but much smaller impact, contributing 118 bps of the 534 bp ROE expansion through 3Q 2012.

We estimate each percentage point rise in aggregate effective tax rates would lower S&P 500 ROE by 22 bp and EPS by $1.50, all else equal. Exhibit 5 shows the sensitivity of index ROE and our 2014 EPS forecast to tax rate changes. For example, a 4 percentage point rise in aggregate tax rate from the trailing four-quarter rate of 26% to 30% would lower current S&P 500 ROE from 16.1% to 15.2% and would reduce our 2014 forecast EPS from $114 to $107. Applying a constant P/E multiple, our year-end 2013 valuation forecast would decline by roughly 6% to 1483.

Effective tax rates vary widely across sectors. Exhibits 6 and 7 show the distribution of tax rates for S&P 500 sectors during the past decade and the potential impact of changes in effective tax rates to sector ROE, respectively. Among other reasons, tax rates and ROE sensitivity vary due to differences in geographic revenue exposure, capital structure, and the applicability of various tax preferences. Details of any corporate tax code changes, not just the size of the change, will determine the specific profitability impact on each sector and company. For example, Information Technology and Health Care firms paid the lowest median tax rates over the past decade, despite having vastly different foreign revenue exposure (59% and 22% of 2011 sales, respectively).

Energy pays the highest effective tax rate among S&P 500 sectors despite being frequently cited as an example of corporate tax preferences. House Minority Leader Nancy Pelosi recently highlighted ending “special subsidies for big oil” as an opportunity for increased government revenues. However, in part due to excise taxes on the sale of oil products, the Energy sector has paid the highest median tax rate during the last 10 years. In the first three quarters of 2012 the sector had the largest aggregate dollar amount of taxes and highest tax rate ($67 billion on $166 billion of pre-tax income, or 40% tax rate).

 

Source: Goldman Sachs

Guest Post: Congratulations Charlottesville, Virginia! The First City To Pass Anti-Drone Legislation

Via Michael Krieger of Liberty Blitzkrieg blog,

This simple piece of legislation proves that you can make a difference at the local level.  We need a lot more of this type of thing all over these United States.  As I have said many times, it’s not that I am against drones in all capacities; however, we must be vigilant about how these things are used and must have serious safeguards in place to protect civil liberties.  Kudos to the Rutherford Institute for leading the charge here.

From US News:

Charlottesville, Va., has become the first city in the United States to formally pass an anti-drone resolution.

 

The resolution passed by a 3-2 vote and was brought to the city council by activist David Swanson and the Rutherford Institute, a civil liberties group based in the city. The measure also endorses a proposed two-year moratorium on drones in Virginia.

 

Councilmember Dede Smith, who voted in favor of the bill, says that drones are “pretty clearly a threat to our constitutional right to .”

 

“If we don’t get out ahead of it to establish some guidelines for how drones are used, they will be used in a very invasive way and we’ll be left to try and pick up the pieces,” she says.

 

“With a lot of these resolutions, although they don’t have a lot of teeth to them, they can inspire other governments to pass similar measures,” she says. “You can get a critical mass and then it does have influence. One doesn’t do much, but a thousand of them might. We want this on [federal and state lawmakers’] radars.”

Full article here.

"Brace For A Stock Market Accident", GLG Chief Investment Officer Warns

Authored by Jamil Baz (CIO, GLG), Originally posted at The FT,

Brace For A Stock Market Accident

Profits and leverage are locked in a deadly embrace

There is a time-honoured tradition in statistics: whipping the data until they confess. Bullish and bearish equity analysts are equally guilty of this practice.

It would seem that statistical conclusions are merely an ex-post justification of a long-held prior belief about equity markets being cheap or overpriced. Clearly, consensus, notably among sellside analysts, is bullish. I present the bullish view before discussing a bearish counterpoint.

The difference between equity and bond yields – also known as the equity risk premium – is therefore close to 10 per cent. This is way above the 4-5 per cent premium required by investors to own equity, and therefore indicative of an ultra-cheap equity market.Who can blame the equity bullish consensus? Earnings yields – a proxy for real equity yields – stand at comfortably high levels. For example, the forward earnings yield on the S&P 500 is 8.3 per cent.

Contrast real equity yields with real bond yields: with the US Consumer Price Index at 1.7 per cent and the nominal Federal Reserve funds rate at 15 basis points, real bond yields are at -1.55 per cent.

There are two reasons why this consensus is misguided. First, because it uses dubious metrics. It is wiser to use a long-dated real bond yield because equity is a long-dated asset.

And forward earnings yields are misleading for well-documented reasons: analysts’ earnings consensus forecasts are known to be wildly optimistic; in a bid for juicier equity and call option compensations, managers encourage their accountants to inflate earnings numbers; and earnings are partially squandered by managements as they seek to prioritise growth over profitability.

So it is probably a good idea to use dividend-based – as opposed to earnings-based – equity valuation models. Unlike earnings, dividends do not lie.

Second, because consensus disregards leverage. Profits and leverage are linked (in a deadly embrace, it turns out). If deleveraging is yet to happen, then earnings growth can only be headed south.

So what if you trust dividends more than forward earnings? In a simple dividend discount model, the real equity yield is the sum of dividend yield and real dividend growth. The S&P dividend yield is 2.15 per cent. The real dividend growth has been historically 1.25 per cent.

The real 30-year yield is 0.4 per cent. Using these numbers, the equity risk premium is now 3 per cent, less than the premium level deemed acceptable. But we are not done yet, as we have not factored leverage into our equation.

Enter Michal Kalecki, a neo-Marxist economist who specialised in the study of business cycles and effective demand. Mr Kalecki showed that profits were the sum of investments and the change in leverage.

In the current environment, the implications of this equation are clear: in G7 economies, total debt is at a record 410 per cent of GDP. And this is excluding the net present value of social entitlements and healthcare expenditures, which is larger than the total debt.

Because leverage stands at unsustainably high levels in advanced economies, it should fall substantially over the long term, affecting profits negatively.

It can be assumed conservatively that the total-debt-to-GDP ratio needs to fall by 100 per cent before the debt position becomes sustainable in advanced economies. This would bring the US back to 1995, when the profit-to-GDP ratio was 45 per cent lower.

We can value the S&P under the following scenario: dividends fall by 45 per cent over a zero-growth period of 10 years. Then they resume their real growth of 1.25 per cent per year. Again, assuming a real yield of 0.4 per cent and a required risk premium of 4.5 per cent, fair market value is only one-third of current market levels.

Leverage is hence the fly in the ointment, begging the obvious question: when does the deleveraging take place? Answering this question is tantamount to timing the next major bear market. It is, of course, futile to predict a date, but as economist Herbert Stein used to say, if something cannot go on for ever, it will stop.

It is increasingly obvious that governments will take no active step towards deleveraging unless they are under the gun. But there are institutions and mechanisms that will trigger deleveraging, namely: Basel III, the bond market, default and, rarely, courageous politicians.

Inflation can also help delever, except in economies where social entitlements are inflation-indexed.

In the short term, it is clear that central banks need to entertain the illusion of viable stock market valuations by pulling rabbits from a hat. But as high-powered money reaches ever higher levels, the probability of accidents looms large.

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