What is the corporate impact of tax reform?

Public Domain. Source: Wikimedia

The new tax law is on the books, and most people will be looking at their paychecks to see how the new rates will affect them personally. But the biggest impact of the law will be on corporate taxes. After all, going into 2017 there was a broad consensus that our highest-in-the-world corporate tax rates needed to be reformed, with a lower statutory rate and a broader base. That happened with this new law. But the devil is in the details, and there are a lot of details, here.

The biggest impact, that everyone knows about, is lowering the top statutory corporate tax rate from 35% to 21%. That puts the US rate in the middle of most other developed countries: higher than the UK and Germany, but lower than Japan or Italy. Corporate inversions, where US companies merge with a foreign firm to change their legal domicile in order to pay lower taxes, should stop. But there are other major changes.

Source: Bloomberg, Deloitte, Crains Cleveland

First, there are limits on how much interest expense can be deducted on a corporate tax return. In the past, companies could deduct an unlimited amount of interest expense from their tax bill. Now the deduction is limited to 30% of their adjusted gross income – with certain industries excepted. This is a radical change that could reduce how levered the US economy is – and affect how much risk corporate managers take with their balance sheets.

Second, operating losses can be carried forward, but only so much can be taken each year. Previously, when companies suffered big losses – as they did during the financial crisis – they could count on having effectively tax-free income for many years in the future. This can distort corporate decision making. Now those losses are limited to 80% of their taxable income. So we shouldn’t have the spectacle of giant companies like GE paying no taxes for years and years because of earlier, wrong-headed decisions. The losses can still be carried – but they can’t totally eliminate their tax burden. Everyone will have some skin in the game. There should be no free riders.

Finally, there are a lot of detailed provisions about R&D expense amortization and renewable energy tax credits and foreign earnings repatriation. These provisions will have the effect of lowering effective tax rates in the first year of tax reform and then raising them later. Under current law, the overall effective tax rate is about 21%. That will fall to 9% in 2018, then go up to 17% in 2023. And – as you might expect – this impact varies by industry.

Source: Wharton, Bloomberg

Banks and insurers currently pay a 26% effective tax rate. This will go down to 14%, then rise to 21%. Farmers pay a 30% rate, that will go down to 17%, then rise to 24%. Bankers and farmers are among the biggest winners. Technology companies pay a 22% rate now that will end up at 19%. Manufacturers pay 18% that just falls to 16%. IT and manufacturing don’t gain as much from the tax bill, but they don’t get hurt, either. In fact, while their effective tax rates don’t go down much, their actual tax savings are pretty big. Health care seems to do quite well, but their overall gains from the bill are small.

Details matter. Taxes matter. Lowering marginal rates across a broader base should lead to higher investment and more money paid both to employees and back to shareholders. There will of course be lots of partisan bickering – but that’s the world we live in.

Douglas R. Tengdin, CFA