Upon absorbing our financial news in a yoctosecond, what would most baffle a highly evolved investor from planet Zog? Certainly the taxing of companies. Why do it, the alien would immediately ask? Doesn’t make sense.
Too right, green fella — the only logical corporate tax rate is zero. Wages and thus income tax receipts would adjust upward. So too money flowing into government coffers from bigger dividends and capital gains. People would spend more with consumption taxes yielding higher revenues. Myriad distortions and inefficiencies vanish.
Good luck convincing us this year, however. The UK government is raising the tax rate in April from 19 to 25 per cent for companies with annual profits of more than £250,000. Over in the US, companies are about to pay a new tax on buybacks, while lawmakers have signed off a minimum rate of 15 per cent for large firms.
Should earthlings care? Sir James Dyson certainly does. The maker of space-age home appliances flew into orbit over corporate taxes last week, fuming that businesses were “targeted to pay ever higher tax bills”. Advertising supremo Sir Martin Sorrell said the next day that cuts were needed.
Most company bosses tend to be more terrestrial on the matter, though. Some chief executives in Britain have said they are just happy for some stability around corporate taxes, after four different policy announcements in the past 12 months.
One reason for a reluctance to speak out is that companies are generally seen as fair game when it comes to taxes. It looks much better on television to target the global headquarters of a faceless mega-firm than a hard-up family with bills to pay.
And therein lies the problem. Dyson was correct when he said politicians seem to think “penalising the private sector is a free win at the ballot box”. Except it isn’t. Companies are not faceless at all. Their staff have faces. Their customers have faces. So do employees of their suppliers.
And investors have faces too. What politicians around the world fail to understand is that companies do not exist as such — they are nothing but a series of trade-offs between four groups of humans: staff, customers, suppliers and investors.
Companies do not generate tax. Only people can do that. So when governments raise the burden on firms, what happens? Either the return to investors is reduced in the form of lower dividends or capital appreciation. That hurts the millions of retirees and readers of this column.
Or a company can increase the prices customers pay for its goods or services. Or it pays less to suppliers — merely shifting the pain on to their employees, investors and suppliers. Or wages can be cut or employees laid off.
Not much fun. And yet it is popular to hit companies with taxes. Everyone should read a 2020 working paper from the National Bureau of Economic Research, which estimates that almost one-third of any rise falls on consumers via higher prices, roughly the same “tax incidence” suffered by investors. Employees cop almost 40 per cent of any increase.
Which is why our alien friend wouldn’t understand why politicians are raising corporate taxes while at the same time expressing shock at the tens of thousands of job cuts being announced recently — from big tech and retailers to Wall Street banks. Don’t homo sapiens do irony?
For investors, meanwhile, corporation taxes should also hurt in theory. As I’ve mentioned, equity and bond holders shoulder some of the burden, along with workers and customers. In practice, however, a higher rate is nothing to worry about.
For example, equity strategists at BMO Capital Markets have looked at the past five tax hikes in the US, going back to 1945. The average return of the S&P 500 in the calendar year of each raise was 13 per cent, with no negative readings. By contrast, on the seven occasions corporate taxes were lowered, the average return was 5 per cent.
Likewise, longer periods are unaffected. The average annual return of 10 per cent across the years when corporate tax rates were below 35 per cent is the same as in regimes when they were above 50 per cent (mostly in the 1950s and 1960s). Profitability metrics and earnings growth rates are oblivious to tax changes too.
Why don’t corporate taxes seem to matter for investors? Partly because employees and customers share the pain. We also know that companies are adept at dodging tax. General Electric filed a 57,000-page return in 2011 and concluded it owed the Inland Revenue nothing. The effective rate of tax in the US (what is actually paid) is about half the official 21 per cent rate — in the UK it is about a fifth lower than the official rate. A third of Australian large companies paid no tax in 2021, according to Tax Office data.
Most importantly, however, there are bigger drivers of returns for companies than tax. Economic growth, competition, technological change, strategy, input prices and so on simply matter more.
Therefore I’m not going to sell my UK equity fund ahead of the corporate tax rise this year. Nor will I reduce my exposure to US stocks — which did amazingly over the decades when America had the highest rate in the world. Good equity analysts keep the effective tax rate in their long-run valuation models constant. It’s just not important.
But my alien friend and I will cheer and invest in sectors that manage to minimise what they pay in corporation taxes — without an iota of guilt. We both know any savings flow to the government in other ways, via people, and hope that politicians spend the cash wisely. But that’s a topic for another day.