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This report examines whether the Trump tax cuts (tax cuts and jobs act of 2017) impacted the US GDP. This report also includes a discussion as to why a lower tax rate may be beneficial for smaller firms, start-ups and why the stock market boomed after the act was signed.
This is not an examination of political policy, favoring one view or the other; this is purely a financial analysis to understand the impact of the 2017 tax cuts, to ascertain how a similar policy or an opposite policy may impact the GDP and the stock market.
This report utilizes the annual GDP growth figure to examine the impact of the tax cuts. Accounting and finance principles are applied for the discussion.
The annual average US GDP growth rate after the 2008 financial crisis, from 2009 to 2016, stood at 3.1%. However, after the implementation of the 2017 Tax cuts, the GDP growth rate jumped to 5.5% in 2018 (Reference); the growth rate had not reached a figure that high since 2006; for over a decade (12 years), the GDP did not hit a growth figure of over 5%, yet, after the tax cuts, it did. Another thing worth noting is that GDP is not a future indicator of the economy like the stock market. Aggregate productivity is the metric calculated by the GDP, not the perceptual expectations regarding the economy, which the stock market may reflect.
Due to a massive economic decline caused due to Covid, we couldn't examine the extended impact of the tax cuts, nonetheless. But, arguably, if we did not suffer a global pandemic, the tax cuts may have positively supported the GDP figure, or, at the very least, extended the last inning of the business cycle, as many financial analysts around 2018 assumed that we were in the final inning of the business cycle.
We can, therefore, claim that there is evidence that the GDP positively responded to the tax cuts, and, arguably, if the Covid pandemic hadn't hit economies around the world, the tax cuts would have further supported the economy positively (reasons elaborated below). In addition, the stock market, which is considered a leading indicator of the economy, did indicate a positive reception by the market.
However, contention exists amongst economists on this subject; the debate on the tax cuts between supply-siders (politically right leaning) and demand-siders (politically left leaning) rages on, with economists bringing their predilections to the debate at times, rather than purely basing their opinions on data and empirical evidence. It thus also depends on whom you ask; their viewpoints may be 'colored,' based on their political leanings and the biases brought to the discussion. Sometimes, economists' responses can also be predictable; for example, if you know the political affiliation of an economist, deducing 'how they may see the 2017 tax cuts and the impact of the act' can be elemental.
Why did the stocks boom after the 2017 tax cuts? What are the logical arguments supporting tax cuts?
Arguably, as tax cuts reduce the corporate or business tax burden, they should, in an efficiency-seeking organization, make more capital available as retained earnings for the organizations; this should enable firms to invest a portion of this capital without an associated cost of capital in avenues that otherwise wouldn't be tax-deductible, etcetera.
Thus, tax cuts should provide two levels of savings: 1. The apparent tax savings, 2. The elimination of the cost of capital for using retained earnings for investment projects for future growth, eliminating the need to borrow, and increase liabilities, or raise capital through equity finance, i.e., preferred shares or secondary offerings, which can be expensive due to high fees of underwriters and brokerage houses, for public or private placements (brokerage fees, flotation costs, etcetera), which, though lower than an IPO, can still be considerable.
Using retained earnings is the preferred method for organic growth, as it reduces or obstructs reliance on external parties for raising capital.
Furthermore, this may also be an impeding factor for smaller firms that don't have access to capital markets or may have to bear substantial interest expenses to raise capital due to lower credit ratings. Such firms, due to this barrier, may not invest at all, in projects that may have been viable with a lower cost of capital, thus limiting the growth perspective of these smaller, weaker firms.
As we can see in this rudimentary example above, lower tax rates increase the amount available for a business to reinvest, which is the simple example above, is around 21% higher, or $7 higher. Additionally, if the firms had to borrow this money externally, with a 10% cost of capital, it would need to further pay 70 cents per year, which, over 10 years, would accumulate to $7, a substantial sum for this hypothetical simple business, but, of course, in real world examples, these savings are likely to very substantial figures. Thus, the reduction in the two costs, the cost of raising capital externally and the cost of the tax outflow, work together to reduce the entity's profits.
Tax cuts, especially for smaller firms, firms in competitive industries, and firms with low operating margins, increase retained earnings and should enable these smaller firms to organically grow with significantly lower cost of capital compared to raising debt finance with a lower, junk grade credit rating, for example. While this may not be a problem for the Amazons (AMZN) and the Apple's (AAPL) of the world who have sufficient earnings and cash assets for investing in new projects, but it is a very real problem for smaller firms, firms in competitive industries, and firms with low operating margins.
Firms cannot deduct the cost of investment that has a multi-year life span in one year and are required to depreciate, amortize, or deplete the costs over time; thus, they cannot lower their taxable income through deduction of the entire outflow for the investment that has a multi-year life span. Even if this was a possibility, claims of profit manipulation, etcetera, would arise, maligning the character of the management.
Another important point worth mentioning here is the high debt to equity ratio of firms, causing reluctance in management regarding further increasing the debt level. For example, a firm may have a high debt to asset ratio of 65% (debt value being $65 for $100 total assets), the management may be unwilling to take on further debt, due to cumbersome debt covenants, or the concern that further debt may increase solvency ratios and increase the overall solvency risk associated with the firm, which would then increase the risk associated with the equity of the firm.
Shareholders may then demand higher returns, considering the increased level of risk. If the firm is unable to increase returns to shareholders in this situation, with a higher level of risk, and returns that did not comparatively increase, many shareholders, logically, would sell the stock to acquire an alternative stock that provides the same level of returns with a lower level of risk.
In this condition, if the tax rate is reduced, the management may use the excess retained earnings to invest in projects that they wouldn't otherwise, due to the factors mentioned above.
The stock market did see a boom after the 2017 tax act. The corporate tax rate dropped by 40% (35 to 21 percent) and retained earnings and profit-reinvestment rates were expected to rise, increasing the future earnings expectations, which resulted in an asset price boom.
Had the Covid pandemic not hit the global economy, arguably, due to the tax cuts, we may have seen further productivity improvement, especially from smaller firms as their reinvestment should have increased. Smaller firms cannot hire a brigade of lawyers or conduct international mergers and acquisitions to reduce their tax liability, like larger corporations can. This effect, thus, may have been a strongly positively one for smaller firms, start-up, and family businesses, i.e. increases in productivity, logically, for such firms should have substantially improved.
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