Saturday, September 2, 2017

The Relationship Between Corporate Profits And Investment Is Zero

The details of the tax plan that is being debated by Republicans have not been determined.  However, it is clear that the final plan will call for a cut in the corporate tax rate.  The rationale for cutting the corporate tax rate is that it will increase corporate profits.  It is assumed that corporations will invest the additional profits.  That would be a good idea if there were a positive relationship between corporate profits and the level of investment.  The graph below shows that there is no positive relationship between corporate profits and corporate investments.  The profits can also be used for stock buybacks and to increase dividends payouts.  Stock buybacks increase the stock price by reducing the number of shares outstanding.  CEO's tend to manage the stock price for two reasons. Their performance and their bonuses are strongly influenced by increases in the stock price.  Moreover,  their compensation plans typically pay out less in salary than they do in stock options.  Since they are large holders of stock they also benefit from dividend payouts which are taxed at a much lower rate than their salaries.  A higher stock price also lowers the cost of acquiring another firm which typically involves swapping your stock for the acquired firms stock.  Acquisitions also tend to increase the stock price since the combined firm will have larger revenues and profits as soon as the acquisition is completed.  The return on capital investments is less certain and the profits may not be realized for several years.  The average tenure of a CEO is around seven years.  Capital investments could be more reliably increased by changing the form of CEO compensation than by cutting the corporate tax rate.

The blue line in the graph shows corporate after tax profits as a percent of GDP.  The red line is corporate fixed investment as a percent of GDP.  The relationship between profits and investment is pretty random.  After tax profits were low in 1980s because taxes were high, but investment was higher during this period than they were after the tax rates were lowered.

This does not mean that we should not reform corporate taxes.  The current system creates an incentive for corporations to engage in tax avoidance strategies by shifting their profits to tax havens. It also encourages corporations to borrow money to pay out dividends because interest payments are tax deductible.  That rewards current stockholders while lowering the effective tax rate.

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