Markets Would Struggle to Digest Corporate Tax Reform
Financial markets have been optimistic since the election of Donald J. Trump in the U.S., in part because investors assume that the incoming administration will pass some sort of business-friendly tax reform. But some of those reforms could hit investors in unexpected ways.
One plank of Trump's business-friendly tax reform, which Hillary Clinton proposed as well, entails giving multinational corporations a one-time chance to repatriate overseas cash at a lower tax rate. Some investors fear that this would create a large one-time tax payment that would suck liquidity out of financial markets.
U.S. corporations hold over $2.5 trillion in cash overseas. President-elect Trump has proposed that the repatriation tax rate for this cash be 10 percent. Perhaps after negotiations with Congress as part of a larger tax reform bill, the rate ends up being more like 15 percent -- still a hefty discount on the U.S. corporate income tax rate of about 35 percent. And then let's imagine that $1 trillion gets repatriated at that tax rate, for a one-time tax bill of $150 billion. How would that affect markets?
Large tax payments tend to be drags on markets. The most extreme example of this might be in early 2000, as investors were paying capital gains taxes based on the booming late-1990s stock market. It's when we last had a federal budget surplus. The peak of the Nasdaq during the dot-com boom occurred on March 10, 2000. Investors had to sell some of their high fliers in order to pay their elevated tax bills -- even though on April 14, barely a month after the peak, the Nasdaq had fallen almost 35 percent.
Since this next tax bill would be paid by corporations rather than individuals, the dynamics will be different. As my business partner Guillermo Roditi Dominguez showed in an infographic this year, most of the overseas cash is held by technology, health-care and conglomerate firms. In recent years, many of them have been piling up cash overseas, and borrowing money in corporate bond markets in order to buy back stock, preferring to use debt markets to fund the buybacks rather than paying taxes on their overseas cash.
But that overseas "cash" isn't just sitting in cash. As Bloomberg reported last year, Apple, the largest holder of overseas cash, has been using it to buy U.S.-denominated corporate debt. The trend has been for a cohort of multinationals to amass overseas cash and then park it in U.S. corporate bonds issued by other companies in that cohort. All the while, deferred tax liabilities have grown.
With tax reform, this process could unwind. As mentioned earlier, if a trillion dollars gets repatriated at 15 percent, that's an immediate $150 billion tax bill that corporate America will owe. Rather than Apple using its overseas cash to buy Microsoft debt, and Microsoft using its overseas cash to buy Apple debt, they might both be sellers of each other's debt as they bring their cash home. Some of that repatriated cash will be used for stock buybacks, which would cushion the blow to equity markets, but even here all of that retirement of stock means that someone -- individuals and funds -- will be sellers of that stock, and they will have to pay capital gains taxes on those sales, creating yet another liquidity demand to pay taxes.
A tax bill that large -- up to 1 percent of gross domestic product -- would warp Treasury markets as well. Treasury issuance will plunge as deficits turn into surpluses. The "safe asset shortage" may return as U.S. Treasuries become scarce and global investors seek other havens. All of this would occur as the Federal Reserve looks to tighten monetary policy -- creating particular challenges for investors using changes in interest rates to gauge what's happening in the economy.
How this impacts the real economy is anyone's guess. It's certainly possible that this pro-growth plank in Trumponomics would be a boon to the tax collector -- but not to corporations, investors or the economy as a whole.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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