Saturday, July 30, 2011

Foreign Income Rising

In Converging on the Horizon (courtesy of John Mauldin), Ed Easterling explains that pre-tax corporate profits as a percentage of GDP are expected to set new record highs in 2012. As reported earnings per share (EPS) are also significantly above normalized EPS based on both Crestmont’s and Shiller’s methodologies. Continuing strength in these figures plays a major role in buoying bullish viewpoints and frustrating bears. Easterling does a wonderful job using historical evidence to support his view that mean reversion of corporate profits is likely nearing. Agreeing with Easterling’s basic outlook, attempting to understand the reasons behind this profit levitation seems a worthwhile endeavor.

Various explanations currently circulate within investment and economic research regarding the superb corporate margins. One theory points to an increasing share of profits accruing to corporations instead of employees. Stagnating wages, a less unionized workforce and regulations increasing barriers to entry all support this notion. Another consideration holds that strong emerging market growth has made up for weak economic growth in developed markets. While probably true to some degree, with U.S., U.K., EU and Japan’s (50%+ of world GDP) growth flat-lining, it’s hard to foresee this trend continuing. A less widely discussed topic deserving attention is the growing percentage of foreign income being deferred from US corporate income taxes.

Over the past several weeks publicly held corporations have been filing their second quarter reports. While firms continue beating expectations at a strong clip (this happens during bear markets too), the reasons behind stronger earnings appear to be changing. During the first portion of this recovery, cost cutting through layoffs boosted margins. As Russ Winter points out in Corporate Tax Avoidance (courtesy of Zero Hedge), diverging effective tax rates are more recently producing larger margins. Just last week Microsoft reported a 7% decline in their effective tax rate as foreign income rose to 68% of the quarter’s total. That’s correct, based on income Microsoft is primarily a foreign company and they’re not alone.

Apple, darling of US investors and techies alike, is only slightly more American than Microsoft. During the most recent quarter, 33% of Apple’s reported income came from the US. The following section from their quarterly filing explains the decrease in effective tax rate (emphasis mine):

“The Company’s effective tax rate for the three- and nine-month periods ended June 25, 2011 was approximately 24%, compared to approximately 24% and 26% for the three- and nine-month periods ended June 26, 2010, respectively. The Company’s effective rates for both periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S..” (Apple, 10-Q, 2nd qtr 2011, p.33)

As stated by Apple, an increasing portion of their earnings are never intended to be reinvested in the U.S. through higher wages, larger dividends or any other manner.

While Apple and Microsoft represent only a minute sample of U.S. corporations, my presumption is that further research focusing on large multinationals will find similar patterns of decreasing effective tax rates and increasing undistributed foreign earnings. For investors, the pertinent question is whether or not effective tax rates will remain or continue moving lower. Investors should also recognize that a significant portion of cash on these companies balance sheets is held abroad and cannot be reinvested in the U.S. without incurring income taxes. A broader concern of this tax policy focuses on its potential long-term economic impact.

In 2004, the U.S. allowed domestic corporations to repatriate undistributed foreign profits at significantly reduced tax rates. Congress hoped this “one-time” tax break would result in firms spending their extra cash to increase domestic jobs. Data largely implies that the special tax break had no visible effect on employment. Unsurprisingly, a more direct effect appears to have been a growing number of firms and percentage of earnings being classified as undistributed foreign profits. With unemployment remaining high, large U.S. multinationals are once again pressing Congress to allow repatriation of foreign profits at a minimal tax rate (5%). Despite historical evidence, several Democrats have supported the proposal. As companies become more confidant in another “one-time” tax break, undistributed foreign profits may experience another surge.

Congress is currently struggling to compromise on a debt limit deal that cuts future spending and reduces deficits for the next decade. Given this debate, a good question regarding corporate taxes would be “why are domestic companies allowed to avoid corporate taxes with undistributed foreign profits?” Jesse’s Café Américain (courtesy of The Big Picture) directs us to ten charts from the Center for American Progress displaying the vast decline in corporate tax revenues:

Corporate tax revenue this year (1.3% of GDP) is near all time lows despite record corporate profits and a supposedly uncompetitive corporate income tax rate of 35%. As chart 9 shows, the effective tax rate for U.S. corporations is only 13.4%, well below most OECD countries. Tax breaks and loopholes not only reduce tax revenue, but heavily favor large corporations. Rather than consider more tax breaks, Congress would be well advised to focus on corporate tax reform.

Corporate tax reform that eliminates breaks and loopholes, while reducing rates, holds the key to several issues plaguing Congress and the current administration. Small businesses, which typically create the most new jobs, will benefit from lower tax rates. Federal tax revenue will increase as far greater sums of income are taxed. Consumers will likely benefit as increased business competition drives down prices and encourages innovation. Although this idea seems simplistic, it has a unique benefit of being both a market-oriented solution (for the right) and more progressive tax system (for the left).

Unfortunately these type of drastic overhauls rarely occur outside a crisis and are in direct opposition of numerous parties with invested interests (as well as significant cash to spend on lawyers and political contributions). Regardless, moving in the opposite direction by allowing another “one-time” tax break is almost certain to hurt economic growth, employment and federal debt in the long run. Hopefully after the senseless debt limit debate ends, the country will begin discussing more valuable issues including tax reform.  

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