WASHINGTON, DC – MARCH 3: Federal Reserve Chairman Jerome H. Powell. The Fed is helping with leverage … [+]
When President Trump signed his $ 1.5 trillion tax cut in late 2017, which cut statutory corporate tax rates by nearly half, Morgan Stanley analysts had a fitting slogan for signing his administration’s legislative performance. “It’s happy hour in America,” said a team of researchers and economists at the investment bank, noting that the incentive at the end of a ten-year bull market could lead to risky financial behavior.
With the cuts, CEOs and boardrooms across America had a number of options as to what to do with the extra cash: rent and invest in growth projects, use their extra cash to lower risk by paying off debt, or give all for rewarding shareholders and acquisitions. The de facto strategy has been to maximize corporate credit cards. Buybacks set records after the tax cut and debt rose. Adding financial risk has been the dominant trend in this bull market.
In a recent investigation, Forbes found that in the good times between 2010 and 2019, American blue-chip companies had roughly $ 2.5 trillion in net debt on their balance sheets, and with more leverage than ever before Covid recession had occurred. The ratio of net debt to revenue for the typical S&P 500 company has nearly doubled over the past decade, our research found.
As ominous as our numbers were, especially with Covid-19 now besieging the US economy, there is a grim reality. Covid or not, leveraged companies were poised to be hit by an almost forgotten provision in Trump’s 2017 tax cut for the next several years. That’s the part the cuts should be paid for.
In 2022, the tax law stipulated that interest deductibility would be limited to 30% of earnings before interest and taxes instead of EBITDA, which includes depreciation. Morgan Stanley’s 2018 Happy Hour in America report found that 8% of investment grade companies and half of junk rated companies would increase their tax burden in 2022. Even so, only 6% of companies showed interest in deleveraging at the time. according to their research.
These expected additional tax revenues from leveraged borrowers from 2022, especially high wealth companies, were one of the ways TCJA put this into law. The idea of actually generating tax revenue in this way has always been seen as a long way off. The following record-breaking shareholder returns show that the average C-suite expects the can to be brought to its knees and that a calculation of EBIT-based interest deductibility will never see the light of day.
As Morgan Stanley said in his happy hour note:
“[I]In our view, it is unlikely that companies will make themselves less vulnerable to these incentives prematurely. When the tax reform was originally passed late last year, we heard some optimism from investors that companies would use their tax cuts in a credit-friendly way, especially to pay off debts. We have consistently pushed back the view that tax reform will trigger a huge wave of voluntary debt relief. Most importantly, we note that confidence is one of the biggest drivers of debt growth in any cycle. We were skeptical that with soaring business and consumer confidence, and after the biggest corporate tax cut in decades, companies would suddenly decide to “play defense” and take the pressure off their balance sheets instead of looking to increase Shareholder Returns. In our view, after an economic downturn, as is almost always the case, companies will start deleveraging. This is how credit cycles work. ”
How right Morgan Stanley was.
Buybacks topped $ 1 trillion in 2018 and 2019 and dividends skyrocketed. Now, of course, Covid-19 has thrown a wrench in almost every capital plan. Budget deficits are rising, emergency aid to business is likely to eclipse the cost of TCJA, and the pandemic will result in corporate tax loss carryforwards in the years to come.
The CARES bill, a non-partisan post-Covid-19 economy boost, helped mitigate some dire realities for stretched corporate balance sheets. According to the law, the interest deductibility is increased to 50% of the adjusted taxable income and can be applied retrospectively to the 2019 tax year, according to the independent tax expert Robert Willens. “This is helpful because in most cases, you might think that the 2019 number will eclipse that of 2020,” he says.
But what will happen in 2021, 2022 or beyond?
Subject to a “V-shaped” recovery from Covid-19, these years the US economy will begin to fully recover from the pandemic. Now they will coincide with some of the 2017 tax law payment mechanisms, and the number of companies affected by an EBIT-based cap on interest deductibility will ultimately be well above Morgan Stanley’s original estimates.
Worse, companies will drag mountains of debt into the recovery, which could limit hiring plans and capital investments. The same applies to the national balance sheet, which was already being used extensively before the recession.
Again, Morgan Stanley’s happy hour note hit the nail on the head:
“The tax cut has created new economic” cliffs “and procyclical incentives. Important tax reform provisions encourage short-term spikes in consumption and dampen growth this year. But many stocks expire in a few years. The immediate expenses will expire in late 2022 and will fully expire in late 2026. Interest deductibility will be more restricted in 2022. Both would create incentives for companies to cut their spending, especially when they are in a recession. Personal tax cuts expire in late 2025, adding another burden. While all regulations could certainly be expanded, the markets at least have to grapple with the possibility that it will not and the last second drama that normally accompanies such expansions.
Suffice it to say that the “moral hazard” idea pervaded corporate boardrooms long before Covid-19, and the Federal Reserve signed almost unlimited support for corporate bond markets from March onwards.
In the last few years of the bull market, taking on debt and throwing the can on the street. It is also likely to be the predominant theme of a recovery.
For more: Read Forbes’ investigation into the $ 2.5 trillion debt that brought blue chips near junk