Who benefits from lower corporate taxes?

Here in the UK, we have a new Prime Minister and one big question for most people in government is how to deliver on the tax cuts promised during the leadership contest. One obvious way is to eliminate the planned increase in corporate income taxes or even cut these taxes. In general, such tax cuts do not increase corporate investments or to a much smaller degree than supply-side economists argue. All corporate tax cuts tend to do is boost earnings growth in the year after the cut due to a lower tax base and thus create a bit of a sugar high in the stock market. But in the long run, investors don’t really benefit from lower corporate tax rates. But one group of people does.

In 2017, the Trump administration in the United States enacted large corporate income tax cuts as part of the Tax Cuts and Jobs Act (TCJA), cutting Federal corporate tax rates from 35% to 21%. Now, five years later it is easy to see that this massive tax cut has not created an increase in corporate investments or for that matter an increase in employment.

But this study from the London Business School shows that executives of companies affected by that tax cut did benefit. Executive compensation is rightfully linked to the profitability of the company, but if corporate tax rates drop, it allows executives to game the system. If a company has net deferred tax liabilities it can try to pay off these liabilities in the new regime of lower taxes, thus reducing the liabilities on its balance sheet and boosting profitability in the year after the tax reduction. This, at least in theory could boost executive compensation.

---

Cambria’s Global Momentum ETF (GMOM) is a global allocation ETF with a flexible approach to take advantage of recent trends in real assets.  GMOM will go where the trend and momentum is in the market, while at the same time potentially offer risk mitigation during drawdowns. Learn how GMOM can help your portfolio. Distributed by ALPS Distributors Inc.  View Prospectus here.

---

The study showed that this practice did happen after the introduction of the TCJA, but only in some firms. Companies that were more in the spotlight of investors and analysts because they were larger, had a broader investor base, or were covered by more analysts did not engage in this artificial boosting of earnings. Companies that were less visible to the public did. And on average, CEO compensation in these companies got boosted by some 8.3% in the year after the TCJA due to this kind of accounting trick. Given the large bonus packages of top executives, this is an effect that can go into the hundreds of thousands of extra income.

Now, let me be clear. I don’t think that CEOs in the UK will necessarily do the same as their American counterparts if corporate taxes are cut. And they can’t play that game if all that happens is that the planned tax hikes will be abolished because then the net effect is that corporate income tax rates will stay level.

However, I want to warn investors that there is a potential loophole that some executives could try to exploit to boost their compensation packages. And it is the job of equity analysts and investors to make sure executives don’t get away with it. Meanwhile, my message for executives is simple: Play it straight. Don’t try to boost your compensation with accounting gimmicks and focus on growing shareholder value in the long run. That will ultimately be more profitable for you as well.