The Other State Fiscal Consequence of Federal Corporate Tax Reform

There is much to potentially criticize about the 2017 Tax Cuts and Jobs Act (TCJA) including the rushed, poorly vetted, and temporary nature of many of its provisions; its timing; its impact on the federal debt; and the many new administrative challenges, complexities, and opportunities for gaming the tax system.    But as this legislative session’s tax policy debate shows, collectively all these concerns play a distant second fiddle to distributional consequences.   Just 6 years after legislators enacted Minnesota’s controversial 4th income tax tier with a 9.85% rate, the call for tax fairness is back -- only the focus has shifted from the wealthy to multinational corporations.

The 40% cut in the federal corporate rate combined with the even lower deemed repatriation rates on foreign income have raised the progressive community’s ire.   Critics note research indicating the vast majority of the corporate tax savings are not boosting wages or generating domestic capital investments but are being directed to shareholders through dividend increases and stock buybacks which disproportionately benefit wealthy households.  According to one recent study, the top 10% of American households, as defined by total wealth, owned 84% of all stocks in 2016 through direct and indirect (trusts, mutual funds, pension plans, etc.) ownership.[1]

Nevertheless, in a corporate equity market worth about $48 trillion, even small ownership shares represent very big money, and “small owners” include the defined benefit pension plans providing retirement income for state and local public employees.  According to the Pew Research Center, state and local public retirement systems held $3.8 trillion in assets in 2016, about $1.8 trillion of which was tradeable equities.   So it’s worth taking a closer look at what the TCJA has accomplished with respect to the health and welfare of Minnesota’s underfunded pension plans.  

The Contribution of Corporate Tax Reform Expectations to Stock Market Gains

From an investment return standpoint, the last few fiscal years have been unquestionably excellent for the state’s pension plans.  The Minnesota State Board of Investment (SBI) reported returns of 10.3% and 15.1% for fiscal years 2018 and 2017 respectively.   Domestic equities within the SBI portfolio performed even better – 15.4% in FY 2018 and 19.4% in FY 2017.    The first half of FY19 featured a notable correction as SBI domestic equities lost 8.8%.  However, since the beginning of January stocks have rebounded sharply with the Russell 3000 – the benchmark index for the state’s domestic equity portfolio -- up 18.8% as of this writing.

Identifying the role the 2016 presidential election generally, and corporate tax reform specifically, played in recent stock market performance is a challenging task.   Stock markets are forward looking mechanisms reflecting expectations about policies as well the enactment of the policies themselves.    They also reflect general economic activity and conditions both domestically and internationally which are partly a function of policies enacted years in the past.    Yet three research investigations we came across took this effort on offering interesting insights in the process.

The first, an NBER working paper from scholars at Harvard University and the Swiss Finance Institute, studied the “elections expectations effect” by examining company stock reactions from election day through the end of 2016.[2]   Regressing abnormal returns from S&P 500 companies during this period on firm characteristics, the study found the companies with high effective tax rates were clear winners.  The relationship between corporate disclosed effective tax rates and abnormal returns, “proved strongly positive in the first day after the election,” and “remained large and significant in the period running into year end.”   Companies with large deferred tax liabilities gained, while companies with significant deferred tax assets lost as the anticipated value of these assets declined.  They concluded, “this relatively clean natural experiment also confirms that taxes are a very important component of firm value.” 

Continuing beyond the immediate post-election expectations effect, the same scholarly trio continued investigating this natural experiment throughout 2017 as the prospects for federal tax reform waxed and waned and the specific details shifted.  A follow up paper[3] examined to what extent the anticipated and ultimately implemented tax reform was responsible for the steep increase in the stock market through the end of 2017.   This time the researchers examined abnormal stock returns in the Russell 3000 occurring on what they called “milestone days” (major developments which occurred from the introduction of the tax bill in early November to the Senate passage of the revised bill) and regressed them again on firm characteristics affected by the TCJA.  Once again researchers found “over the entire legislative period, the TCJA has a significant relative positive effect on high tax firms.” 

To what extent did tax reform drive the overall market?  To find out, the researchers first examined the relationship between excess stock returns and the cash effective tax rate of firms (along with numerous controls) and then performed a time series regression on all these factors to determine just what drove the market’s overall return during this period.  They found a “highly significant and sizeable” relationship between the cash effective tax rates of firms and overall market moves.   In other words, the market tended to move upward on those days when high tax firms outperformed low tax firms and vice versa.    A similar and even stronger result applied for foreign revenue exposure.   They conclude that while these results cannot prove a causal impact, “the findings strongly suggest that corporate taxes play an important role for aggregate stock market valuations.”

If corporate tax savings matter, can an actual estimate be put on how much this influenced the market?  That was the topic of an International Finance Discussion Paper from the Board of Governors of the Federal Reserve System.[4]   It also looked specifically at the evolution of U.S. stock prices from the time of the 2016 presidential election through the actual passage of the TCJA.   The researchers concluded a bit more than half of the 25% increase in stock prices during this period could be attributed to the actual increase in dividends (9%, or 36% of the increase) and the anticipation of higher dividends (4%, or 16% of the increase) due to the tax package.   

Together, these research studies showed that the expectation and enactment of corporate tax reform has contributed to the stock market’s performance and that some of the biggest beneficiaries were the stocks of higher effective tax rate companies most likely to benefit from the reform.

Tax Reform Impacts:  Year of the Buyback

“The main reason stocks have done so well this cycle and could still have further upside potential, even as stocks are overweight by both the public and institutions, is that corporations continue to be huge buyers.”

Ned Davis Research Group

2018 marked the transition from expectation effects to actual tax reform policy effects.  In one respect nothing changed as 2018 continued a multi-year trend that began with the end of the Great Recession of returning considerable amounts of operating earnings back to shareholders through dividends and stock buybacks (boosting share prices in the process).    According to Standard and Poors, dividends and buybacks totaled 93% of S&P 500 operating earnings in Quarter 3 of 2018.    But a breakdown of the two strategies reveals something interesting.   Dividend growth maintained the general steady upward trajectory that has been in place since the end of the Great Recession.    Stock buybacks, however, have been a different story.   In 2018, announced buybacks increased dramatically to an all-time record $1.1 trillion, and companies are acting on them.  According to Barron’s about $800 billion of stock has been bought back, facilitated by the reduced corporate income tax rate and the even lower deemed repatriation tax rate for offshore cash holdings.   

Use of tax savings and repatriated cash for stock buybacks has earned the scorn of many who see it as a tool for management self-dealing by goosing executive compensation tied to earnings per share growth and offsetting dilution from stock-based compensation all while coming at the expense of actually investing in the business.   There has been some evidence to suggest that companies engaging in buybacks aren’t the best investments.  According to a report by Trim Tabs Asset Management in the late summer of 2018, of the 350 of companies in the S&P 500 that had repurchased their shares up to that point, 57% had underperformed the overall market.  The S&P 500 Buyback ETF was underperforming the S&P index by 23%.

Yet it remains a way to return cash to investors and an especially popular one when management believes its stock price has fallen below the company’s intrinsic value during market corrections.   A closer look at 2018 reveals buybacks spiked in Q1 in conjunction with the sell-off in February that kicked the S&P 500 into correction territory, then spiked again in Q4 as another market correction took place.   These efforts, according to Barron’s, “have been one of the biggest supports to the nearly 10-year old bull market rally”[5] stabilizing equity prices at times when both retail and institutional investors were becoming nervous about national and global economic developments.   

The combined impact of both those market corrections resulted in a lousy calendar year 2018 for the state’s domestic equity portfolio as it lost 5.3%.   But as a J.P. Morgan analyst noted, “With the largest one-way buyer returning in size to the market post earnings, we expect liquidity to improve and equities to move higher”[6] which certainly seems to have transpired.   Even if buybacks deserve the skepticism surrounding them, pension commission and state budget discussions this year would have likely looked a little different without TCJA corporate tax savings and tax-favored repatriated cash flow at work behind the scenes.

Comparing the Fiscal Impact on the State

The SBI is, of course, agnostic to tax policy and politics in its investment mission.  From its latest asset listing (June 2018), we calculate SBI held a $3.5 billion equity stake in the ten S&P 500 companies with the largest offshore cash holdings[7]; ten companies that represent 11.8% of the SBI’s entire domestic equity portfolio.   We also identified 44 S&P 500 companies which had $3 billion or more in stock buybacks in 2018, cross-referenced them with the SBI asset list, and found those companies represented $6.3 billion or 21.5% of the entire domestic equity portfolio.[8]   Occasionally legislators introduce bills to rid the state of what are considered socially irresponsible investments like tobacco or fossil fuel companies.   Despite the hypercriticism currently directed at big corporations, there has been no attempt to rid the state of investments in multinationals which are big users of tax havens.   Perhaps, in places not talked about at parties, there is grudging recognition that these large corporations and their TCJA-affected stock prices are currently saving the state from another round of difficult decision making with respect to its pensions.

What many do want to do, as our accompanying article highlights, is tax the savings and the repatriated cash which has helped extend the longest running bull market in history.    According to data provided by the Minnesota House’s Fiscal Analysis Department, the two primary corporate revenue raisers being considered this year – deemed repatriation of foreign income and GILTI -- are expected to raise $540 - $750 million in the coming biennium (depending on the approach); declining thereafter as the deemed repatriation income phases out.  If we apply the 4% estimate of the effects the corporate tax reform package had on the growth in stock prices we cited earlier to the 21.4% net gain of the state’s domestic equity portfolio in 2017, that yields $890 million of positive fiscal benefit for Minnesota’s pension plans just in anticipation of the TCJA.    Even if we limit the state fiscal impact to just one year of domestic stock price appreciation, ignore potential TCJA impacts on the state’s over $10 billion stake in alternative investments such as private equity (and the merger and acquisition activity within it), and assign zero long term market or economic benefits from corporate tax reform, the asset appreciation is larger than the revenue we hope to collect in the next biennium from international conformity.

“Happy Hour in Minnesota”?

The real question is one of staying power.   Many analysts see the tailwind subsiding in the not-too-distant future as the high bar of earnings growth becomes increasingly difficult to exceed, thus setting the market up for a bigger fall.   As Goldman Sachs put it, “while there’s a fair amount of debate about how much this fiscal expansion extended the economic cycle, for markets our analysis suggests we’re closer to the end of the day than the beginning.  Hence there’s less reason to behave like it’s morning in America than happy hour in America.”[9]

That alone should create questions about the staying power of the “path to full funding” mantra being communicated in the wake of last year’s pension fixes.   But the state also has found its own way to extend the happy hour buzz through its stability fixes by keeping its pension tab to a minimum:

• Using a 7.5% assumed annual rate of investment return that according to the plans’ own actuaries has only a slightly better than a one in three chance of being achieved over the next 20 years.[10]
• Discounting future pension liabilities at the same rate as expected asset returns which means  a larger pool of liabilities grow at the same rate as a smaller pool of assets hope to grow, all else being equal.
• Creating another fresh 30-year amortization period for unfunded liabilities which is 10-15 years longer than what the Government Finance Officers Association recommends in its standards of practice.

Arguments about fiscal irresponsibility within the TCJA are more than matched by the high risk, extend and pretend culture in which current state pension finance operates.

Connecting the Dots

It’s in this context that the DFL’s plans for revenues resulting from taxing foreign earnings in the next biennium need to be reevaluated.   DFLers have proposed considerable new permanent tax reductions and spending predominantly supported by taxation of foreign earnings.  This enabling revenue is quantifiably questionable, highly volatile, prone to litigation, and - in the case of deemed repatriation – temporary.   It’s a highly unstable, uncertain foundation for such big ambitions. 

To protect the state’s fiscal integrity, it’s important to mitigate the considerable fiscal and legal risk accompanying attempts to generate revenue from taxing foreign earnings.   If the state insists on pursuing the taxation of foreign earnings it would be imperative to use money only after it has been collected and then only use it for one-time spending.    The state has a laundry list of such possibilities – highway projects, local sewer and water grants, and communication infrastructure to name a few.  Pension reform should be added to this list.

Minnesota’s pension funding is still trying to get by on the cheap with large intergenerational transfers of obligation and risk.  As a result, substantive pension reform -- whether within or outside of the existing defined benefit system -- that puts state retirement systems on a truly sustainable path in a fiscally responsible and manageable way will inevitably require some infusion of cash.    Notably, corporations that still operate defined benefit plans and are still trying to recover from the Great Recession are using considerable amounts of their tax savings and repatriated cash for this specific purpose.[11]  The difference is that corporate defined benefit plans operate under the far more stringent valuation and funding rules of ERISA while states have created their own administrative Wild West.   As a result, states have even greater urgency to tackle this problem, especially those like Minnesota more economically exposed to long term negative impacts from comparative tax disadvantages stemming from the elimination of the SALT deduction.   

Unsurprisingly, nothing like this has been even hinted at.   The spending wishes of the present outweigh the spending demands of the future, failing the instant gratification test.  Moreover, it simply remains too easy to make current pension plan health look better than it is.    However, as pension expenses gradually grow and swallow up larger and larger portions of state and local budgets, governments will be forced to do more with less.  Absent in all the discussion about needed state investments is this undeniable fact: real pension reform is no less a vital investment in Minnesota’s future.