Archive for the 'corporate income tax' Category

What Do Stock Prices Tell Us about the Economy?

Stock prices (as measured by the S&P 500) in 2017 rose by over 20%, an impressive amount, and what is most impressive about it is perhaps that this rise prices came after eight previous years of steady increases.

Here are the annual year-on-year and cumulative changes in the S&P500 since 2009.

2009              21.1%              21.1%*

2010              12.0%              33.1%*

2011              -0.0%               33.1%*

2012              12.2%               45.3%*

2013              25.9%               71.2%*

2014              10.8%               82.0%*

2015              -0.7%                81.3%*

2016             9.1%                   90.4%*            (4.5%)**          (85.9%)***

2017             17.7%                 108.1%*          (22.3%)****

2018 (YTD)    2.0%                  110.1%*           (24.3%)****

* cumulative increase since the end of 2008

** increase from end of 2015 to November 8, 2016

*** cumulative increase from end of 2008 to November 8, 2016

**** cumulative increase since November 8, 2016

So, from the end of 2008 until the start of 2017, approximately coinciding with Obama’s two terms as President, the S&P 500 rose in every year except 2011 and 2015, when the index was essentially unchanged, and rose by more than 10% in five of the eight years (twice by more than 20%), with stock prices nearly doubling during the Obama Presidency.

But what does the doubling of stock prices under Obama really tell us about the well-being of the American economy, and, even more importantly, about the well-being of the American public during those years? Is there any correlation between the performance of the stock market and the well-being of actual people? Does the doubling of stock prices under Obama mean that most Americans were better off at the end of his Presidency than they were at the start of it?

My answer to these questions is a definite — though not very resounding — yes, because we know that the US economy at the end of 2008 was in the middle of the sharpest downturn since the Great Depression. Output was contracting, employment was falling, and the financial system was on the verge of collapse, with stock prices down almost 50% from where they had been at the end of August, and nearly 60% from the previous all-time high reached in 2007. In 2016, after seven years of slow but steady growth, employment and output had recovered and surpassed their previous peaks, though only by small amounts. But the recovery, although disappointingly slow, was real.

That improvement was reflected, albeit with a lag, in changes in median household and median personal income between 2008 and 2016.

2009                    -0.7%                   -0.7%

2010                    -2.6%                    -3.3%

2011                     -1.6%                    -4.9%

2012                    -0.1%                    -5.0%

2013                      3.5%                    -1.5%

2014                    -1.5%                     -3.0%

2015                     5.1%                       2.0%

2016                      3.1%                      5.1%

But it’s also striking how weak the correlation was between rapidly rising stock prices and rising median incomes in the Obama years. Given a tepid real recovery from the Little Depression, what accounts for the associated roaring recovery in stock prices? Well, for one thing, much of the improvement in the stock market was simply recovering losses in stock valuations during the downturn. Stock prices having fallen further than incomes in the Little Depression, it’s not surprising that the recovery in stocks was steeper than the recovery in incomes. It took four years for the S&P 500 to reach its pre-Depression peak, so, normalized to their pre-Depression peaks, the correlation between stock prices and median incomes is not as weak as it seems when comparing year-on-year percentage changes.

But considering the improvement in stock prices under Obama in historical context also makes the improvement in stock prices under Obama seem less remarkable than it does when viewed without taking the previous downturn into account. Stock prices simply returned (more or less) to the path that, one might have expected them to follow by extrapolating their past performance. Nevertheless, even if we take into account that, during the Little Depression, stocks prices fell more sharply than real incomes, stocks have clearly outperformed the real economy during the recovery, real output and income having failed to return to the growth path that it had been tracking before the 2008 downturn.

Why have stocks outperformed the real economy? The answer to that question is a straightforward application of the basic theory of asset valuation, according to which the value of real assets – machines, buildings, land — and financial assets — stocks and bonds — reflects the discounted expected future income streams associated with those assets. In particular, stock prices represent the discounted present value of the expected future cash flows (dividends or stock buy-backs) from firms to their shareholders. So, if the economy has “recovered” (more or less) from the 2008-09 downturn, the expected future cash flows from firms have presumably – and on average — surpassed the cash flows that had been expected before the downturn.

But the weakness in the recovery suggests that the increase in expected cash flows can’t fully account for the increase in stock prices. Why did stock prices rise by more than the likely increase in expected cash flows? The basic theory of asset valuation tells us that the remainder of the increase in stock prices can be attributed to the decline of real interest rates since the 2008 downturn to historically low levels.

Of course, to say that the increase in stock prices is attributable to the decline in real interest rates just raises a different question: what accounts for the decline in real interest rates? The answer, derived from Irving Fisher, is basically that if perceived opportunities for future investment and growth are diminished, the willingness of people to trade future for present income also tends to diminish. What the rate of interest represents in the Fisherian framework is the rate at which people are willing to trade future for present income – i.e., the premium (discount) that is placed on present (future) income.

The Fisherian view is totally at odds with the view that the real interest rate is – or can be — controlled by the monetary authority. According to the latter view, the reason that real interest rates since the 2008 downturn have been at historically low levels is that the Federal Reserve has forced interest rates down to those levels by flooding the economy with huge quantities of printed money. There is a certain sense in which that view has a small element of truth: had the Fed adopted a different set of policy goals concerning inflation and nominal GDP, real interest rates might have risen to more “normal” levels. But given the overall policy framework within which it was operating, the Fed had only minimal control over the real rate of interest.

The essential idea is that in the Fisherian view the real rate of interest is not a single price determined in a single market; it is a distillation of the entire intertemporal structure of price relationships simultaneously determined in the myriad of individual markets in which transactions for present and future delivery are continuously being agreed upon. To imagine that the Fed, or any monetary authority, could control or even modestly influence this almost incomprehensibly complicated structure of price relationships according to its wishes is simply delusional.

If the decline in real interest rates after the 2008 downturn reflected generally reduced optimism about future economic growth, then the increase in stock prices actually reflected declining optimism by most people about their future well-being compared to their pre-downturn expectations. That loss of optimism might have been, at least in part, self-fulfilling insofar as it discouraged potentially worthwhile – i.e., profitable — investments that would have been undertaken had expectations been more optimistic.

Nevertheless, the near doubling of stock prices during the Obama administration did coincide with a not insignificant improvement in the well-being of most Americans. Most Americans were substantially better off at the end of 2016, after about seven years of slow but steady economic growth, than they were at the end of 2008 when total output and employment were contracting at the fastest rate since the Great Depression. But to use the increase in stock prices as a quantitative measure of the improvement in their well-being would be misleading.

I would also mention as an aside that a favorite faux-populist talking point of Obama and Fed critics used to be that rising stock prices during the Obama years revealed the bias of the elitist Fed Governors appointed by Obama in favor of the wealthy owners of corporate stock, and their callous disregard of the small savers who leave their retirement funds in bank savings accounts earning minimal interest and of workers whose wage increases barely kept up with inflation. But this refrain of critics – and I am thinking especially of the Wall Street Journal editorial page – who excoriated the Obama administration and the Fed for trying to raise stock prices by keeping interest rates at abnormally low levels now unblushingly celebrate record-high stock prices as proof that tax cuts mostly benefiting corporations and their stockholders signal the start of a new golden age of accelerating growth.

So the next question to consider is what can we infer about the well-being of Americans and the American economy from the increase in stock prices since November 8, 2016? For purposes of this mental exercise, let me stipulate that the rise in stock prices since the moment when it became clear who had been elected President by the voters on November 8, 2016 was attributable to the policies that the new administration was expected to adopt.

Because interest rates have risen along with stock prices since November 8, 2016, increased stock prices must reflect investors’ growing optimism about the future cash flows to be distributed by corporations to shareholders. So, our question can be restated as follows: which policies — actual or expected — of the new administration could account for the growing optimism of investors since the election? Here are five policy categories to consider: (1) regulation, (2) taxes, (3) international trade, (4) foreign affairs, (5) macroeconomic and monetary policies.

The negative reaction of stock prices to the announcement last week that tariffs will be imposed on steel and aluminum imports suggests that hopes for protectionist trade policies were not the main cause of rising investor optimism since November 2016. And presumably investor hopes for rising corporate cash flows to shareholders were not buoyed up by increasing tensions on the Korean peninsula and various belligerent statements by Administration officials about possible military responses to North Korean provocations.

Macroeconomic and monetary policies being primarily the responsibility of the Federal Reserve, the most important macroeconomic decision made by the new Administration to date was appointing Jay Powell to succeed Janet Yellen as Fed Chair. But this appointment was seen as a decision to keep Fed monetary policy more or less unchanged from what it was under Yellen, so one could hardly ascribe increased investor optimism to a decision not to change the macroeconomic and monetary policies that had been in place for at least the previous four years.

That leaves us with anticipated or actual changes in regulatory and tax policies as reasons for increased optimism about future cash flows from corporations to their shareholders. The two relevant questions to ask about anticipated or actual changes in regulatory and tax policies are: (1) could such changes have raised investor optimism, thereby raising stock prices, and (2), if so, would rising stock prices reflect enhanced well-being on the part of the American economy and the American people?

Briefly, the main idea for regulatory reform that the Administration wants to pursue is to require that whenever an agency adopts a new regulation, it should simultaneously eliminate two old ones. Supposedly such a requirement – sometimes called a regulatory budget – is to limit the total amount of regulation that the government can impose on the economy, the theory being that new regulations would not be adopted unless they were likely to be really effective.

But agencies are already required to show that regulations pass some cost-benefit test before imposing new regulations. So it’s not clear that the economy would be better off if new regulations, which can now be adopted only if they are expected to generate benefits exceeding the costs associated with their adoption, cannot be adopted unless two other regulations are eliminated. Presumably, underlying the new regulatory approach is a theory of bureaucratic behavior positing that the benefits of new regulations are systematically overestimated and their costs systematically underestimated by bureaucrats.

I’m not going to argue the merits of the underlying theory, but obviously it is possible that the new regulatory approach would result in increased profits for businesses that will have fewer regulatory burdens imposed upon them, thereby increasing the value of ownership shares in those firms. So, it’s possible that the new regulatory approach adopted by the Administration is causing stock prices to rise, presumably by more than they would have risen under the old simple cost-benefit regulatory approach that was followed by the Obama Administration.

But even if the new regulatory approach has caused stock prices to rise, it’s not clear that increasing stock valuations represent a net increase in the well-being of the American economy and the American people. If regulations that are costly to the economy in general are eliminated, the benefits of fewer regulations would accrue not just to the businesses whose profits rise as a result; eliminating inefficient regulations would also benefit the rest of the economy by freeing up resources to produce goods and services whose value to consumers would the benefits foregone when regulations were eliminated. But it’s also possible, that regulations are providing benefits greater than the costs of implementing and enforcing them.

If eliminating regulations leads to increased pollution or sickness or consumer fraud, and the value of those foregone benefits exceeds the costs of those regulations, it will not be corporations and their shareholders that suffer; it will be the general public that will bear the burden of their elimination. While corporations increase the cash flows paid to shareholders, members of the public will suffer more-than-offsetting reductions in well-being by being exposed to increased pollution, suffering increased illness and injury, or suffering added fraud and other consumer harms.

Since 1970, when the federal government took serious measures to limit air and water pollution, air and water quality have improved greatly in most of the US. Those improvements, for the most part, have probably not been reflected in stock prices, because environmental improvements, mostly affecting common-property resources, can’t be easily capitalized, though, some of those improvements have likely been reflected in increasing land values in cities and neighborhoods where air and water quality have improved. Foregoing pollution-reducing regulations might actually have led to increased stock prices for many corporations burdened by those regulations, but the US as a whole, and its inhabitants, would not have been better off without those regulations than they are with them.

So, rising stock prices are not necessarily a good indicator of whether the new regulatory approach of the Administration is benefiting or harming the American economy and the American public. Market valuations convey a lot of important information, but there is also a lot of important information that is not conveyed in stock prices.

As for taxes, it is straightforward that reducing corporate-tax liability increases funds available to be paid directly to shareholders as dividends and share buy-backs, or indirectly through investments expected to increase cash flows to shareholders in the more distant future. Does an increase in stock prices caused by a reduction in corporate-tax liability imply any enhancement in the well-being of the American economy and the American people

The answer, as a first approximation, is no. A reduction in corporate tax liability implies a reduction in the tax liability of shareholders, and that reduction is immediately capitalized into the value of shares. Increased stock prices simply reflect the expected reduction in shareholder tax liability.

Of course, reducing the tax burden on shareholders may improve economic performance, causing an increase in corporate cash flows to shareholders exceeding the reduction in shareholder tax liabilities. But it is unlikely that the difference between the increase in cash flows to shareholders and the reduction in shareholder tax liabilities would be more than a few percent of the total reduction in corporate tax liability, so that any increase in economic performance resulting from a reduction in corporate tax liability would account for only a small fraction of the increase in stock prices.

The good thing about the corporate-income tax is that it is so easy to collect, and that it is so hard to tell who really bears the tax burden: shareholders, workers or consumers. That’s why governments like taxing corporations. But the really bad thing about the corporate-income tax is that it is so hard to tell who really bears the burden of the corporate tax, shareholders, workers or consumers.

Because it is so hard to tell who bears the burden of the tax, people just think that “corporations” pay the tax, but “corporations” aren’t people, and they don’t really pay taxes, they are just the conduit for a lot of unidentified people to pay unknown amounts of tax. As Adam Winkler has just explained in this article and in an important new book, It is a travesty that the Supreme Court was hoodwinked in the latter part of the nineteenth century into accepting the notion that corporations are Constitutional persons with essentially the same rights as actual persons – indeed, with far greater rights than human beings belonging to disfavored racial or ethnic categories.

As I wrote years ago in one of my early posts on this blog, there are some very good arguments for abolishing the corporate income tax altogether, as Hyman Minsky argued. Forcing corporations to distribute their profits to shareholders would diminish the incentives for corporate empire building, thereby making venture capital more available to start-ups and small businesses. Such a reform might turn out to be an important democratizing and decentralizing change in the way that modern capitalism operates. But even if that were so, it would not mean that the effects of a reduction in the corporate tax rate could be properly measured by looking that resulting change in corporate stock prices.

Before closing this excessively long post, I will just remark that although I have been using the basic theory of asset pricing that underlies the efficient market hypothesis (EMH), adopting that theory of asset pricing does not imply that I accept the EMH. What separates me from the EMH is the assumption that there is a single unique equilibrium toward which the economy is tending at any moment in time, and that the expectations of market participants are unbiased and efficient estimates of the equilibrium price vector toward which the price system is moving. I reject all of those assumptions about the existence and uniqueness of an equilibrium price vector. If there is no equilibrium price vector toward which the economy is tending, the idea that expectations are governed by some objective equilibrium which is already there to be discovered is erroneous; expectations create their own reality and equilibrium is itself determined by expectations. When the existence of equilibrium depends on expectations, it becomes impossible to assign any meaning to the term “efficient market.”


Why Are Corporations Hoarding all that Cash?

One of the ongoing puzzles of this joyless recovery (to give it the benefit of the doubt) has been the huge accumulation of cash by corporations. The puzzle is that the huge cash hoards that companies are sitting on are being generated by high earnings, high earning reflected in – or, perhaps more accurately, anticipated by — rising stock prices since the stock market bottomed out in March 2009. So one would think that the high earnings would have encouraged these highly profitable companies to expand output, building new capacity and hiring new workers, rather than accumulate all that cash. But the growth in cash holdings by companies has dwarfed the growth in new capital spending and employment. So what gives?

Corporations, obviously, are not all the same, so that any simple broad generalizations about what they are doing and why are very questionable. A disproportionate share of the newly accumulated cash is in the hands of large companies, especially in the telecommunications sector, the most notorious case being Apple, whose hoard is reportedly close to 200 billion dollars. Let me also observe that the increase in cash holding by corporations has been increasing for a long time, especially since the mid-1990s, tapering off in the mid-2000s before dipping during the financial crisis. But the upward trend resumed and accelerated after the crisis.

Here are some of the reasons that I have seen mentioned or have thought of myself for all this corporate cash hoarding.

A basic proposition of the theory of the demand for money is that an increase in uncertainty increases the demand for money. It is certain that the financial crisis was associated with increased uncertainty, raising the demand for money during and, owing to residual effects of the crisis, after the crisis. One might wonder why, if the demand for money increased during the crisis, corporate cash holdings decreased. The answer is that cash flows during the crisis were drastically reduced, requiring companies to expend cash even though they would have preferred to squirrel it away. The crisis was a period of extreme disequilibrium, and corporations (like many other economic agents) were forced way off their demand curves. So some part of the increase in corporate cash holdings can probably be attributed to a general increase in overall macroeconomic uncertainty. However, macroeconomic conditions has been fairly stable now for the last two or three years, at least in the US. So, although one could argue that the general macroeconomic environment is more uncertain than it was before the crisis, it would be hard to argue that uncertainty has not been gradually diminishing over the past few years, even as corporate cash hoards have continued to grow rapidly.

Some people – I don’t have to name them, you know who they are – like to say that the increase in uncertainty is all, or perhaps only mostly, due to the policies of the Obama administration and the Federal Reserve, especially, but not only, Obamacare and quantitative easing. But Obamacare was enacted in 2010, and it has been implemented gradually since then, coming more or less fully into effect this year. So the uncertainty associated with Obamacare should have been decreasing over time. Quantitative easing has been in effect in one form or another for most of the past four years, so people have gotten used to it. There is now uncertainty about when and how it will come to an end, but there is no sign that concerns about its gradual termination are causing any major market disturbances. So one can’t easily attribute the continuing increase in corporate cash-holding to uncertainty caused by Obamacare or quantitative-easing.

There are also microeconomic sources of uncertainty that are specific to particular sectors or industries, accounting for faster rates of increase in cash-holding by particular types of corporations, but the increase in cash-holding has not been confined to any single group of corporations, though large multi-national corporations, especially technology, media, and telecommunications companies have shown the largest increases in cash holdings. A study by economists at the St. Louis Fed suggested that R&D intensive corporations, being subject to high uncertainty owing to the unpredictable outcomes of their R&D activities, have been increasing their cash holdings more rapidly than less R&D intensive corporations. As R&D expenditures increase as a share of total investment, total cash holding by corporations would be expected to increase. But, again, this explanation can account for a long-term trend towards increased corporate cash holding, but not for the surge in corporate cash holding since 2009.

Let’s think again about why a profitable company is holding a lot of cash. So what can a profitable company do with all that cash gushing into its coffers? Well, 1) it can just hold on to the cash, 2) it could invest in new plant and equipment, (we’ll come back to this in a moment), 3) it could go out and buy other companies, 4) it could pay bonuses to some or all of the employees (guess which ones) of the company, or 5) it could return the cash to the owners of the company by paying dividends or by repurchasing stock.

As promised, let’s now think a bit more about option 2). There are broadly speaking three categories of capital investment. First, there is capital investment that replaces old and depreciating equipment with new and possibly improved equipment, but does not alter the firm’s structure or methods of production. It simply allows the company to keep doing what it has been doing, but perhaps a little bit more efficiently. Second, there is capital investment that aims to alter the structure of production, by adopting a new method or technique of production. Third, there is capital investment intended to increase the total productive capacity of the firm, enabling the firm to expand its output and increase its sales.

Notice that the first category is necessary for any firm unless it is about to go out of business. A firm may postpone such investment if it is not currently profitable, but it can’t postpone it for long without compromising the viability of the firm. Capital replacement is important, but to a large extent it is automatic, not being sensitive to relatively small changes in economic incentives.

The second category does depend importantly on the relative profitability of different techniques, and these decisions require pretty careful and detailed assessments by corporate management to decide which ones will be profitable and should be undertaken and which ones are unlikely to be profitable or involve too much risk to be undertaken. I note parenthetically that it is only a subset (probably a small subset) of this category that is sensitive to the interest-rate mechanism that looms so large in Austrian business-cycle theory. To presume that this probably small sub-category of interest-sensitive investment is what drives the business cycle involves a huge, and empirically unsupported, assumption.

The third – and undoubtedly the largest — category depends primarily not on calculations about the relative cost and profitability of different techniques, but on expectations about future demand for the firm’s output. If firms believe that they can increase sales at current prices, they will expand capacity to produce more output. If they don’t invest in increased capacity, they will probably lose market share to their competitors.

So, if corporations have been accumulating cash rather than investing in new plant and equipment to expand output – the sort of investment that would involve major expenditures and a significant drawdown of cash hoards — the most obvious explanation seems to be that firms don’t expect future demand at current prices to increase enough to justify such investments. A surge in corporate cash holding is an indication that corporate expectations about future demand are not very optimistic. Mildly pessimistic expectations about future demand are not inconsistent with high current profitability and rising stock prices.

I will not comment about why companies are not using their cash to buy other companies or to pay more and bigger bonuses to employees, but I do want to say something about why companies aren’t paying higher dividends to stockholders or buying back stock. One reason that they are not increasing dividend payments is that dividends are not tax-deductible. The non-deductibility of dividends is a terrible flaw in our corporate tax code. (See this post about Hyman Minsky’s opinion of the corporate income tax.) It penalizes giving the owners of companies the ability to decide how to allocate their capital, locking up capital in existing corporations because capital gains are taxed at a lower rate than dividends.

Now it would still be possible for corporations with excess cash to repurchase stock, allowing stockholders to be taxed at the lower rate on capital gains instead of the higher rate on dividends. But for multinational corporations, there is another obstacle to returning cash to stockholders either by paying dividends or by stock repurchase: cash now held overseas would be subject to the 35% corporate tax rate on either dividends or stock repurchases, imposing a huge penalty on returning idle cash to stockholders. So, instead of the cash being made available to millions of stockholders to spend or invest as they wish, creating new demand for output or providing capital to firms seeking new financing, the money is now effectively embargoed in corporate treasuries. What a waste.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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