Editors’ Note: Our discussion of politics and elections is purely focused on potential market impact. Neither Republicans nor Democrats are favored by stocks. Believing in the market/economic superiority of one group of politicians over another can be a source of bias—and investing on biases can cause significant investment errors.
Patriotism. A beautiful word. We love the Stars and Stripes and chanted “USA! USA!” with the best of them during the World Cup. But sometimes, when patriotism bleeds into economic policy, it can have a dark side. That’s the case, in our view, of the administration’s efforts to crack down on US companies buying or merging with foreign firms to get a new address for tax purposes—the so-called inversion deal. On Tuesday, Treasury Secretary Jack Lew wrote a letter to key members of Congress urging legislation to all but ban the practice, later saying a ban was tantamount to “economic patriotism.” In practice, however, seems to us it would be more like another ism: protectionism, which is generally negative for markets. If the proposed ban were to become law, it wouldn’t be great. However, the probability is slim in a gridlocked Congress, limiting the risk this disrupts the bull market.
We’ll step away from the third rail of whether paying US corporate taxes is “patriotic.” For investors, the issue is more whether inversion deals are an economic negative. We’ve had 76 since 1983. They spiked in the 90s, then leveled off after Congress tried to kill the practice in a 2004 law requiring firms to keep their US address—and pay US corporate taxes—if shareholders of the foreign company they acquired received less than 20% of the resulting entity’s stock. Companies soon realized that’s a pretty easy workaround and activity resumed in earnest, with 42 inversions completing since 2008. Yet the US economy has grown overall (notwithstanding the business cycle’s normal ups and downs). So has business investment—those companies still keep their existing US offices, R&D facilities, factories and employees. So far, so fine.
The IRS would beg to differ, of course, and it’s true inversions mean the US gets less corporate tax revenue. Yet even here, it’s difficult to see a material impact. Even with potential tax dollars going overseas, the US’s total tax take is at all-time highs and rising thanks to our growing economy. The deficit is falling, with 2014’s gap on track to be the smallest since 2008’s $459 billion—both of which aren’t hugely removed from 2004’s $412 billion, before the rise in inversions.[i] The nonpartisan Joint Commission on Taxation estimates halting inversions would boost tax revenue by about $20 billion over the next 10 years.[ii] On the surface, it sounds like a lot. But compared to the $992.8 billion increase in US tax revenues over the past 10 years, it’s pocket change.[iii] Now, we wouldn’t suggest using straight-line math to assume $20 billion is an equivalent fraction of all added revenue over the next decade. But it does suggest the fiscal impact is tiny.
The administration’s proposal, as outlined in its 2015 budget, wouldn’t ban inversions outright. Instead, it would raise that 20% threshold to 50% (retroactive to May 2014, which would upend several in-progress deals)—the sheer mathematics would effectively end the practice, as it’s extraordinarily difficult to “buy” a firm if the target’s shareholders end up with half the company. From a pure economic standpoint, this wouldn’t be much of a negative. Companies would keep going about their normal business, and their boards and executives would continue fulfilling their fiduciary duty to shareholders to increase profitability in part by limiting their tax burden to the best of their ability, keeping foreign profits off US soil, funneling cash to foreign subsidiaries in tax-friendlier climates and using all available deductions to duck that 35% US corporate tax rate. Executives would just lose one means of benefiting shareholders.
However, as a means of protectionism, it is a negative for markets (see: Tariff, Smoot-Hawley). Raising the bar for completing a merger, regardless of the impetus for said merger, would impede the free flow of capital globally. If it were just the US moving in this direction, that would be one thing, but there is a growing sentiment against foreign takeovers globally. France’s government recently threatened to upend one big proposed merger on the grounds that was perhaps not in the “interests of France” before eventually relenting.[iv] This week, UK Business Secretary Vince Cable proposed giving the government power to veto foreign takeovers on “national interests” grounds and fine foreign firms who acquire UK companies but fail to honor pledges to keep certain operations and jobs in the UK. These pledges play well politically, but they are effective bans on the export of capital. If this is popular as patriotism, what’s next? A ban on exports of natural resources? Certain products? Services? Protectionism is a dangerous, slippery slope. Trade barriers can rise before you know it.
Thankfully, we don’t see the tide actually turning here—France’s move was a one-off (and it’s France), and Cable’s proposal doesn’t have the government’s support. On our shores, the administration’s proposal likely finds little traction in this gridlocked Congress. Key Senate Democrats support the measure, but the House supports a different fix: They passed a bill on July 10 that would simply prevent firms that redomicile in Bermuda or the Cayman Islands from receiving certain federal contracts, with 34 Republicans breaking ranks to support the measure. Meanwhile, House leadership is arguing against a temporary patch of any sort, preferring to address what’s causing the wave of inversions: the US’s developed-world-leading[v] at 35% corporate tax rate and onerous tax code.
The House isn’t alone in this larger goal. Republicans and Democrats alike agree the corporate tax code needs an overhaul, with a lower headline rate and far fewer loopholes. So does the administration, which also sees the proposed patch as temporary and a tax-code rewrite as the ultimate solution. To which we say, Hear, hear! But “grand bargains” aren’t easy. This Congress has talked of tax reform for ages, but they can’t seem to agree on how to accomplish it. We aren’t too optimistic this changes magically after the election, which likely yields more gridlock.
But the status quo isn’t a negative—it’s just the absence of a long-term positive. Overall, gridlock is far more beneficial than not, as it prevents potentially risky measures from becoming law. Markets did react to Lew’s proposal on Wednesday, with several foreign takeover targets hit hard, and rhetoric will likely ratchet up as campaign season progresses. Again, it’s popular. That noise even might spook stocks some. But overall, investors likely needn’t brace for a long-term impact. This political posturing stands little chance of becoming actual policy.
[i] Source: White House Office of Management and Budget, Historical Tables.
[ii] Note: Several factors make these estimations difficult. This is a rough estimate.
[iii]Source: White House Office of Management and Budget, Historical Tables.
[iv] Ironically, the government was fine with a foreign takeover. They just seemed to prefer a German buyer, not an American firm. Which is weird for so, so many reasons.
[v] By leading, we mean in first place in the race for highest statutory corporate tax rate.