The backlash against tax avoidance is bad news for US stocks

US INternal Revenue Service © Getty Images
US: relatively high corporate tax rates

It seems that almost every day we hear another story about a celebrity who has been using dodgy schemes to avoid tax.

But just as important – if not more important to investors – are the companies that stretch laws to the limit in an effort to reduce their tax bills.

Many firms have become adept at exploiting loopholes in the system to boost their profits, and therefore their share prices.

Now a backlash is brewing, especially in the US – and that could be bad news, particularly given how overpriced stock markets already look…

US companies have done well by gaming the tax system

US firms have been big winners from the tax dodging game. As late as the mid-1980s, firms paid nearly 40% of their profits in tax. This wasn’t much different to the highest marginal tax rate on incomes, which was 35%.

The official tax rate for companies hasn’t changed since then, but the effective rate has fallen to just above 20% thanks to skilful exploitation of loopholes. In fact, some estimates suggest that if you consider only the profitable firms, the effective tax rate is barely 10%.

What’s more, about a third of total growth in S&P 500 companies’ profits since then has been due to falls in the effective tax rate, according to Pictet Asset Management.

There are many reasons for this. Firstly, firms have exploited the longstanding loophole in tax law that allows firms to deduct interest payments on their debt from their taxes. Indeed, a key part of the strategy of private equity is to buy firms and take out a load of tax-deductible debt to pay for the purchase.

Another common trick is to manipulate the supply chain to shift revenues to a low-tax jurisdiction. Take a drugs company that has a research clinic in a low-tax country such as Malaysia. Even if the centre clinic only costs $50m, it could bill the headquarters for $100m. As a result, the additional $50m would be taxed at 25%, not 35%. Provided that the extra cash was not brought back to the US, this would result in a saving of $5m (10% of $50m).

Some argue that America’s relatively high corporate tax rates encourage these. If America cut its rates, many firms would bring money back to the US, creating more jobs in the process.

This may be true, but this isn’t just an American problem. Britain has a much lower rate of only 21%. And yet there have been a number of high profile companies, such as Starbucks and Amazon, who have managed to avoid paying much or any corporation tax at all. Overall, it’s estimated that in 2011-12 that there was a corporation ‘tax gap’ of just under £5bn.

In any case, there are limits to how far countries can reduce business taxes, especially while they are raising other taxes. According to Pictet, over 80% of countries increased consumption tax rates between 2010 and 2013. At the same time, far more countries have hiked social security, income, wealth and excise taxes, than cut them.

In contrast, there have been net cuts to corporate tax rates. That’s hard to maintain at a time when everyone else is being asked to pay more for less.

A major backlash is brewing

Luca Paolini, chief strategist at Pictet, reckons there’s a risk of a major crackdown against corporate tax avoidance – and it’s something that investors need to be aware of.

In the UK, the backlash is well underway. After its low contribution to the Treasury was revealed, Starbucks saw its first drop in sales in 15 years. As a result it has decided to review its UK tax policy.

Meanwhile, the EU is investigating the corporate tax system in Luxembourg, one of the countries at the epicentre of many of the most notorious schemes. The probe is taking a look at deals struck by a number of well-known firms, including Apple, Starbucks and part of Fiat.

In the US, there is growing anger against a host of ‘tax inversion’ deals, where American companies shift their tax liability outside the US by merging with competitors in other countries. Indeed, experts think it is likely that legislation will be passed to make such moves illegal.

Clearly, this trend will take time to gather momentum. However, it’s clear that governments around the world are facing fiscal crises. Cutting spending is difficult, while raising income and consumption taxes is unpopular. Closing loopholes for business is a solution that would be politically popular.

Avoid the US – buy Japan

A potential increase in the amount of tax companies are paying, leading to a fall in profits, is yet another reason to avoid the US stock market. With corporate margins at record highs, it seems hard to see how profits could grow at a rate that justifies the US market being valued on a cyclically-adjusted price/earnings (Cape) ratio of over 25.

However, Japan might be an exception. A key aspect of ‘Abenomics’ is to cut Japan’s high corporate tax rates by nearly half over the next few years, and shift the long-term burden to sales taxes.

As a result, Japanese firms are likely to do well. One way to buy into Japan is through either the Lyxor Japan ETF (LSE: JPNL) or the Baillie Gifford Japan investment trust.

And finally, before I go – and on a completely separate topic – I thought you might like to know that one of the big crowdfunding platforms, Crowdcube, is looking for investors in its business. A venture capital firm, Balderton, has just invested £3.8m in Crowdcube, and Crowdcube is looking for a further £1.2m from private investors. This is a very high-risk investment, but if you want to find out more, visit the Crowdcube website.

You can also find out more about crowdfunding in Ed Bowsher’s recent MoneyWeek cover story on the topic – Investing in start-ups: How to set yourself up as a ‘Dragon’. (If you’re not already a subscriber, you can sign up for a free trial of  MoneyWeek magazine here.)

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  • pennysjp

    Matthew, a back-lash clearly orchestrated by governments to blur the line between perfectly legal tax avoidance using existing British law and illegal tax evasion. Just why anyone would want to pay more tax than they have to the useless, second rate politicians who can’t stop spending other people’s money in an effort to get re-elected beats me. Not paying what you legally owe is clearly wrong, trying to legally keep your tax bill down is not. Morality? What is moral about governments spending more and more bribing the electorate with benefits and bankrupting the country? Then demanding that your average Joe fills their coffers so they can do it all over again.

    • Inquisitor

      Good comment but this is the government’s MO. Spend spend on whatever buys the most votes and lobbies, vanity projects etc, stick taxpayers with the bill, then whine about morality or patriotism ex post facto. Never mind that most people have no issue in engaging in tax avoidance of their own, eg pensions. Politicians are purely paid through taxes and still, along with many bureaucrats, dodge taxes as much as they can. It is farcical to hear them accuse anyone of this. Instead, people should be outraged by the spending that demands so much taxation, that future generations will incur debt without any say in it and the legalised counterfeiting called QE. Countries like the US deserve the exodus of corporate wealth production coming their way.