This piece has a sentimental place in my heart. It was my first published article investment subjects (and the first of many in the Financial Analysts Journal). While tax rate redirection was getting all the attention for fast-growing corporations, accelerated payments resulted in a tax-paying increase, which few had recognized. This article analyzing JFK's Tax Cut went into specific detail no longer of interest to most readers, so they are not included. Still, the key concept was important: while tax rate reductions got all the attention and stimulated the economy, tax collections were accelerated so the government's tax income actually increased. Personally, only one year out of Harvard Business School, getting published in my new profession's most important journal was a thrill. This would, over the years, be the first of many.
Reflecting the general belief that the reduction in corporate income tax rates would provide a major stimulating addition to the reductions in individual tax rates, President Kennedy told a national television audience, as he prepared to sign the Revenue Act of 1964 into law, “on larger corporations, the rate will drop from 52% to 48%. Companies can now pay more of their earnings to those who own their stock. And they can increase their investments which, in turn, will benefit the whole country … they will use much of this money to buy new machinery, for new construction, for goods of all kinds, and most importantly, for the creation of new jobs.” In contrast to such optimism, this article shows that the revisions in corporate tax rates will not be so simply beneficial as the President and many investors seem to expect.
Since some observers expect the corporate tax cut to benefit business generally, it may be well to begin by indicating some industries which will not benefit fully. First, any company currently paying a low rate of tax will not derive as great a percentage increase in net-after-tax income as would a company now paying at the full 52% rate. For example, many railroads have taken book losses on the disposal of obsolete or worn-out capital equipment (not depreciated during the 1930s) and have typically had effective income tax rates of between 30 and 35%. Reducing their tax rates by 4 percentage points in two years would increase after tax net income by only 6% rather than the “standard” 8% increase.
Many natural resource companies also do not pay full tax rates. An oil-producing company, such as Amerada, incurs little or no federal tax liability after deducting depletion, foreign taxes, and state taxes. On the other hand, an oil refiner and marketer, such as Sohio, typically does pay higher rates of tax and will benefit accordingly.
An American corporation with extensive foreign earnings will not enjoy the same benefits from the new tax rates as similar wholly domestic companies. Since foreign taxes paid on overseas earnings can be used as credit against U.S. taxes only on that portion of total earnings derived abroad, international companies paying taxes to foreign governments at rates higher than would be applied by the Internal Revenue Service will not benefit from a reduction in the U.S. tax rates. Since the cut will be only on U.S. tax levies, an “international” company will benefit relatively less than a “domestic” competitor.
On the other hand, some companies will benefit more than average. Corporations now paying a state income tax or filing consolidated tax returns, will derive a higher than normal percentage gain in net-after-tax income. Thus, elimination of the 2% surtax will add an extra 4% to Stanley-Warner's per share earnings. And, a company now paying Minnesota's income tax of 5% and the full Federal tax rate will enjoy a potential increase in net-after-all taxes from 43% of pretax income in 1963 to 47% in 1965, or a 9% increase in reported earnings over the two-year period (compared to 8% for a company subject only to the full federal income tax rate).
An interesting application of the tax cut will be made in the utility industry, where the rate of return on investment is regulated to within certain limits, usually 6–8% of the rate base. Those utilities now earning at maximum levels would have “surplus” earnings as a result of the tax cut and regulatory agencies might impose rate reductions to bring earnings back down to acceptable levels. At least one utility management has announced that it will pass the benefits of the tax cut on to its customers by voluntarily revising the present rate structure. Accordingly, it appears that the tax cut initially will tend to benefit the customers of the most profitable utilities; also, the shareholders of the utilities now earning less than the allowable rate of return on investment, since the latter are more apt to maintain present rate schedules and use tax reductions to increase net income.
A relatively unheralded feature of the corporate tax reduction program has more general interest for financial analysts. To soften the impact of corporate tax reductions on the Federal budget, companies with annual tax liabilities in excess of $100,000 are required to advance their present tax-paying timetables. In recent years, corporations have paid taxes in four installments, due September 15 and December 15 of each year in which the income was earned, with “clean up” payments due in the following year on March 15 and June 15. The new law requires a gradual advance over a seven-year period so that by 1971, the quarterly payments will be due on the 15th of April, June, September, and December of the same year in which the income is earned and the tax liability incurred.
The net effect of the payments acceleration will be to postpone the effective reduction to a 50% rate until 1969 and delay the 48% level to 1971. In fact, cash tax rates actually rise above present rates and increase substantially for a company with a 20% compound growth rate!
Consequently, while rate reductions will result in higher reported earnings, the acceleration of payments will keep cash flow from rising, and dividends may not be increased proportionately. A caveat following from this possibility is that applying the present generous price-earnings multiples to higher reported earnings may be unjustified if higher dividends and retained earnings are not forthcoming to give support to stock prices—particularly for growth companies which have enjoyed lower effective tax rates by delaying current tax liabilities while earnings increase.
Source: Charles D. Ellis (1964) Implications for Financial Analysis: The Corporate Tax Cut, Financial Analysts Journal, 20:3, 53–55, copyright © CFA Institute reprinted by permission of Taylor & Francis Ltd, http://www.tandfonline.com on behalf of CFA Institute.