On Tax Reform
President Trump and Congress have proposed tax reforms that would be the most far-reaching in decades — and reform is much needed. A recent survey by the Tax Foundation ranked the United States No. 3 for top marginal corporate tax rates in the world:
Figure 1: Highest Top Marginal Corporate Tax Rates in the World
Source: Tax Foundation
The U.S. corporate tax burden outranks even failed states like Congo, Chad, and Argentina. Here, at the bad-boy right end of the Laffer Curve, the only people that pay the statutory tax rate are the poor, the honest, and the naïve.
Just as in Congo, Chad, and Argentina, the U.S. tax burden does not affect all equally. Small companies generally pay the full rate, while the bigger and better-lawyered companies pay far less.
Figure 2: Cash Taxes by Company Size
Source: CapitalIQ
Tax reform will therefore disproportionately benefit smaller companies. The markets have already honed in on this insight, with small-cap companies rallying significantly since Trump’s election.
A reduction in the top rate would have a significant positive impact on after-tax profits. Consider the simplified cash savings of a hypothetical reduction from a 35% to a 20% tax rate.
Figure 3: Modeled Impact of Tax Reform on the Median Firm
Source: Verdad analysis
A 23% increase in EPS may result in a dramatic change in the valuation of our public companies, and it has the potential to create an enriching event for shareholders.
As investors in leveraged companies, we are particularly focused on the proposal to eliminate the tax deduction for corporate interest. While this would obviously be a bad thing for leveraged companies, the benefits of the change in statutory rates outweigh the costs of eliminating deductions for all but the most highly leveraged firms. We ran a simplified LBO model and found the breakeven is at about 5x debt/EBITDA, which means our competitors in the private equity industry who are buying expensive >10x LBO deals are likely to suffer under the effects of the new tax reform.
Figure 4: Modeled Impact of Elimination of Tax Deductibility of Interest on Leveraged Firms
Source: Verdad analysis
If eliminating the corporate interest deduction is the cost of tax reform, we believe it’s a price well worth paying.
The United States’ uncompetitive corporate tax rate is the undertaker of an invisible business graveyard. And because a mix of workers and consumers pay the corporate taxes anyway, tax reform is something akin to a free lunch.
Of all the changes planned under the new administration, we believe tax reform may be the single most consequential for the economy and the markets. And this year, 2017, may prove to be the only year since Reagan’s 1986 reformation when it is possible. The current president said it with his typical poise, precision, and eloquence in his 23 January meeting with business leaders:
“What we’re doing is we are going to be cutting taxes massively for both the middle class and for companies, and that’s massively. We’re trying to get it down to anywhere from 15% to 20%, and it’s now 35%. But it’s probably more 38% than it is 35%, wouldn’t you say? That’s a big thing.”
It is a big thing, particularly for the small companies that do most of the hiring in this country. And it would be a big thing for equity investors in small-cap companies.