Taxes, Regulations, and the Value of U.S. and U.K. Corporations

Transcription

1 Taxes, Regulations, and the Value of U.S. and U.K. Corporations Ellen R. McGrattan and Edward C. Prescott Review of Economic Studies (2005) March 2015

2 Outline 1 Motivation 2 Theoretical Model 3 Application to the U.S. 4 Application to the U.K. 5 Conclusion Summing up...

3 Motivation Facts 768 REVIEW OF ECONOMIC STUDIES Relative to GDP 1 Total value Equity value FIGURE 1 Value of U.S. corporations, In particular, we find that the large decline in the effective marginal tax rate on U.S. corporate distributions accounts for the high value of equities in the late 1990 s relative to the 1960 s. There are two reasons for the big decline in this tax rate. First, there were reductions in marginal income tax rates, with the largest changes beginning in the early 1980 s. Second, and more importantly, there were changes in the legal and regulatory system that led to a dramatic increase in the share of corporate equity held by entities that pay no tax on dividend or capital gains income. The percentage of corporate equity held by these entities namely, pension funds, individual retirement accounts, and non-profit organizations increased from 4% in 1960 to 51% in The crucial prediction of the theory we use is that the effective marginal tax rate on distributions affects the value of the stock market, through the price of tangible and intangible capital, but does not affect the cost of reproducible capital. The principal reason that the total value of corporations nearly doubled relative to GDP between 1960 and 2000 was not that the cost of reproducible capital relative to GDP increased, as the ratio changed hardly at all. Rather it was that the effective marginal tax rate on corporate distributions fell by more than a factor of two. There was an extended period from 1975 through 1985 when the value of corporate equity was about half of the 1960 s average. One contributing factor to these lower equity values was the substitution of debt-financing for equity-financing. This swap occurred as personal income tax rates fell below corporate income tax rates. Another contributing factor was a change in tax policy that subsidized new capital. Increased use of investment tax credits and accelerated depreciation allowances led to a fall in the price of capital and thus a fall in the value of equity relative to corporate capital. Stock market values began to rise in the mid-1980 s because most capital subsidies were eliminated by the Tax Reform Act (TRA) of 1986, individual income tax rates were lowered, and tax-deferred accounts were increasingly used. The adjustment to a higher value output ratio was gradual, taking about 15 years. We find that constraints on individuals shifting savings from non-retirement accounts to retirement accounts result in a long adjustment, with a 15-year Great Variation of US stock market value relative to GDP. Puzzling fact: No significant change relative to GDP in: Corporate capital stock After-tax corporate earnings Corporate net debt Downloaded from at Universidad Carlos III on January 8, 2015

4 Motivation Facts Possible explanation: Changes in the country s tax and regulatory system. Approach:Use growth theory to derive the quantitative implications of U.S. tax and regulatory changes of U.S. valuations. Findings: Large decline in the effective marginal tax rate on U.S. corporate distributions accounts for the increase in the value of equities from 1960s to 1990s. Low corporate value from 1975 to 1985 relative to 1960 is due to the substitution of debt-equity financing and increase of investment subsidies.

5 Motivation Facts Similar trend in the U.K., though movements were even larger than those in the U.S. 786 REVIEW OF ECONOMIC STUDIES Relative to GDP United Kingdom United States FIGURE 2 Value of U.S. and U.K. corporate equities, large run-up in the 1980 s and 1990 s (see Figure 2 28 ). What distinguishes the patterns are the magnitudes of the changes in values. The decline and increase are significantly larger in the U.K. In this section, we determine whether the movements in U.K. corporate equity values during are accounted for by changes in the key fundamental factors we have identified for the movements in U.S. valuations: corporate net debt, the corporate capital stock, and the tax and regulatory policies facing corporations. We find some change in all of these factors, but the quantitatively important factor is the U.K. tax and regulatory system. There were similar 4.1. Changes inchanges U.K. taxes and regulations in effective tax rates in the two Why are the two countries following the same pattern? countries. We begin with a review of changes in U.K. policies that affected the tax rate on distributions, the tax rate on corporate income, and subsidies to corporate investment during Tax rate on corporate distributions. Major tax reforms affecting corporate distributions occurred in 1965 and in In 1965, the U.K. introduced a system that was like that of the post-war U.S. Corporations paid tax on profits at the corporate income tax rate and shareholders paid tax on dividends at the personal income tax rate. In 1973, what the U.K. Department of Inland Revenue calls a partial imputation system was introduced to mitigate double taxation when profits are distributed. Under this system, those receiving dividends are given a dividend Downloaded from at Universidad Carlos III on January 8, 2015

6 Outline 1 Motivation 2 Theoretical Model 3 Application to the U.S. 4 Application to the U.K. 5 Conclusion Summing up...

7 1.-Households Infinitely lived households that maximize: max {c t,n t,s t} t=0 β t U(c t.n t ) (1) t=0 s.t. p t {c t +v t (s t+1 s t )} p t {(1 τ dist )d t s t +w t n t +ψ t } (2) t t where v t is the price per share. s t is the number of shares held at the beginning of the period. ψ are government transfers. i t = p t /p t+1 1 is the after-tax interest rate.

8 2.-Corporations CRS technology y t = f (k m,t, k u,t, z t n t ) (3) The technology parameter z t grows at γ. Distributions are d t = f (k m,t, k u,t, z t n t ) x m,t x u,t w t n t τ corp [f (k m,t, k u,t, z t n t ) x u,t w t n t ] + τ subs x m,t (4)

9 Corporations maximize s.t. max {n t,k t} t=0 p t d t (1 τ dist ) (5) t=0 k m,t+1 = (1 δ m )k m,t + x m,t (6) 3.- Market clearing s t = 1 c t + x m,t + x u,t = f (k m,t, k u,t, z t n t ) k u,t+1 = (1 δ u )k u,t + x u,t (7)

10 Equilibrium Conditions p t p t+1 = v t+1 + (1 τ dist )d t+1 v t (8) p t p t+1 = (1 τ corp)(f 1 (k m,t+1, k u,t+1, z t+1 n t+1 ) δ m ) + τ subs δ m 1 τ subs +1 (9) p t p t+1 = f 2 (k u,t+1, k u,t+1, z t+1 n t+1 ) δ u + 1 (10)

11 Proposition 1 An equilibrium relation specifying the price of corporate equity as a function of tax rates and corporate capital stocks is v t = (1 τ dist )[(1 τ subs )k m,t+1 + (1 τ corp )k u,t+1 ] (11) Price of tangible capital (1 τ dist )(1 τ subs ) 1 Price of intangible capital (1 τ dist )(1 τ corp ) 1

12 Interpreting τ dist In the U.S. tax system, capital gains are taxed upon realization. Therefore, τ dist in equation (11) is different depending on the way of making distributions: Personal income tax rate on dividends τ per if by paying dividends. Realized capital gains tax rate if by buying back shares. τ dist = 0 if equity is held in tax-deferred retirement accounts.

13 The prediction for value-output and capital-output ratios Proposition 2 If two economies A and B are identical except that i)their tax rates on distributions are not equal, τ A dist τ B dist, and ii)the difference in transfers offsets the difference in revenues from distributions, ψ A t ψ B t = τ A dist d A t s A t τ B dist d B t s B t then the equilibrium paths of the economies A and B are the same except for the price of corporate equity, v t

14 Outline 1 Motivation 2 Theoretical Model 3 Application to the U.S. 4 Application to the U.K. 5 Conclusion Summing up...

15 Changes in U.S. taxes and regulations A bit of history... Reduction of τ dist, from 41% on average to 17% 1 Individual tax rates τ per highest marginal income rate from 91% in 1960s to 28% in 1990s 2 Changes in the regulation of pension funds 3 Change in regulation of share repurchases Reduction of τ corp from 43% on average to 35%, measured as ratio of corporate profits tax liability (from NIPA) to before-tax corporate profits. Reduction of τ subs, via Investment tax credits Depreciation allowances in excess of economic depreciation.

16 Changes in U.S. taxes and regulations Some numbers Table 1. U.S. Tax Rates and Credits Across and Within Periods Tax on Corporate Income End of period Average for period Tax on Corporate Distributions a End of period Average for period Investment Tax Credit End of period Average for period a These estimates are based on data through Table 1 reports the U.S. tax rates used in the evaluation. 18 As Table 1 shows, average rates and end-of-period rates are about the same during the two periods, which is not surprising because tax policy changed little within these periods. We assume that people do not expect major changes

17 Model of U.S. economy Customizing the simple model 1.-Households s.t. max {c t,n t,s t} t=0 β t U(c t.n t )N t (12) t=0 p t {(1+τ c )c t +v 1s,t (s 1,t+1 s 1,t )+v 2s,t (s 2,t+1 s 2,t )+b t+1 b t } t p t {(1 τ dist )d 1,t s 1,t +d 2,t s 2,t +(1 τ b )r b,t b t +(1 τ n )w t n t +ψ t } t Population grows at N t+1 = (1 + η)n t, technology grows at γ

18 Model of U.S. economy Customizing the simple model 2.-Firms. There are two sectors, that produce a composite good. c t + g t + x 1m,t + x 1u,t + x 2m,t y t Sector 1.Corporate sector. max p t d 1,t (1 τ dist ) (13) s.t. t=0 k 1i,t+1 = [(1 δ 1i )k 1i,t + x 1i,t ]/(1 + η) for i = m, u (14) d 1,t = p 1 y 1,t x 1m,t x 1u,t w t n 1,t τ 1,k k 1m,t (15) τ 1 [p 1,t y 1,t ˆδ 1mˆk 1m,t ˆδ 1x x 1m,t w t n 1,t τ 1k k 1m,t ] + τ x x 1m,t

19 Model of U.S. economy Customizing the simple model, Firms cntd Sector 2.Non-corporate firms. max p t d 2,t (16) t=0 s.t. k 2m,t+1 = [(1 δ 2m )k 2m,t + x 2m,t ]/(1 + η) (17) d 2,t = p 2,t y 2,t x 2m,t w t n 2,t τ 2,k k 2m,t (18) τ 2 [p 2,t y 2,t ˆδ 2mˆk 2m,t ˆδ 2x x 2m,t w t n 2,t τ 2k k 2m,t ] + τ x x 2m,t

20 3.-Government g t + ψ t + r b,t b t = b t+1 b t + all tax receipts (19) If only subsidy is investment tax credit, then τ dist = τ d, τ subs = τ x, τ corp = τ 1 Total value of corporate equity On a balanced growth path, the total value of corporate equity satisfies V t = (1 τ d )[(1 τ x τ δ )K 1m,t+1 + (1 τ 1 )K 1u,t+1 ] (20) where ( )( )] δ m (1 δ1,m )(1 + π) 1 + ˆδ 1m τ δ = τ 1 [ˆδ 1x +(1 δ 1x ) i + π + ˆδ 1m γ + η + π + ˆδ 1m (21)

21 Proposition If two economies A and B are identical except that i)their tax rates on distributions are not equal, τd A τ d B, and ii)the difference in transfers offsets the difference in revenues from distributions, ψt A ψt B = τd Ad t A st A τd Bd t B st B then the equilibrium paths of the economies A and B are the same except for the price of corporate equity, V t

22 Outline 1 Motivation 2 Theoretical Model 3 Application to the U.S. 4 Application to the U.K. 5 Conclusion Summing up...

23 The rise in equity values between 1960 and 2001 K 1m = fixed corporate capital and inventory stock (BEA)+ estimate of value of corporate-owned land (IRS) Kum is estimated assuming equal after tax returns to tangible and intangible assets NIPA profit in t = p 1,t y 1,t δ 1m k 1m,t w t n 2,t τ 1k k 1m,t x 1u,t (22) i = (1 τ 1 )(γ + η + δ 1m ) x 1m,t + (i γ η)k 1u,t (23) Assuming constant i, γ, η and ˆδ 1m = δ 1m

24 The rise in equity values between 1960 and 2001 Estimating intangible U.S. capital Table 2. Estimating Intangible U.S. Capital U.S. Values Corporate tax rate (τ 1) Growth of real GDP (γ + η) Real interest rate (i) Tangible depreciation rate (δ1m) Average corporate investment a (x1m) Contributions to domestic pre-tax profits a Tangible assets [i x1m/[(1 τ 1)(γ + η + δ1m)]] Intangible assets [(i γ η)k1u] Total Estimate of intangible capital a (k1u) a These values are relative to the value of gross domestic product. Presented by Beatrizcorporate González profits is the contribution from tangible assets. For the 1990s, we find a similar result Taxes, Regulations, at and90the percent. ValueInferring of U.S. the andstock U.K. ofcorporations intangible capital using formula (33), we find that it is 0.714

25 The rise in equity values between 1960 and 2001 Estimating intangible U.S. capital In 1960, 92% of domestic pre-tax corporate profits is the contribution from tangible assets In 1990, it descends slightly to 90% Estimated intangible capital is GDP in the 1960s and 0.65GDP in the 1990 s

26 The rise in equity values between 1960 and 2001 Estimating corporate equity values and price-earning ratios Table 3. Predicted and Actual U.S. Corporate Values Predicted Fundamental Values a Domestic tangible capital Domestic intangible capital Foreign capital Total Relative to GDP Total Relative to Earnings b (P/E) Actual Market Values a Corporate equities Net corporate debt Total Relative to GDP Total Relative to Earnings b (P/E) a All values are relative to GDP except the price-earnings ratio. b Earnings are after-tax national corporate profits reported in the NIPA. Presented by Beatriz estimate González of what Prescott and Visscher (1980) call organization capital investment is conservative. Taxes, Regulations, and Evidence the Value for this ofview U.S. isand the U.K. importance Corporations of firm-specific learning-by-doing and the difficulty that

27 The rise in equity values between 1960 and 2001 Estimating corporate equity values and price-earning ratios To compute the contribution of... Intangible capital (1 τ d )(1 τ 1 )k 1u Tangible capital (1 τ d )(1 τ x )k 1m Foreign capital Kt+1 = c (1 τ x c τδ c)k 1m,t+1 c + (1 τ 1 c)k 1u,t+1 c Robustness tests show that the estimates are insensitive to assumptions concerning foreign taxes. Main results not sensitive to errors in measuring the intangible capital stock.

28 The low equity values in the 1970 s There are three factors that account in large part for low equity values after 1973: Swaping of debt financing for equity financing personal income taxes fell below corporate income taxes. Introduction of tax policies that lowered the price of new capital, and depressed corporate valuations (τ x +τ δ increased 22%, it accounts for 43% of the change) Investment tax credits (ratio investment tax credit to corporate investment went from 2% in 1960 s to almost 6% in the period !) Depreciation allowances in excess of economic depreciation (reached the nearly tripled rate, same as changing τ d from 0 to 0.18)

29 The low equity values in the 1970 s But with these two changes, the value of U.S. corporations would be 24% higher than its actual value... what could else have happened? Expectation of market participants taking into account much more generous policies, following same trend as in Europe. The previous calculations assume no further expectations of change

30 Outline 1 Motivation 2 Theoretical Model 3 Application to the U.S. 4 Application to the U.K. 5 Conclusion Summing up...

31 Changes in U.K. taxes and regulations A bit of history... Reduction of τ dist, from 49.1% on average to -5.3%! 1 Introduction of a partial imputation system in 1973 people receive dividend credit that reduces their tax liability (tax exempt institutions also received it, though they had no tax liability!- this was elimininated in 1997) 2 Small fraction of distributions through share repurchases, though it increased after Reduction of τ corp from 47.7% on average to 30.7%. Increase of τ subs, via Investment grants decreased. Significant increase in tax allowances for depreciation.

32 Changes in U.K. taxes and regulations Some numbers Table 4. U.S. and U.K. Tax Rates, Capital Stocks, and Foreign Profits U.S. U.K Tax Rates Corporate Profits End of period Average Corporate Dividends End of period Average Investment subsidy End of period Average Capital Stocks a Domestic tangible Domestic intangible Foreign/Domestic Profits a Values are relative to GDP. U.K. tangible stocks in the 1960s are available

33 Changes in U.K. taxes and regulations Some numbers Important increase in tangible capital Here, take direct measure (investment in R&D), assume it is the same fixed fraction of intangible capital in both countries, and use it to estimate value of overall investment in intangible capital.

34 Outline 1 Motivation 2 Theoretical Model 3 Application to the U.S. 4 Application to the U.K. 5 Conclusion Summing up...

35 The rise in equity values between 1960 and 2001 Table 5. Predicted and Actual U.S. and U.K. Corporate Values (Relative to GDP) U.S. U.K Predicted Fundamental Values Domestic tangible capital Domestic intangible capital Foreign capital Total Relative to GDP Actual Market Values Corporate equities Net corporate debt Total Relative to GDP The low equity values in the 1970s Next we consider the effects of changes in tax policies on U.K. valuations in the 1970s. Presented by BeatrizU.K. González equity values were on average about 0.77 GDP in the 1960s and only 0.37 GDP in the second Taxes, Regulations, and half the of the Value 1970s. of U.S. Someand of this U.K. decline Corporations was offset by a rise in the value of net corporate debt.

36 The low equity values in the 1970 s Equity values were about 0.77 GDP in 1960, but only 0.37 GDP in the second half of the 1970 s Some offset by a slight increase of net corporate debt. Increase in the rate of capital subsidies (immediate expense of many investments) near to the extreme case ˆδ 1x = 1, and then τ δ = τ 1. If calculations are done again, but only with τ δ changing from 0 to 43.1%, the prediction would be GDP, very close to the actual market value in the period (near GDP).

37 Summing up... Outline 1 Motivation 2 Theoretical Model 3 Application to the U.S. 4 Application to the U.K. 5 Conclusion Summing up...

38 Summing up... Conclusion Summing up... Derived the prediction of growth theory for the value of U.S. and U.K. corporations in the period Given the changes in tax and regulatory policy during this period, theory predicts that both countries should have experienced dramatic declines of corporate value in the 1970s and dramatic increases starting in 1980 and continuing to 1990 and both did! Predictions are very close in magnitude. Computed the price of corporate equity using National Account statistics and tax and regulatory information Large secular movements accounted for by the theory.

39 Summing up... Thank you very much!