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Unintended Consequences In The Tax Law

New York Stock Exchange trading floor, viewed from above.

The tax reform package that passed in late 2017 may be the least-loved tax cut in recent history.

The Tax Cuts and Jobs Act passed a year ago, and it should have been one of the Republicans’ purest victories since winning both chambers of Congress and the White House in 2016. But many Republicans found that the tax reform was a liability, rather than a boon, in this year’s midterm elections – especially Republicans running in states where the new cap on deducting state and local taxes hit constituents hard. Exit polls found that 45 percent of voters said that they had seen no impact from the Tax Cuts and Jobs Act, and 23 percent said it had hurt them. Ouch.

Businesses, at least, should be enjoying the new world that the 2017 tax reform created. In many ways, the centerpiece of this reform was the permanent reduction of the corporate income tax rate from 35 percent to 21 percent, along with the one-time tax break it offered on foreign profits if companies returned them to the United States. Certainly, the people who run American companies were happy with these changes. But they did not show it in the way that legislators suggested they would.

Rather than meaningfully increasing wages or expanding production, American corporations are on track to spend more than $1 trillion collectively on stock buybacks for the first time ever in 2018. S&P 500 companies alone engaged in 48 percent more buybacks in the first half of 2018 than in the first half of 2017.

Based on this behavior, companies appear to be viewing the tax cut as a short-term windfall, rather than a new long-term reality. Many politicians who supported the tax cut argued that cutting corporate taxes would let businesses spend that cash on new projects, invest in new property and equipment, or pay greater wages in the form of raises for existing employees, new jobs or both. And companies have spent on these things to some extent: Business spending was up 19 percent, an increase of $55 billion, in the first half of the year. Yet buybacks have outpaced other types of spending by far.

Despite some critics’ stance to the contrary, share buybacks are not necessarily a bad use of cash. For instance, they can be a tax efficient alternative to dividends. That’s because dividends are taxed twice: first as corporate income and then as personal income for the shareholder. Stock buybacks, on the other hand, raise the earnings per share by reducing the total number of outstanding shares, giving remaining stockholders a boost without the tax hit dividends would bring.

However, just because buybacks aren’t inherently bad does not mean they are necessarily the best use of company’s profits, either. The timing of the current buyback craze certainly does not seem to be ideal. After years of booming markets and low volatility, 2018 has brought new rumblings of uncertainty. Companies buying back shares now may be in danger of buying at the wrong time. If the company itself is struggling, the picture may look even worse – just ask the beleaguered executives at General Electric.

Many observers are frustrated. After all, the case for giving companies a major tax break was that it would stimulate more economic activity over the long term and boost stagnant wages. At least so far, that’s not what has happened.

Politicians and economists alike should not be surprised, however, when people don’t always act the way they are expected to in the face of a new law or policy. There are plenty of historical examples of carefully planned strategies that fell apart when they arrived in the real world.

Consider, for instance, the George W. Bush-era tax rebate program. The Economic Stimulus Act of 2008 included payouts to individual taxpayers designed to boost the economy and avert a recession. At the time, some people liked the approach and some disliked it, but today the effort is almost universally regarded as a failure. After all, its goal of averting a recession demonstrably did not work.

The way the tax rebate plan actually played out reminds me of the current situation, in which funds that policymakers expected to spur growth, for the most part, simply were not used that way. In the 2008 Act, most individual taxpayers received a rebate of between $300 ($600 for couples filing jointly) and $600 ($1200 for couples). A study released in December 2009 found that of the $96 billion allotted for these rebates, only about a third had been spent. Most people instead ended up saving it or using it to pay down existing debt. While those were sensible choices on the individual level, they meant that the program did little, if anything, to slow the course of the oncoming Great Recession.

The extensive stock buybacks in 2018 signal that either corporations have been pessimistic about the economy all year long, or they view the tax cut as a temporary windfall instead of the permanent change it was designed to be. Many of the 2017 law’s advocates promised that tax reform would pay for itself, but for now that seems unlikely. The national deficit is projected to expand to $898 billion by the end of the year, compared to $666 billion the year prior. If corporate uncertainty over the tax regime’s future really is the culprit, it is hard to blame business leaders for their skepticism. Democrats have shown plenty of interest in raising the corporate tax rate in the future if they are given the opportunity, and corporate leaders may see a future tax increase as inevitable, even if the timing is not clear.

Regardless, it is important to learn from and consider the likelihood of unintended consequences when we design future policies meant to stimulate economic growth. Human beings, from ordinary taxpayers to corporate executives, are not always as easy to predict as lawmakers expect.

Vice President and Chief Investment Officer Paul Jacobs, of our Atlanta office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 12, “Retirement Plans;” Chapter 15, “Investment Approaches and Philosophy;” and Chapter 19, “A Second Act: Starting a New Venture.”

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