Are Taxes the Problem?
A rather curious event took place in the course of the Republican tax overhaul push last week. At an event hosted by the Wall Street Journal, CEOs were asked if passing Republican sponsored tax reform would spur them to increase capital expenditures. The paltry show of hands raised by the group left little doubt that cutting corporate tax rates would do virtually nothing to raise the level of capital expenditure ( CEOs raise doubts about cutting the corporate tax rate ). The meager rates of capex since the financial crisis have not been a function of either the level of taxes corporations pay, nor the structure of the tax system in place. That realization should be a wake up call for Republicans seeking to pass the most ambitious overhaul of the tax system in 30 years, considering it debunks their primary argument for the legislation. My previous post ( ’80’s Nostalgia: Glue That Binds the GOP ) already made this case by comparing compound growth rates for U.S. GDP between the ’70s and the ’80s, as well as, deficits. There is literally no basis for the belief that growth will be spurred by the tax cuts, but there is a basis to predict that deficits will rise. In fact, the house bill that just passed is expected to raise deficits by almost $1.5 Trillion over the next decade.
The irony here is that in recent years Republicans have been held captive by “Tea Party” Republicans pushing for fiscal austerity, rather than largesse. But with the GOP in complete control in D.C., and facing a first year with little to show, Republicans are desperate to achieve a legislative victory. Unfortunately, with economic growth actually looking quite solid, it looks as though they are prescribing the wrong medicine at the wrong time.
Have We Just Been Depressed?
The most simplistic reason often given for the depressingly low rate of investment in this cycle is a hangover effect from the crisis. Without a doubt, the desire for risk taking after a catastrophic financial crisis is going to be lacking. To illustrate the damage to “animal spirits” Chart 1 shows the level of U.S. Fixed Investment as a percentage of GDP.
U.S. Fixed Investment as a Percentage of GDP
U.S. Bureau of Economic Analysis
It’s easy to see from Chart 1 that fixed investment in this cycle has peaked well below previous cycles (16.5% of GDP vs. 19-20%), and the average has been substantially lower. The argument that this lower level of investment is a function of poor sentiment, and risk aversion, isn’t wrong, it’s just incomplete. Record low interest rates have not raised investment levels because the cost of capital was not the problem. The issue was, and continues to be, a surplus of capital. An extraordinary level of fixed investment was accumulated in the years prior to 2008, and nowhere was that more evident than in China.
The Real Culprit: Capacity Glut Led by China
The elements of the lead up to the financial crisis of 2008 at this point is well known. Stories of obscene leverage applied through complex derivatives, and the ensuing credit bubble have been catalogued extensively in books and movies. A lesser known aspect, but a crucial ingredient, was the policy driven expansion of fixed investment in China. The opening of the Chinese economy from a communist to a more market driven system, which had accelerated in the 1990’s, went into hyperdrive with the acceptance of China into the World Trade Organization in 2001.
Aided by an undervalued exchange rate, the Chinese promoted export growth through a classic mercantilist strategy. Augmenting China’s advantage further, their currency was pegged to the U.S. dollar, which depreciated massively through the early and mid-2000’s (approximately -40%). On the monetary side, to hold the peg, China needed to buy enormous amounts of dollars, and invest in U.S. treasuries. This action acted like a perpetual motion machine for liquidity, keeping rates low, and risk assets buoyant.
In regards to the real economy, China promoted growth in various ways that exacerbated the bubble. Local officials were given GDP targets to hit without regard for whether the growth was healthy and sustainable. State-run banks had loan quotas that guaranteed excessive credit growth, and back-stopped reckless investment. Chart 2 shows the inexorable rise in Chinese investment as a percentage of GDP throughout the 2000’s.
China Gross Fixed Investment as a Percentage of GDP
National Bureau of Statistics of China
What is quite shocking is that the ratio didn’t top out prior to the financial crisis. That’s because in the immediate aftermath, China issued new directives for banks to increase credit growth, setting off another leg in the fixed investment bubble. As the chart shows, gross fixed investment topped out in 2014 at a little over 45% of GDP. For perspective, it’s important to know that this is a level double that of the average economy. Emerging markets, during periods of rapid expansion, have registered much higher levels than the average, but prior to China, the highest we had seen was around 35%. When you take into consideration the size of China, at about 15% of the global economy, it’s easy to understand how such massive investment levels have global implications. Excess investment in China has been the primary contributor of surplus manufacturing capacity around the world.
If You Build It, Will They Come?
Chart 3 shows Capacity Utilization for the U. S. economy, which indicates the percentage of manufacturing capacity that is in use at any given time.
U.S. Capacity Utilization (Percentage of Available Capacity)
You may notice a positive correlation between Chart 1 and Chart 3 (Fixed Investment/GDP Ratio vs. Capacity Utilization). That makes perfect sense. Why build new factories, warehouses, etc. when you’re utilizing a historically low level of existing capacity. Zero interest rates, negative interest rates, and trillions of dollars in central bank purchases of securities does nothing to change this reality. Businesses are reacting to real economic fundamentals. And if we take corporate leaders at their word, lower tax rates will not lead to more capex either. Nor should it. Adding to capacity is only likely to lead to more excess capacity, ultimately driving down returns on capital.
Theoretically, if these monumental monetary efforts had stoked demand, capacity utilization would have risen, and new capex may have been justified. But as we know, demand has been lackluster for most of this cycle. Sentiment explains much of this, but once again is only half the story. Consumers and businesses, traumatized by the crisis, have been reluctant to take risk. Households in particular had spent well beyond their means, aided by bubble level house prices, and easy credit (particularly home equity loans). In 2008, household debt as a percentage of GDP reached a record high 98%. In subsequent years, it has dropped to 76.5%. Bankruptcy, mortgage forgiveness, and somewhat higher savings rates have lowered household debt. That is marginally comforting, until you realize that it has simply been offset by government and corporate debt accumulation, leaving the U.S. Total Non-financial Debt to GDP ratio close to its record high at roughly 245%!
So if we buy into the argument for the GOP tax plan, we believe that cutting corporate taxes will unleash growth beyond what we’ve seen in this cycle. As I have shown, this is in contrast to the evidence I presented in a prior post. First, the ’80’s tax cuts do not look to have improved growth, but they did raise deficits. Second, corporate leaders show no desire to use the windfall from tax cuts to increase capex. Beyond having excess capacity, a look at S & P 500 net profit margins shows they are near record highs. Corporations are not suffocating under repressive taxation, and they are not capital constrained in any respect. Furthermore, the economy seems to be on solid ground right now. The GOP is risking expanding deficits into an economy 8 years into an expansion while the labor market seems to be tightening. I’m sorry, but that doesn’t seem like smart policy. Which begs the question: Why are Republicans really doing this? Actually, that’s rhetorical. I think readers know why. And some members of the GOP have already told us: it’s to keep donors happy.
The longer-term implications of Republican’s cynical political strategy are not academic. Corporations have used excess cash flow in this cycle primarily to buy back stock in lieu of expanding capex. Along with about $4.5 Trillion in balance sheet expansion from the Fed, their actions have helped push equity market valuations to levels similar to prior to the 1929 and 1987 crashes. Of course, valuations were much higher at the height of the tech bubble. Continuing QE from Japan and Europe, a global coordinated expansion, and tax cut fever, have people feeling giddy. If the GOP manages to pass these tax cuts in a form similar to what’s been proposed, I think they will learn two harsh lessons: one economic; and one political. I look forward to covering these in the near future. For now, I’ll leave you with the immortal words of Chuck Prince, Citigroup CEO, circa 2007:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”