With the U.S. presidential election well under way, tax reform is an increasingly prominent topic in the news. The trend of companies using tax inversions to re-domicile outside of the U.S. has caused increased scrutiny of the practice and the factors underlying the popularity of the move.
The United States has the highest corporate tax rate in the developed world at 35 percent. Candidates from both parties have proposed different measures for preventing inversions, from exit taxes to changing the tax rate domestically. Several leading presidential candidates have proposed lowering taxes for businesses to prevent future inversions and incentivize companies to keep their headquarters in the country. One candidate in particular, Donald Trump, proposes lowering the tax rate to 15 percent, as mentioned in a recent Reuters News article.
The corporate tax rate of 35% is rarely realized by large companies. Within the S&P 500, two-thirds of the companies had an effective tax rate less than 35%. The median company had an effective tax rate of 29.3%, as shown in Exhibit 1 below.
Source: I/B/E/S data
Median tax rates differ between sectors. Some of the heavily regulated sectors like Telecommunication Services and Utilities have median effective tax rates near the statutory rate at 33.6% and 34.0%, respectively. On the other hand, companies in the Information Technology, Health Care, and Energy sectors pay taxes significantly below the 35% rate.
Analyzing effective tax rates
Considering the difference in effective tax rates realized by different companies, one may wonder if the market rewards those companies that are more effective in minimizing their tax bills. To assess this, we looked at the past 10 years of effective tax rates for the companies in the S&P 500 and compared them with annual stock returns. The correlations can be found below in Exhibit 2.
The results of this analysis are correlation coefficients near 0, although slightly negative for most of the past decade. This indicates an extremely weak to nonexistent relationship between effective tax rates and stock returns.
Source: I/B/E/S data
Relationship to margins
Although it appears that the market integrates effective tax rate information into stock prices efficiently, we see that companies that effectively minimize their tax bills or operate in tax-favored industries tend to have higher margins. As shown below, the correlation between tax rate and net profit margin is near zero, although consistently slightly negative, and more negative on average than the relationship between tax rate and stock return. This is unsurprising, as companies that pay less in taxes should tend to see more revenue flow through to the bottom line; however the effect is still fairly weak.
Source: I/B/E/S data
