Ever since Donald Trump got elected as the president of the United States, there has been constant chatter in the corporate world about the US reducing its corporation tax rate. President Trump wants to reduce the corporation tax rate in the US to 15%. This is music to Wall Streets ears as it would mean more money flowing in to the pockets of investors. As a result of reduced taxes, stocks have began to price in more profits by rallying higher. But the question is, does a reduction in taxes lead to increased profits or does it lead to lower prices for consumers?
That may seem like a silly question at first, but the more you think about it the less straightforward it becomes. One the one hand, reducing corporation tax leads to higher profits as corporations now need to pay a lower amount over to the government. But on the other hand, lower taxes for all companies means that companies will now reduce their prices for their products in order to win market share – other companies in the industry will also reduce prices to remain competitive and thus the value of decreased taxation is lost by the company; instead the consumer wins.
If you want to fully understand if reduced taxation will lead to higher profits, look at the except below from the 1986 Berkshire Hathaway letter to shareholders written by Warren Buffet.
The Tax Reform Act of 1986 affects our various businesses in important and divergent ways. Although we find much to praise in the Act, the net financial effect for Berkshire is negative: our rate of increase in business value is likely to be at least moderately slower under the new law than under the old. The net effect for our shareholders is even more negative: every dollar of increase in per-share business value, assuming the increase is accompanied by an equivalent dollar gain in the market value of Berkshire stock, will produce 72 cents of after-tax gain for our shareholders rather than the 80 cents produced under the old law. This result, of course, reflects the rise in the maximum tax rate on personal capital gains from 20% to 28%.
Here are the main tax changes that affect Berkshire:
The tax rate on corporate ordinary income is scheduled to decrease from 46% in 1986 to 34% in 1988. This change obviously affects us positively – and it also has a significant positive effect on two of our three major investees, Capital Cities/ABC and The Washington Post Company.
I say this knowing that over the years there has been a lot of fuzzy and often partisan commentary about who really pays corporate taxes – businesses or their customers. The argument, of course, has usually turned around tax increases, not decreases. Those people resisting increases in corporate rates frequently argue that corporations in reality pay none of the taxes levied on them but, instead, act as a sort of economic pipeline, passing all taxes through to consumers. According to these advocates, any corporate-tax increase will simply lead to higher prices that, for the corporation, offset the increase. Having taken this position, proponents of the “pipeline” theory must also conclude that a tax decrease for corporations will not help profits but will instead flow through, leading to correspondingly lower prices for consumers.
Conversely, others argue that corporations not only pay the taxes levied upon them, but absorb them also. Consumers, this school says, will be unaffected by changes in corporate rates.
What really happens? When the corporate rate is cut, do Berkshire, The Washington Post, Cap Cities, etc., themselves soak up the benefits, or do these companies pass the benefits along to their customers in the form of lower prices? This is an important question for investors and managers, as well as for policymakers.
Our conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its shareholders, and that in other cases the benefits are entirely, or almost entirely, passed through to the customer. What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of that franchise is regulated.
For example, when the franchise is strong and after-tax profits are regulated in a relatively precise manner, as is the case with electric utilities, changes in corporate tax rates are largely reflected in prices, not in profits. When taxes are cut, prices will usually be reduced in short order. When taxes are increased, prices will rise, though often not as promptly.
A similar result occurs in a second arena – in the price- competitive industry, whose companies typically operate with very weak business franchises. In such industries, the free market “regulates” after-tax profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the same function in dealing with the price- competitive industry as the Public Utilities Commission does in dealing with electric utilities. In these industries, therefore, tax changes eventually affect prices more than profits.
In the case of unregulated businesses blessed with strong franchises, however, it’s a different story: the corporation and its shareholders are then the major beneficiaries of tax cuts. These companies benefit from a tax cut much as the electric company would if it lacked a regulator to force down prices.
Many of our businesses, both those we own in whole and in part, possess such franchises. Consequently, reductions in their taxes largely end up in our pockets rather than the pockets of our customers. While this may be impolitic to state, it is impossible to deny. If you are tempted to believe otherwise, think for a moment of the most able brain surgeon or lawyer in your area. Do you really expect the fees of this expert (the local “franchise-holder” in his or her specialty) to be reduced now that the top personal tax rate is being cut from 50% to 28%?
Your joy at our conclusion that lower rates benefit a number of our operating businesses and investees should be severely tempered, however, by another of our convictions: scheduled 1988 tax rates, both individual and corporate, seem totally unrealistic to us. These rates will very likely bestow a fiscal problem on Washington that will prove incompatible with price stability. We believe, therefore, that ultimately – within, say, five years – either higher tax rates or higher inflation rates are almost certain to materialize. And it would not surprise us to see both.
In essence, Buffet makes the point that tax cuts will be competed away by the market thus making no difference to investors. The only beneficiaries from tax cuts are those companies with high quality unregulated businesses.