The premise of the 'Tax Cuts and Jobs Act' is that lower taxes will lead to an increase in business investment and consumer spending, spurring on growth that will more than offset revenue cuts. We do it by entrusting the corporate class with a windfall we hope they spend wisely.
There's reason to believe it won't play out this way.
Jeremy Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co., has pointed out the price-earnings ratio of the stock market over the past 20 years has been 70 percent higher than the previous 100. The profit margins of U.S. corporations have been 30 percent higher. It's a golden age for U.S. corporations.
At the same time, Grantham notes that companies aren't using these dividends to build new plants in the U.S. They're buying back stock, for one, to drive equity prices higher. Great for corporate executives and stockholders, not so good for U.S. economic growth. "There aren't as many new firms that get started," says Grantham, "the number of public companies has halved, the number of people working for firms that are one or two years old, are half what they used to be in 1970."
Instead, the capital resulting from higher profits is camped out in paper, including billions in private equity. There are 10 times as many private equity firms in the U.S. today than there was in 1990, with over $500 billion to invest but a record capital overhang. Corporations and private investors have more capital to invest than ever. They're conservative when it comes to investing it.
Why aren't they spending?
Investors point to a lack of companies. "Equity firms tell us the toughest issue they face is simply finding enough good candidates to look at," according to Generational Equity, a PE firm based in Dallas, in 2012. "They are hungry for deals, but they just don't see enough." Five years later, $100 billion more in equity capital is poised to be invested through dozens of new firms, family offices, and capital funds. It's more likely that investors aren't seeing enough deals they like, not that deals aren't there to be had.
It's not for want of opportunity. The economy is undergoing a shift to small and middle-market companies. Doug Tatum chronicles the importance of early-stage companies navigating the perilous stage from start-up mode to growth company in 'No Man's Land'. Today these emerging middle-market companies "account for less than 3 percent of all businesses, yet contribute 30 percent of all new jobs added by all businesses," Tatum says. He also writes, "From 2010 to 2013, the number of companies in the U.S. with 20 to 99 employees increased 10 percent, while the number of U.S. corporations with 1,000-plus employees decreased by 16 percent." Grantham's point.
For Tatum, these companies are the new heroes of the U.S. economy. They're also the most vulnerable, as capital and management expertise are most elusive for businesses of this size.
If tax cuts don't motivate buyers, will lower rates improve the quality of acquisition targets for investors? It's hard to say. In over 800 interviews with manufacturing executives that we've completed the last four years, only a handful of companies cited high taxes as a barrier to growth.
Today the corporate class seems comfortable investing in next quarter's profits, not next year's emerging growth company. Tax cuts help the balance sheet. Tax reform, done right, might pursuade them differently.
Bart Taylor is publisher of CompanyWeek. Reach him at email@example.com.