Downtown Ho Chi Minh

Tax Bill Good News: Funding for your Business

The Tax Cut and Jobs Act of 2017 has been criticized for numerous reasons one of those being the huge tax cut for corporations. However, I’d argue having companies keep more of their profits isn’t as detrimental as it seems to the budget and could even be productive for the country. What if companies used their profit to invest in start-up businesses that provide services or do research related to their sector? Businesses functioning like venture capitalists in their sector by providing capital to start ups in exchange for stock would encourage innovation and allow corporation investors on the ground floor to shepard innovation’s growth and implementation.

Policy that encourages business to use their profits to invest in start-ups, raise the wages of all their workers, and reduce stock buybacks and dividend payments would be a boon to America. Start-ups and small businesses employ more people and create more innovation than corporations, but have limited capital. Worker wages especially those for the middle class have not risen, while those at the top have. And stock buybacks and dividend payments have stagnated real growth in businesses for years. Addressing these problems could harbor in a new age of prosperity for large corporations and the everyday citizen alike.

The results and conclusions are listed next and the calculations and sources are listed below. The calculations are a bit long, but even for skimmers I recommend clicking on some of the links.

Results and Conclusions

Facts

In 2017, the S&P 500 spent more money on buybacks ($780 billion) than either CAPEX ($610 billion or R&D ($290 billion). They spent more on buybacks and dividends combined ($1.2 trillion) than they make in profit ($900 billion), and funded it all with more and more debt ($1.3 trillion total corporate debt issued in 2017).

Corporations are expected to pay almost $200 billion less in taxes due to the tax plan; however this difference is only about 5% of the federal budget, and corporate taxes as a whole only make up only 7-9% of the federal revenue. The loss of corporate tax revenue should be counteracted by higher business investments.

Meanwhile, venture capitalist invested a record $148 billion in startups and small business loans totaled $600 billion. Both sums pale in comparison to the amount spent on buybacks and dividends. 

Assumptions

If buybacks or dividends were capped at 50% of profits, the other half could be used to expand CAPEX, R&D, wages, and business investment.

We assumed S&P 500 investment for CAPEX and R&D increased 10% ($61 and $29 billion respectively) and wages increase 3% totaling $45 billion (5% of profit), leaving $321 billion for investment.

CAPEX and R&D have fallen as a share of companies cash, not only from financial pressure, but simply because the sums have gotten so large it is hard to efficiently invest more. Small business and startups could be invested in instead to contract out jobs and find new innovations. Companies constantly buy smaller companies that create related innovative products; investing in from the start and helping development with the support of money and resources is the next logical step.

Venture capitalist expect returns of 20%, but usually from only 20% of their portfolio. In 2017 venture capital invested a record $148 billion into startups and outstanding small business loans totaled $600 billion with returns from 7-9%. Small business loans under $100,000 made up 92% of all small business loans (22.3 million), but with a value of $151 billion.

Doubling the investment in startups ($148 billion) and using the remainder ($178 billion) to invest in small business would foster innovation and create more jobs. Policy could influence whether more sole proprietorships (20 million currently) are formed or if funding employer small businesses would be more wise (6 million currently).

Results

This is a better employment strategy than encouraging large corporations to hire more people. Between automation and running lean corporations are expected to be more productive with less people not more. However, small businesses and startups have a small but steady number of employees encouraging the creation of small businesses creates more steady jobs.

Buybacks including dividends ROI over the past few years is 13.8%, while a S&P 500 index fund’s ROI is 15.8%. Investing $148 billion in startups with a return of 20% and $178 billion in small business for a return of 12% (this return includes the cost savings of labor and certain tasks achieved from partnership), the ROI of small business investment (15.6%) would exceed buybacks ROI and be on par with a S&P 500 index fund during a historical bull market.

Despite the fact, excessive stock buybacks and dividend payments have been shown to stifle growth, cost money to companies in the short and long term, and encourage larger levels of debt; CEOs invest in buybacks because they get paid in stock and buybacks increase stock’s value. Removing the incentives for buybacks due to SEC regulations, the favorable tax treatment of capital gains and corporate debt, and encouraging investment in productive measures instead will have untold effects on the economy.

Calculations and Sources

Sources, Methods, and Calculations below. 

Facts

S&P 500 Buybacks and Dividends combined for a total of $1.2 trillion. That is more than their profit ($900 billion), CAPEX spending ($610 billion) and R&D spending ($230 billion). Since buybacks and dividends exceed corporation’s profits they finance the remainder with tax preferred debt ($1.3 trillion issued). The amount of debt issued for corporations exceeded the outstanding amount of small business loans ($600 billion) and Venture Capitalist Investments ($148 billion) in 2017.

Corporations paid $418 billion in taxes in 2017 and are expected to pay only $225 billion in 2018 due to the tax cut. However, this $200 billion difference is only about 5% of the federal budget, and corporate taxes as a whole only make up only 7-9% of the federal revenue. Having tax rates that are competitive with the rest of the world discourages tax sheltering and encourages business investment in the United States and only costs a small percentage of federal revenue that could make up for it in other ways (i.e. increasing capital gains tax, employment increases, wages increases).

S&P 500 Profit

$900 billion

Fortune (2017)

Total Business Profit

$2.1 trillion

The Balance (2017)

Corporate Total Taxes (2017)

$418 billion

Tax Policy

Corporate Total Taxes (2018)

$225 billion (estimated)

The Balance

S&P Buybacks

$780 billion

Forbes (2017)

S&P Dividends

$420 billion

Market Watch (2017)

S&P Debt

$775 billion

Seeking Alpha (2017)

Total Corporate Debt

$1.3 trillion

CNBC (2017)

S&P CAPEX

$610 billion

Barrons (2017)

S&P R&D

$230 billion

Calc Bench (2017)

VC Total Investments

$148 billion

Pitchbook (2017)

Small Business Loans

$600 billion

SBA (2015)

Assumptions

Our goal is to use this data to see what effects capping the amount of money corporations can spend on buybacks and dividends would do for investment, capital expenditure, R&D and wages. We will use a conservative cap of 50% of the year before profit for buybacks and dividends. We also assume the next year has identical profit as this year; that puts $450 billion of profit in the fold.

After the new tax plan was put in place CAPEX spending increased to a near record amount, but as a percentage of corporation cash it has fallen to a near low (Bloomberg). In the same vein R&D spending has increased to record highs as well, but still remain a low percentage of corporate cash (PWC). This isn’t necessarily a misalignment of priorities, but a limitation of scale. It is difficult for business especially large corporations to put such large amounts of money in CAPEX or R&D and expect quality results. Therefore, for our model we will predict 10% growth in CAPEX and R&D, which is still more than we could predict under these circumstances. The 10% growth would cost $84 billion of the $450 billion in profits leaving $366 billion.

Wages could also eat into the profits. There are about 24 million workers employed by the S&P 500 and the median household income is $59,039 (Business Insider). If everyone gets a 3% raises ($1,772 per person) that would cost $43.6 billion. So we assume 5% of profits go to wages costing another $45 billion leaving us with $321 billion. What could corporations do with the extra money? Were they right buybacks are simply the best use for their extra cash or could other investments be better for them and the country?

 

VC Average Return

20%

Angel Blog

Startup Average Employees

5 employees

Business Insider (2012)

% of Small Business Loans under $100,000

92%

SBA (2015)

Loans under $100,000

22.3 million

SBA (2015)

Worth of Loans under $100,000

$151 billion

SBA (2015)

Worth of all Small Business Loans

$600 billion

SBA (2015)

Workforce Participation Rate

60-63%

BLS (2018)

Number of Sole Proprietorships

~20 million

IRS 2018

% of workers employed by small business

50%

SBA (2012)

Number of employer small businesses

6 million

SBA (2012)

Small Business Loan Return

7-9%

Fit Small Business (2018)

 

Expected Outcomes

I’ll argue investing in startups and small businesses is a better use of that extra profit than buybacks or dividends. CAPEX and R&D spending has dropped as a percentage of companies cash, not just because of the finicial sector’s influence, but also because it is hard to put that large of a sum to good use efficiently: enter small businesses and startups. Corporations could delegate tasks that they are too big to achieve efficiently to contractors and invest in startups to innovate their industry. However, would it be profitable?

Venture Capitalist invested a record $148 billion last year in startups and expect returns of 20% usually generated by only 20% of their portfolio. Startups have on average 5 employees, are less than 10 years old, give equity to receive funding, and typically try to achieve rapid disruptive growth despite profitability. However, small business are usually debt financed and seek to be profitable immediately. There is about $600 billion of small business loans outstanding with average interest rates around 7%, 92% of them (22.3 million) are for less than $100,000, but only amount to about $151 billion. With the remaining $321 billion corporations could double startup investment for another $148 billion and have $173 billion left for small business loans. However, what would be the best use for these loans? Investing in as many companies as possible? Or only companies that employ more than a certain number of people?

There are about 20 million sole proprietorships and only 6 million small business classified as “employer-businesses”. Corporations could more than double the amount of loans less than $100,000 to diversify their options, most of those loans would go to sole proprietorships and encourage a new wave of entrepreneurs. However, if the focus was on jobs corporations could invest the $173 billion only in small businesses that employ more than 1 person, spread evenly that would be almost $30,000 per employer business. Either way this huge boom in small business investment would create millions of jobs, currently their are around 141 million workers, 3% less than 2008 (Business Insider). If just half the extra $173 billion in investment went to wages it could add 3 million jobs with a salary of about $30,000 a year.

So how does investing in startups and small business compare to the returns from dividends and buybacks. According to Fortune, the median return on investment for buybacks including dividends is 13.8 % while the return for the market as a whole is 15.8%. Venture capitalist expect returns of at least 20%, but only from 20% of their portfolio. Small business loans can only be as high as 9% and average around 7%, but partnering and investing in small business could result in lower labor costs and capital expenditures for work that could be contracted out cheaper, so we assume a 12% return on investment including cost savings for small business loans. On the $321 billion if it was used for stock buybacks and receive the median return it would net $44.3 billion, $6 billion less than putting it into a S&P 500 index fund. However, if it was $148 billion was used to fund startups and $173 billion used to loan out money to small businesses, and receive returns of 20% and 12% respectively it would yield $50.6 billion more or less on par with the S&P 500. However, the stock market as a whole generally only has returns of around 8%, these past years have been historically high, but investing in startups and small businesses still outperforms investing in stock buybacks and dividends. Furthermore, it is on par with one of the largest bull markets in history, when things correct back to normal averages investing in small businesses will far exceed investing even in the stock market.

So why do companies perform stock buybacks at such scale if they don’t even outperform the market? The main answer is CEO pay is determined by the worth of the stock market and they get paid in stock which is tax preferred when compared to normal pay. Fixing CEO compensation and capital gains laws to not incentivize this behavior would reduce buybacks; however a cap would ensure it. Encouraging companies to invest in startups shouldn’t be too difficult, but also encouraging them to provide small business loans would require policy incentives. However, the employment and innovation benefits are worth any policy costs.

 

 

 

Comments

comments

Share This