January 2018 Data Update 8: Debt and Taxes

In the United States, as in much of the rest of the world, and as has been true for most of the last century, the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to those that use equity to fund their operations. While the original rationale for this debt bias was to allow the large infrastructure companies of the equity markets (railroads, followed by phone and natural resource companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment of the economy is built on debt. The most revolutionary component of the US tax reform package that passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so, challenges companies that have long depended on debt to reexamine their financing policies. 

In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper than equity and dilution benefits:

The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to borrowing were greater in the United States than in any other country last year, for a simple reason. The US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%, that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year, partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction against its highest taxed income (its US income). For those of you who find this unethical, please spare me the moralizing since your disdain should be directed at those who wrote the tax code.

As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax benefits of debt, which will be dramatically decreased starting this year, for two reasons:

1. Lower marginal tax rate: The marginal tax rate for the United States has gone from being the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been entirely in shades of red last year, before the tax rate change, since there was no other country with a corporate tax higher than 40%.

Datasets

1. Debt Ratios by Sector, US (January 2018)
2. Debt Ratios by Sector, Global (January 2018)
Spreadsheets
1. Capital Structure Optimizing Spreadsheet (with 2017 US Tax Code changes built in) (with YouTube guide to using this spreadsheet)
2. Disney Optimal Capital Structure 
3. Facebook Optimal Capital Structure
4. Ford Optimal Capital Structure
Data Update Posts
1. January 2018 Data Update 1: Numbers don’t lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value – Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: The Cash Harvest – Dividend Policy
10. January 2018 Data Update 10: The Pricing Prerogative