The impact of proposed federal tax reforms on U.S. financial markets

Business Economics, Jan, 1996 by Albert E. DePrince, Jr., William F. Ford

Corporate Taxes, the Cost of Capital and

Stock Prices

The Corporate Tax Base: The VAT (either a stand-alone VAT tax or the Nunn-Domenici proposal) and the Armey gross corporate receipts tax effectively eliminate the deductibility of interest in calculating the corporate tax base. From a corporation's point of view, this has both a positive and negative effect. On the positive side, the disparate treatment of interest and dividends is eliminated, as neither will be a deductible business expense. As a result, debt will no longer be preferred over equity as a means of financing expansion. On the negative side, the loss of the deductibility of interest expense eliminates an important tax shield that has influenced the weighted average cost of capital (WACC) for businesses. If the cost of debt and equity is unchanged in the new environment, loss of the tax shield will raise the WACC. By itself, this would inhibit corporate capital formation and therefore discourage expansion and growth.

Fortunately, other aspects of these tax reform proposals may lower the WAAC. First, without the tax shield provided by debt, it is likely that firms would begin to deleverage their balance sheets, i.e., less debt will be used, relative to equity, to finance fixed assets. Also, as debt matures, there is a good chance that it will be partly replaced by equity in the new tax environment. Reduced leverage, in turn, should have several positive effects. The reduced supply of corporate debt issues could lead to a reduction in the general level of interest rates, although there is no way to provide an exact estimate of the possible decline. Second, increased equity will lessen the default risk faced by firms that deleverage. Also, such a decrease in default risk will have a favorable effect on the cost of both equity and debt. In sum, share prices should rise, and interest rates on corporate debt should decline.

However, the overall effect on the WACC depends upon the relative importance of the positive effects of deleveraging, as noted above, versus the effect of losing the corporate interest tax shield. If the positive effects mentioned above more than offset the loss of the interest tax shield, firms could more easily finance expansion as a result of the Armey tax reform program.

The Treatment of depreciation: Armey's proposal also provides for the immediate expensing of newly acquired capital goods. This will have the effect of boosting the near-term cash flow of capital intensive firms because they will no longer be forced to recover capital investment over many years. It also will most likely boost the market value of capital-intensive firms, because near-term cash flows are more valuable than later cash flows. Their shares prices should, therefore, improve and their cost of capital should be reduced. However, how to treat the stock of existing unused depreciation remains an unresolved Armey issue.

Nunn-Domenici also provides for immediate expensing of investments and goes a step further, by providing some relief for existing unused depreciation.