Interview with James Lucier, co-founder Capital Alpha


Jackie: / Hello, I'm Jackie Doherty, a contributing editor with Yardeni Research. Today I'm interviewing James Lucier, a co-founder and managing director at Capital Alpha, a non-partisan research shop that analyzes the policies coming out of Washington, DC, and their impact on the markets. Lucier leads the energy, environmental, and tax practices and has studied tax issues for more than 30 years. Today we're asking him to look into his crystal ball and tell us how corporate taxes will change under the Trump Administration and what it will mean for markets.
Before we start, please see the hedge clause on our website. In brief, Yardeni Research does not recommend individual securities. All views expressed by our guests, especially on stocks, are solely their own without any explicit or implied endorsement by Yardeni Research. Let's begin.
One of Donald Trump's main campaign promises was a dramatic reduction in the corporate tax rate. Meanwhile, House leader Paul Ryan has put forth a proposal deemed one of the most radical changes in US history. Jim, can you give us an idea of why US corporate tax policy needs changing, and whether it's likely to happen?
Jim: / Jackie, it's a pleasure to be back in touch with you and Dr. Ed. We've been fans of his for years and years and years--almost as long as I've been waiting for the tax code to change. Yes, the US corporate tax system is dramatically out of sync with that used by our other trading partners throughout the world. We have the world's highest corporate tax rate, which is all the more remarkable in that the next highest corporate tax rate is in the Central African Republic. We also maintain a worldwide tax system, which operates on the assumption that a manufacturing economy in the United States, dating from the 19th century, is exporting products around the world. That's really all the trade there is. We don't really look at the complex global networks of trade, we don't look at trade in services. We really don't look at trade in the global environment like other countries do.
Most other countries, the major trading partners, with which the United States both trades and competes, have a much lower corporate tax rate, a tax rate of about 20%. They also have something along the lines of a territorial tax system, which means that essentially you can do business in one country without having tax consequences in another. I call it the Vegas Principle; what happens in Vegas stays in Vegas, so that what you do in Germany doesn't have tax implications for the US and vice versa. That just makes things a lot easier for corporate CFOs and tax planners.
Jackie: / So does US tax policy need to change to make us more competitive with countries in the rest of the world?
Jim: / Yes, competition is the real driver. In past cycles of tax reform we've talked about simplicity for the individual taxpayer and we've talked about the economic case for lowering marginal tax rates and providing those incentives to individuals. I think we still have an opportunity to increase economic efficiency by flattening the tax structure here, but we've got really serious problems on the corporate side, in that US businesses operating in a global arena are operating on tax principles that are different from everyone else's. We have a really high marginal tax rate applied as well, which means that tax avoidance strategies can become extraordinarily complex.
For instance, take this problem we have of earnings repatriation. US multinational companies do business overseas, they have taxes due which result from their activities in those countries. I should say that the taxes are due only when the dividend is remitted back to the US, so in other words, we have untaxed foreign earnings mounting up. The real problem for CFOs, because they've got this cash around the world and yet they can't repatriate it without paying a very substantial tax on it when they do. In many ways, we have the worst of both worlds. We have the world's highest tax rate, but we also have the world's leakiest tax system. Because of this, we're running into issues with the corporate inversion problem or with other forms of corporate tax avoidance. Everything from earnings strippings transactions, where companies use intercorporate debt to shield their US earnings from US taxation to schemes where patent portfolios are sent overseas and intellectual property payments are used as a tool for earnings stripping.
In other words, we need to come up with a tax system that deals with 21st century trade patterns and also addresses the huge problems the US has on the international side for structural reasons, clearly there's a lot of complexity to eliminate there, which also gets the corporate tax rate down for competitive purposes. We've seen most of the major countries we do business with lowering their corporate rates in a very steady fashion since 1986. At the time when the United States went to 35%, that was the low rate. That was the bogey that everyone shot at. Again, for competitive reasons, over and over and over again, we've seen major OECD countries like the UK, for instance, not only lower their corporate tax rate, but also move to a territorial type system.
Jackie: / Do you think that Trump and Ryan will wind up on the same page in putting forward something that looks like the Ryan plan right now?
Jim: / I think they do. I think Paul Ryan deserves credit for thinking like Wayne Gretzky. Wayne was the great Canadian hockey player who always tried to skate where the puck was going to be and Paul Ryan is someone who's been very interested in tax reform since the earliest days of his youth. I actually knew Paul Ryan when he was an intern for Senator Kasten 25 or 30 years ago. I made the mistake of thinking that I was much more important than he was because I had a real job and he didn't at the time. Ryan is a man with a plan. He has really thought about doing tax reform for quite a while. He spent his whole life working to become chairman of the ways and means committee. Even though he's had this unfortunate diversion, this unplanned lateral move to be Speaker of the House, he has that long-term goal. Ryan has invested a lot of time and effort to developing a tax reform plan.
Back last year when it seemed that Republicans had 17 candidates, surely one of them would be a credible candidate against Hillary Clinton, Ryan put together what he hoped would be a complete agenda for an incoming Republican president. Sadly, as the year progressed and people saw fewer and fewer serious candidates that might be able to beat Hillary, or at least conventional wisdom had it that Hillary was unbeatable, his efforts didn't get the attention they deserved. One very important thing Ryan did was note Trump's interest in trade issues. In the interest of attracting Trump's attention and also directing Trump's energies away from things that might be disruptive of existing trade deals, like NAFTA or the TPP, which isn’t likely to happen now, Ryan decided to go for a border-adjustable business cash-flow tax.
Jackie: / Do you think that that tax will make it through Congress?
James: / I think it's a credible plan. I should say it's got a credible possibility of getting through Congress. I would have told you two years ago, even a year ago, even six months ago this would not have a chance. There were a couple of reasons for this. Reason number one is that it would take an awful lot to get the United States away from the corporate income tax model that it was on. People like me have been saying for years that the next round of tax reform was likely to be something like a value-added tax or a business cash flow tax because the conventional corporate income tax, the idea of basing corporate taxes on a narrow definition of shareholder income, was getting to be increasingly unworkable over time. We never thought that we'd go all the way to a cash flow tax, the way we are now. One reason for that is that economists told us that exchange rate variation meant that you didn't really get any long-term trade advantage for a border-adjustable tax, as a cash-flow tax would be.
The other thing was that it has structural aspects which are similar to a value-added tax, or even a retail sales tax in that companies which pay taxes on imports might be passing these on to their consumers in a certain way. Anything like that would seem to be politically dangerous. Tax people and obviously economists get the fact that this makes sense structurally, but politically the optics aren't good. It seemed unlikely the US would ever go in this direction, but Donald Trump is really the counterintuitive candidate in his emphasis on making America great again, rebuilding American manufacturing, focusing first on domestic US employment. The fact that he's tapped into such a vein of support from blue-collar voters in the US suggests that maybe this idea of a border-adjustable tax could be sold as something which is a way of supporting US domestic employment and US domestic manufacturing industries. If so, then Trump is really probably the only salesperson who could make it happen.
Jackie: / Because otherwise it would look like what? What would be so bad about it?
James: / The advantage would be going back to the old system, basically going back to the Titanic with the deck chairs rearranged slightly. We had a really serious effort at tax reform two years ago from David Camp, who was then the Chairman of the House Ways and Means Committee. We have been doing tax reform plans continuously for almost the entire seven or eight years, certainly since S&P downgraded the US economy. Members of Congress doing tax reform plans have sometimes reminded me of Pacific Islanders, out in the South Pacific somewhere, building runways in the jungle in the hopes that one day the B-29 Bombers loaded with Hershey bars and cans of tinned corned beef would come back. There was an aspect of a cargo cult to it.
Dave Camp, one of these guys doing tax reform plans, did yeoman’s work in putting together a very elegant, very well thought out, very technically well-supported tax reform plan that did everything he possibly could within the context of the existing system to get the corporate tax rate down to 25%, to flatten everything out, to do it in a way that was distributionally neutral, not only on the individual side so that everybody would be bearing the same share of taxes as before regardless of income quintile, but also on the corporate side. Domestic versus international would have the same tax burden. The whole thing would be revenue neutral, it met all the parameters. The bottom line is that there were so many trade-offs involved in that tax package that it really pleased nobody. Getting the tax rate down to 25% wasn't good enough either, when you have the OECD average rate at the national level going down to about 20% and countries like the UK actively planning to move their corporate rate down even further.
I think that the poor reception of the Camp plan, something that annoyed everybody, also told Paul Ryan that the conventional approach wasn't going to work anymore and that he really needed to roll the dice and to do something big and impressive that would really upset the parameters of what people expected. That's where this cash flow tax comes from.
Jackie: / I can see all sorts of different contingencies and lobbyists that are going to hate this plan because it's going to potentially increase their taxes. How does he still get this through Congress when he's going to be barraged with complaints?
James: / I think that the American business community has gotten to the point where something's got to give. The international situation is particularly egregious and you have the multinational companies leading the campaign for tax reform for quite a while. What we've seen in the case of corporate inversions and the need to address other ways that revenue leaks from the US tax base is important….All these things point to the fact that the US tax code needs to be revamped. Companies generally have a number of specific complaints. The biggest complaint is the corporate rate itself. By dropping the corporate rate to 20%, you have something that does appeal to a vast range of businesses across the country. The question is, how do you get to that 20% rate in a reasonably paid-for manner? How do you also do something that has become extremely popular with US businesses, especially smaller businesses, and that is expensing the equivalent of permanent 100% bonus depreciation.
Ryan wanted to get to these two elements and the way he chose to do it was to go to a consumption-based tax. Structurally similar, although not the same as the European value-added tax, and linked to the idea of permanent expensing would be ending the tax deduction for interest expense. That's potentially something that would be disruptive to highly levered industries in general. Electric power might be a good example, or commercial real estate, another case where you use lots of leverage. I'm sure that we'll hear from these folks at some point, but it seems to me that the biggest factor which Ryan has chosen is border adjustability. That is, including imported goods and services into the tax base, which is a huge revenue raiser. The Tax Foundation estimates that it raises north of a trillion dollars in revenue. You need big revenue raisers like that and the end of the interest expense deduction to make revenue-neutral tax reform even remotely possible.
Jackie Doherty: / We've all read about how the retailers will be affected by this, because they import so much to do their business. What other industries do you think are going to be affected? One of your reports mentioned companies with intellectual property that's been transferred overseas. Why are they affected and which companies do you think will feel the impact the most?