Matt Franz : Zealous For Knowledge

Who Gets To Keep The Tax Break?

The million dollar question for economists is: who ultimately benefits from a tax break?

Yesterday on CNBC Buffett put it this way: Last year the shareholders of a company like Visa (my example, not Buffet’s) owned 100% of Visa’s assets, but only 65% of Visa’s earnings. Now that the corporate tax rate has been reduced from 35% to 21%, those shareholders are entitled to 79% of Visa’s earnings. The tax break effectively gave Visa shareholders 21% (14/65) more “equity”.

Now I specifically chose Visa because Visa has an extremely strong competitive position. It’s effectively a toll road on electronic payments. It benefits from strong network effects, which mean that a lower cost system isn’t likely to overtake it. It would be retail suicide for a merchant not to accept Visa just because Visa isn’t passing its tax break on to them. What I’m saying is Visa is likely to keep all of the benefits of this tax break for itself.

Many companies won’t be so lucky. Buffett specifically points out that any industry that is very cost sensitive and doing rigorous after-tax ROI analysis on their spending is likely to force their suppliers to split the difference. For example, if an airline wanted to buy 100 Dreamliners from Boeing, they would be very price sensitive. And Boeing would want the big order. So they’d likely come so some agreement on price which effectively splits the difference of the tax break in some way.

I’m not sure Boeing is the best example for this, and I can’t confidently say Boeing will have to give in to its suppliers. But its an easy-to-visualize example for me. I think it’s easier to spot companies that are likely to keep the tax break anyway, as they’re in the minority. In addition to Visa, two others immediately come to mind: FICO, and Moody’s.

Just as Visa is a toll road on electronic payments, Moody’s is a toll road on bonds. You cannot really move a bond on Wall Street without a Moody’s rating on it. Investors with significant sums of money at risk want to know what Moody’s, S&P, and Fitch think about an issue before they will buy it. The cost of three ratings on the debt is small compared to the total dollars at stake. Because investors want to know all three ratings, there is effectively no competition between the three. To say Moody’s has a strong competitive position is an understatement.

FICO is well known to consumers because it’s a sort of consumer credit rating agency. Unlike Moody’s, which actually pays analysts to analyze bonds, FICO just built an algorithm. They get paid for running this algorithm and assigning you a number. FICO numbers are entrenched in the financial system – they’re the gold standard of someone’s credit. Simply because they’re already everywhere, they’re likely to stick around.

There’s one last important point about these three companies: they have little to no marginal costs. Visa can process an extra payment for next to nothing. Same with running one more FICO score. Moody’s would eventually have to hire another analyst or two if there was a huge surge in bond issuance, but that cost would be nothing compared to the extra revenue flowing in. These companies have no customers in a position to demand lower prices, and they have no suppliers to raise prices on them. That’s a good position to be in.

So, does the stock market agree that these companies will get to keep their extra “equity”?

Name Return Since 12/1/2017 Return Since 12/29/2017
Fair Isaac Corporation 1.75% 4.60%
Moody’s Corporation 2.92% 5.49%
Visa Inc 8.23% 5.10%
S&P 500 (SPY) 4.41% 3.47%

If each share of these three companies was entitled to 21% more net income, shouldn’t their share prices be up a similar amount? Yet they are not up way more than the market nor anywhere close to 21%.

This leaves three possibilities:

  1. I am wrong. These companies won’t get to keep the benefits of the tax break.
  2. The market began pricing this in before 12/1/2017 and my data doesn’t capture it.
  3. The market is wrong and will price it in later.

Actually, there’s also a fourth possibility. “What the Lord gave, the Lord hath taketh away.” Maybe the market doesn’t believe this tax break actually reflects the long-term state of affairs. The extra 14% is only “equity” if it is forever (or a really long time). But the government could reverse this anytime it wants to.

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