I recently posted about the glaring disconnect between stock market pricing and earnings expectations in the US.
Aside from the US Federal Reserve’s easing policies and from the implicit guarantees also from the same agency, there is another very significant factor that adds to the serial blowing of asset bubbles: massive distortions from a tax regime which promotes share buybacks financed by leverage.
Philip Coggan under the pen name Buttonwood at the Economist articulates Apple as an example
WHAT a crazy world. Apple, a company with $145 billion of cash, is issuing some $17 billion of debt to buy back its own shares. Why doesn't it just use its cash to do the same thing? First, because a lot of that cash is overseas, and bringing it back to America would incur a tax charge. Second, because interest rates are low and debt interest is tax-deductible, making this look a great arbitrage.But think of it from the point of view of the hard-working American taxpayer. Apple's money will still sit overseas and not be invested at home to create jobs. Apple's tax bill will fall, as it offsets the interest payments against its profits. The buy-back will probably push up the share price in the short term*, boosting the value of executive options; profits from those options will probably be taxed at the long-term capital gains tax rate of 15%, lower than the rate many workers pay. Organising a bond issue, rather than using a company's own cash, incurs costs in the form of fees to bankers on Wall Street; the same bankers taxpayers helped support five years ago
In short, the incumbent complex tax structure basically rewards debt accumulation and the principal-agent problem.
The latter or conflict of interest dilemma means that the same tax policies induces a fissure between the economic interests of the shareholders and of the option holders, held mostly by corporate officers. Such has mostly been channeled through the tilting of the balance of incentives that encourages short term outlook and actions at the expense of the long term.
Buybacks and dividend issuance has accounted for a substantial share of the gains in the S&P.
Dr. Ed Yardeni notes that both has totaled “$2.1 trillion for the S&P 500 since stock prices bottomed during Q1-2009 through Q4-2012--has been driving the bull market since it began”.
Yet the distortions from tax incentives that promotes debt funded buybacks has not only been a bane via a conflict interest in corporate relationships particularly between between shareholders and corporate managers, but has also been materially affecting the real economy through the diversion of resources to speculation rather than to investments.
Notes analyst Martin Spring in his latest outlook (no link)
One reason why prices continue to rise despite sluggish growth in corporate profits is the contractionary impact on supply from share buybacks, which are rising towards to levels last seen in 2007.“The motivation,” reports CLSA Asia-Pacific’s Christopher Wood, “appears to be primarily to boost earnings per share – a formula on which so many corporate executives’ remuneration is based.”He adds: “The pick-up in commercial and industrial lending in America over the past two years has been primarily driven by the desire to finance financial engineering exercises such as share buybacks, rather than to fund new investment.”Essentially, the money bubble is being used primarily for speculation rather than stimulating economic activity, its supposed intention.
Government policies whether via taxes or central bank policies or administrative policies (e.g. homeownership) have all been synched or engineered to promote leveraging and debt accumulation.
Debt is the essence of the paper money system.
Since the world’s monetary system shifted away from the gold standard, debt has increasingly been a tool to promote statistical “growth”.
Thus the increasing recourse to debt also means the increasing frequency of financial-banking crises.
Going back on how tax distortions promote systemic fragility, again Mr. Coggan
In short, the whole deal is linked to tax distortions; the treatment of repatriated cash, debt versus equity and capital gains versus income. The ideal tax system, as we have argued many times, is neutral between sources of income. The tax deductibility of interest played its part in creating this mess, both in the corporate and mortgage markets. Why should the taxpayer want to encourage higher leverage, when high leverage is the root of financial crises?
Well, the answer to that is that debt or leverage mainly works to the interest of the banking-welfare warfare state-central banking cartel, who use debt to finance their intertwined interests. The incumbent political architecture in turn gives voters and taxpayers access to debt, via the above policies. Thus, the boom bust cycles.
That which is unsustainable, won’t last.
