Middle-market companies celebrating the Tax Cuts and Jobs Act may soon tone down their celebrations. While the tax overhaul offers corporate tax reductions that could lead to additional capital, the fiscal benefit in the longer term remains to be tested. Tax reform, coupled with the February passage of the Bipartisan Budget Act of 2018, which increased federal spending by roughly $300 billion over the next two years, could spur economic investment while creating inflationary pressure that is expected to cause the Federal Reserve to raise interest rates more aggressively. In light of these conditions, companies may want to take the opportunity to revisit their corporate development and capital spending plans.
When the tax talks were underway last year, I wrote a piece about the potential ramifications for small to medium-sized businesses in which I predicted corporate tax reform would be a boon for U.S. firms, and thus far that has held true, even if the previous 35 percent corporate rate was reduced to 21 percent, and not the 15 percent sought by President Trump. Companies have taken advantage of this 40 percent reduction by hiring staff, enhancing 401(k) matching contributions for employees and purchasing new equipment in the first quarter. How long the spending spree lasts remains to be seen. Last fall, an analysis of the domestic economy seemed to forecast that the potential savings boost from tax reform would outweigh the cost of borrowing, and this remains true in the near term. The Fed has raised rates four times in the past 12 months, bringing the benchmark Fed Funds rate to 1.5 percent. An additional seven more rate increases before 2020 could reasonably be expected, which would bring the benchmark rate to 3 percent by Q4 2019 and potentially undermine some of the fiscal benefits of the tax reduction.
While these figures are still far below the long-term Fed Funds historic average (4.85 percent), they could also come as a shock to businesses used to operating for many years in a near-zero rate environment. With this in mind, businesses may want to take advantage of these low-borrowing costs while they can.
The Budget Multiplier
Although tax reform captured more headlines, the budget passed in February also will likely have a major impact on the economy ― both positively and negatively. The $300 billion influx, including more funding for infrastructure and homeland security, is an increase of 8 percent over 2017.
According to GDP models developed by TD Economics, the independent research arm of TD Bank, prior to the approved budget, GDP growth for 2018 and 2019, were increased by 0.4 and 0.6 percentage points per year, respectively, to account for the additional spending. By comparison, the Tax Cuts and Jobs Act is only expected to accelerate GDP growth by 0.1 percentage points in 2018 and 0.3 percentage points in 2019, with the sheer size of the budget and historically larger fiscal multipliers for government spending accounting for the difference.
Specifically, the infrastructure industry is expected to benefit most from government spending. Corporations from a variety of fields ― and especially construction ― are paying close attention to developments. Industrial companies are hoping for a surge in demand and companies across the spectrum are looking at locating headquarters, warehouses and retail in strategic areas to take advantage of investments in roads, bridges and other transportation infrastructure. Companies that produce and transport raw materials could also see a boon with the government’s additional spending.
On the downside, the new budget could significantly compound the consequences of lower corporate tax rates. The double dose of debt-financed fiscal stimulus (i.e. tax cuts and spending increases) will lead to further issues for both the national economy and for corporations, as a high proportion of federal tax revenue is already being allocated to interest payments, making it unlikely the government’s growing deficit will be sustainable post-2020, according to TD Economics.
Opportunity Now, Not Guaranteed for the Future
The federal government’s recent policies are certainly intended to spur economic growth, but a few factors are also tempering investments. Public debt multiples are high and company valuations are at an all-time high, pricing out many middle-market businesses from the merger and acquisition market. For those companies that can leverage their debt, however, the cost of credit remains relatively cheap on a historic basis and a currently strong U.S. economy provide a conducive short-term environment for investments. Strategic capital expenditures now can position organizations for success in the future. The post-recession party isn’t quite over, but 2018 is a good time to create a clear outlook for your company and the knowledge that good times don’t last forever.
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