How Taxes Impact Your Investments

The negotiations over the fiscal cliff are constantly going back and forth, and one of the thorny issues, as usual, is taxes. President Obama wants to raise rates and the GOP wants to cut loopholes and reduce deductions to raise revenue.

I'm not here to debate the merits of either plan from a political standpoint, as The Motley Fool isn't the forum for that kind of political debate. What does matter is how tax rates impact businesses and by extension our investment profits. Warren Buffett has famously said that he doesn't know a single business owner who has made an investment decision based on tax rates, something that some have refuted, but since he is Warren Buffett, his words have weight in the debate.

So do tax rates matter? And if so, to whom?

I'll try to break it down from a mathematical standpoint and point out the rates that matter to businesses and investors and how it will affect the market going forward.

The theory behind the madness
When a company is considering an investment like a piece of equipment or an R&D project, its financial analysts create a model to weigh the outcomes. These models include outflows of cash to make the investment and inflows of cash that are the return on that investment. Whenever there's an inflow of cash, taxes matter, which is why rates matter to this analysis. 

The rate that companies pay or use in models may change based on location, business type, or any number of factors. But the basic premise is the same: Taxes are part of the equation.

So, let's do a very simplified financial analysis of a hypothetical project and see what taxes do to its return. I've laid out the assumptions below, including 0% inflation and 0% growth initially. We'll assume that there's a one-time cash outflow of $100,000 today (for example, to buy equipment) and that the investment will create cash flows for 10 years in equal amounts starting one year from today before becoming obsolete. 

Capital outlay today

$100,000

Required return on capital / discount rate

10%

Years the project will produce revenue

10

Earnings before taxes and depreciation expected per year

$19,653

Tax rate

35%

Net income per year

$16,275

Rate of return

10%

Source: Author's calculations. Assumes straight-line depreciation allowance for tax purposes.

If we calculate a rate of return, or IRR, for this project, we find that the return is exactly 10%. Based on the cost of capital of 10% in this company, it would be wise to pursue this project because the return on investment is exactly the cost of capital. Notice that I have not included revenue, margins, or other items; these don't matter to the investment thesis as long as we know pre-tax profit and include any other investments in our initial capital outlay number.

Now if we do the exact same project and only change the tax rate, the dynamic changes.

 

30% Tax Rate

35% Tax Rate

40% Tax Rate

Pre-tax profit/yr

$19,653

$19,653

$19,653

Taxes

$2,896

$3,378

$3,861

Net income/yr

$16,751

$16,275

$15.792

Return on investment

10.7%

10%

9.3%

Source: Author's calculations.

Based on this table, tax rates make all the difference in the world when deciding if this project is worthwhile. If rates are 35% or below, we would go forward; if they are higher, we wouldn't.

Other important factors
So, if tax rates are so important to businesses and investors, why has fellow Fool Morgan Housel concluded that tax rates have little correlation to GDP growth? Logic should tell us that lower tax rates will always lead to higher return for investors/businesses and therefore more investments by investors/businesses.

The easy answer is that growth often has the largest effect on most financial models. A 2% change in the growth rate has an even greater effect than a 5% change in the tax rate. Here is the same ROI calculation just like I did above except I've modeled three different growth rates (still 0% inflation).

 

30% Tax Rate

35% Tax Rate

40% Tax Rate

0% growth

10.7%

10%

9.3%

2% growth

12.1%

11.4%

10.6%

4% growth

13.6%

12.8%

11.9%

Source: Author's calculations.

As you can see, growth rates have a big impact on returns as well.

The big lesson here is that a multitude of factors matter when businesses make investment decisions. Taxes matter, growth matters, costs matter, and so do a lot of other factors.

The investment equation
I haven't touched on capital gains yet, and there's a good reason for that. Capital gains rates don't have anything to do with a business's day-to-day decisions because businesses don't pay capital gains on typical business investments -- owners do. So what changes for an owner?

An owner provides one of the key inputs for the cost of capital that I discussed above. They'll decide how much return they need from an investment, and on the stock market they'll adjust the price of the stock accordingly.

So, if an investor requires an 8% return on investment and capital gains taxes are 20%, the company's cost of capital is 10%. In theory, this means that higher capital gains rates should mean lower stock prices and vice versa.

A never-ending debate
Taxes are a complicated and confusing debate for governments, businesses, and investors. It's a balancing act and there are no hard and fast rules with tax rates. Lowering taxes doesn't always lead to more business investment (see the 2000s) and higher taxes also don't mean slow growth (see the 1990s).

What we do know is that taxes are a contributing factor when businesses and investors make decisions. On a purely theoretical basis, lower taxes will make more projects financially viable and businesses will choose to invest more. If only reality were as simple as theory. 

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Read/Post Comments (5) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 11, 2012, at 6:29 PM, dmiles2 wrote:

    I appreciate this analysis. Taxes are not the only factor, but they are an important one.

    Mr Buffett is apparently either dishonest or suffering from loss of memory. Read the article from Tuesday, November 27 at Economic Policy Journal for examples of Buffett himself weighing taxes VERY heavily in business decisions. He was even willing to walk away from a deal if taxes took too much of a bite (whatever that meant to him at the time).

    One has to wonder if now that he has made his fortune, he wants to prevent any of the rest of us from following in his footsteps.

  • Report this Comment On December 11, 2012, at 10:51 PM, nasis wrote:

    Your analysis ignores the effect of taxes on the discounting process itself. The DCF model essentially compares an investment to what can earned risk free -- and since the interest payments in this risk free scenario would also be taxed, why would the tax rate matter at all in your model? (Higher taxes change the risk/reward equation and presumably make the company less likely to make the investment, but that's a different effect from what you try to demonstrate in your analysis.)

  • Report this Comment On December 12, 2012, at 3:38 PM, WyattJunker wrote:

    But lower tax rates in and of themselves will also affect growth in a positive way as more risk filters back into business.

    That didn't seem to make it into the conclusion.

  • Report this Comment On December 13, 2012, at 11:26 AM, TMFFlushDraw wrote:

    @nasis

    I've assumed that these kind of details are included in the cost of capital number. You could add a zillion factors and make an incredibly complex model. In the end, I think simple is better even if you have to neglect a few factors.

    @WyattJunker

    The theory says that lower taxes will positively impact growth, I don't disagree with that. Proving that in practice throughout history is more difficult. There are many things that impact growth (innovation, confidence, etc.) and there's no concrete evidence that lower taxes = higher growth (see 90s and 2000s). Therefore I view them somewhat separately.

    An interesting question over the past few years is...

    If you were a business and you could make a $1M investment in 2008 (as we started the recession and GDP growth was negative) assuming zero growth at best or make the same investment today (GDP estimated to grow slowly) at a higher tax rate but a 2% growth rate -- which would you choose?

    The model above shows that today may be better, despite higher taxes... Just something to ponder...

    Travis Hoium

  • Report this Comment On December 13, 2012, at 10:31 PM, nasis wrote:

    @Travis - I too like the clarity of simple models, and for that reason I typically don't include the so-called "risk premium" in the cost of capital - and assumed you weren't either (my parenthetical comment above). But now that I think about it, you must be including it (I know it 's commonly done, and 8% is too high these days to only include risk-free returns). I don't think anyone can estimate the risk premium well enough for it to be useful, but it must be greater than zero, in which case high enough taxes have to hinder investment at some point. I think other factors almost always dominate in practice - but it seems from your article you might agree?

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