Slashing the corporate tax rate is a no-brainer

Congress is beginning to understand that the key to a stronger economy is to give corporations a break from onerous tax burdens so that they can grow the economic pie, thus benefiting everyone. This is potentially a very big deal.

Rand Paul and Harry Reid are working on a deal to create a three-year corporate tax holiday, during which time corporations could repatriate foreign profits and only pay a 10% tax. That's a very positive step in the right direction, but it would be even better if Congress made the 10% permanent. Permanent changes to the tax code result in much more powerful and lasting changes to incentives. Slashing or even eliminating the corporate tax rate on a permanent basis would provide a powerful boost to economic growth.

At 35%, the U.S. corporate income tax rate is the highest of any developed country. The fact that corporations are refusing to repatriate trillions of dollars of overseas profits is proof that it is negatively impacting the economy. Overseas profits have already passed through the tax tollgate once, but to subject them to another 35% just for bringing them back to the states is unconscionable to any responsible corporate executive. 

In an ideal world, corporate profits should not be taxed at all, since the burden of corporate taxes falls almost entirely on the customers and employees of corporations. In the end, only people pay taxes, and it's highly inefficient to tax businesses and individuals separately. Today, capital faces double and triple taxation: first on business profits, again when shareholders pay tax on dividends (paid out of after-tax profits) received, and again if and when capital gains are realized. Punitive tax burdens inhibit risk-taking and capital formation, and that in turn leads to slow growth. 

And it's not just the level of the corporate tax rate that's debilitating, it's also the cost of calculating and complying with corporate taxes—which some estimate could actually exceed total corporate taxes paid. From an economy-wide perspective, The Mercatus Center last year estimated that "Americans face up to nearly $1 trillion annually in hidden tax-compliance costs, while the Treasury foregoes approximately $450 billion per year in unreported taxes." Fixing and rationalizing our tax code should be a top priority in these times of sluggish growth. Moreover, the distortions and opportunities for cronyism that our corporate tax code creates make things even worse. Getting rid of the corporate tax would instantly make subsidies and deductions a thing of the past, while turning lobbyists into an endangered species.

Thanks to the tremendous improvement in the federal government's fiscal situation in the past several years, now is a great time for Congress to consider slashing or even eliminating corporate taxes. We can absolutely afford to take the risk that cutting corporate taxes will boost the economy, resulting in little or no revenue loss within a relatively short time frame. 

As the chart above shows, federal government spending has not increased at all for the past five years. That's a remarkable achievement, but it says more about congressional gridlock than about any conscious desire to limit spending. Meanwhile, tax revenues have been growing strongly for the past four and a half years, rising at an 8% annualized rate. That's mainly due to rising jobs, rising incomes, and rising profits, and only marginally due to higher income tax rates. Economic growth and some much-need fiscal austerity have essentially solved our deficit problem that just four years ago was thought to be intractable.

The five-year freeze in spending has had the beneficial effect of sharply reducing the size of government relative to the economy, as the red line in the chart above shows. Federal spending has fallen by one-fifth relative to GDP in the past five years, giving the private sector some much-needed breathing room. Meanwhile, tax revenues have risen by one-fifth, to over 17% of GDP from a low of 14.2%.

The net effect of these two developments has been to reduce the federal deficit by two-thirds, to just under 3% of GDP today. It's high time the federal government used its greatly improved finances to make an investment in corporate America by cutting or eliminating corporate taxes.

Corporate taxes represent about 10% of federal revenues currently ($296 billion in the year ending May), or about 1.7% of GDP. Personal income, social insurance, and retirement taxes account for almost all the rest of federal revenues. We could totally eliminate corporate taxes, and assuming no knock-on effects (i.e., no additional investment, no additional jobs, no increases in employee compensation), it would only increase the federal deficit from 3% to 4.7% of GDP—a mere drop in the bucket, and a level that wouldn't be unusual at all by historical standards.

But there would almost certainly be some very positive side-effects to slashing or eliminating corporate taxes. Investment would almost certainly rise, given the substantial increase in the after-tax rewards to risk-taking, as would the number of jobs and income. More jobs and more income would boost personal income, social insurance, sales, and retirement taxes. Economic growth would increase measurably, growing the economic pie for everyone. Corporations would save not only what they currently spend in taxes, but also their tax preparation and hidden compliance costs. The happy result of all this would be difficult to underestimate.

The Joint Committee on Taxation estimates that a tax holiday as proposed by Senators Rand Paul and Harry Reid would cost the government almost $100 billion over a decade, but that is a very short-sighted analysis that ignores the incentives that are keeping foreign profits offshore. I think Paul's estimate of a windfall of up to $60 billion in new revenues in three years makes more sense, and he's most likely severely underestimating the total positive impact.

The Congressional stars appear to be aligning, the budget is greatly improved, and the economy badly needs some genuine stimulus. It's time for Congress to do something smart for a change: cut or eliminate the onerous tax on capital, and watch the economy take off.

Kill the corporate income tax

I've written a lot about corporate taxes over the years and why the corporate tax rate should be dramatically lower or, better yet, zero. John Steele Gordon recently made a strong case for eliminating the corporate tax ("Top 10 Reasons to Abolish the Corporate Income Tax," WSJ). It's so good it should be required reading for every member of Congress. James Pethokoukis joined in with "The bipartisan case for ending the corporate income tax."

It looks there's some momentum building, so I offer some charts to help make the case.

As the chart above shows, there has been a dramatic decline in the federal budget deficit over the past 5 years. It's now just under 3% of GDP, and that's a level that is not at all problematic. We can easily afford to to something "crazy" like eliminating the corporate tax.

In the 12 months ended November 2014, corporate income taxes paid to the federal government totaled $327 billion, which was 10.8% of federal revenues for the period. As the chart above shows, corporate taxes haven't yet exceeded their pre-recession peak (they hit $382 billion in the 12 months ended June 2007, and were an all-time record 15% of federal revenues at the time), even though other taxes have, and even though corporate profits before tax have increased 26% from their pre-recession peak. Corporate tax collections have lagged other tax collections significantly—perhaps because, as Gordon suggests, corporations have a number of ways to avoid paying taxes that they perceive to be onerous. Any corporate executive worth his salt knows that corporate profits are unfairly taxed multiple times, and therefore he or she knows that minimizing taxes paid is a high priority, and in shareholders' best interest.

In any event, corporate profits are only a small part of federal revenues, so they wouldn't be greatly missed. But if we were to couple the elimination of the corporate profits tax with the taxation of profits passed through to shareholders (dividends and capital gains) at ordinary income tax rates, then surely the revenue lost to the federal government would be minimal. And if there were any supply-side effects from eliminating corporate taxes (e.g., more investment, more jobs, more spending), then federal revenues could easily surge as the tax base grew. It would also make sense to lower top individual marginal tax rates.

In my estimation, eliminating the corporate income tax would be the single most effective way to boost economic growth and restore prosperity to the middle class. It would also be a perfect way to begin to downsize our bloated government and simplify the tax code. It's a no-brainer, non-partisan solution to our still-anemic recovery.

Corporate inversions: the facts

Those who claim that companies seeking to reincorporate overseas in order to reduce their tax burdens are "unpatriotic" are not only ignorant of the law but also ignorant of how businesses operate. If there is any one message that should be making the headlines, it would be "Companies seek to escape insane U.S. tax code." When companies vote with their feet, it's a good sign that something is wrong here in the U.S. 

In case you've missed them, here are three short essays, with brief excerpts, that clarify the issues surrounding corporate tax "inversion."

Miles D. White, "Ignoring the Facts on Corporate Inversions:"

... inversion is legal. Period. It's allowed in the tax code. The tax code even specifies the terms and conditions under which it may be done. 

Inversion doesn't change a company's tax rate. A company pays the same tax rate in the U.S. after inversion as it does before inverting. A company also pays the same tax rates in foreign domiciles before and after inversion. 

Inversion does not relieve any pre-existing tax burden. It does not reduce the tax that any company would ultimately have to pay on past earnings overseas that have been deferred under the U.S. tax system. 

What does change after inversion is a company's access to its future foreign earnings generated outside of the U.S. tax system. Those future earnings may be used for any capital allocation purpose the company may have, including investment in the U.S., without the additional U.S. repatriation tax. 

The U.S. is among only a handful of countries, and the only one in the Group of Seven, that taxes companies on world-wide earnings rather than the earnings in their home domiciles. It's a double whammy: the highest rate, by far, and it's applied worldwide.
Legislation to block inversion is not tax reform. It would make the U.S. even less competitive globally. It would not stimulate economic recovery.

WSJ op-ed, "Jack Lew's Flee America Plan:"

The pace of inversions has been picking up as more CEOs conclude that President Obama isn't serious about tax reform. These executives have a fiduciary duty to their shareholders, and they can't cede a permanent tax advantage to their global competitors. So they decide to move. 

Mr. Lew doesn't know much about economics or he'd realize that his rush to block these inversions will have the perverse effect of driving even more deals in the coming months. If CEOs think Congress will close the inversion possibility, and that tax reform is dead until Mr. Obama leaves office, more of them will decide to move while they still can. 

A real agenda for "economic patriotism" would support a tax policy to make America competitive again as a destination for global investment and job creation.

Michael J. Graetz: "Inverted Thinking about Corporate Taxes:"

Inversions by U.S. companies to take advantage of more favorable corporate tax laws abroad are nothing new. Of the more than 25 U.S. companies that inverted between 1982 and 2002, more than 20 made Bermuda or the Cayman Islands their home.

To ask, "How do we stop American companies from leaving for more favorable tax jurisdictions?" is asking the wrong question. The right question is "How do we make the United States a more favorable location for investments, jobs, headquarters, and research and development activities?" That will require genuine tax reform. The U.S. is the only OECD country that doesn't have a national tax on consumption. Relying, as we do, so heavily on individual and corporate income taxes to pay for federal expenditures hobbles us in today's global economy.

I would add that, in the 12 months ended June, 2014, the federal government received a total of $303 billion in corporate income tax payments. That represented only 10.3% of total federal revenues over the same period. Eliminating that source of revenue entirely would increase the federal deficit from its current 3.1% of GDP to 4.9%, all else remaining equal. This would not be an earth-shaking loss, and it would very likely be offset to a significant degree by increased corporate investment, more hiring, more incomes, and lower prices to consumers.

Corporate tax reform is a matter requiring urgent and thoughtful attention. Let's do it right, please.

Thoughts on Tim Cook's testimony

I can't help but note the media's bias which is exemplified by a Bloomberg article that implies that Apple has avoided taxes by "shifting income ...  to offshore tax havens."

Given that Apple has fully complied with all applicable laws, why should anyone presume that corporations have a duty or an obligation to maximize their tax liability? Corporations' duty is first and foremost to maximize shareholder profit. Without profit corporations cannot exist. If corporations fail to maximize their profit they are wasting scarce resources.

Are financial journalists ignorant of the fact that the incidence of corporate taxes falls almost entirely on consumers? The bulk of any tax on corporate profits must eventually be passed on to consumers in the form of higher prices, since corporations must earn a minimum return on equity in order to remain in business. Corporations benefit society most by adding value to scarce resources and satisfying consumer demands, not by paying taxes.

Are politicians and journalists arguing that we would all be better off if the government took a much larger share of Apple's profits? Show me one example in which the government utilizes scarce resources more efficiently than Apple and I might agree that Apple should pay higher taxes. But I am quite comfortable believing that Apple can more efficiently utilize scarce resources than the government, and that therefore Apple's tax burden should be as low as possible in order to advance the common good.

I'm with Rand Paul on this:

“I’m offended by a $4 trillion government bullying, berating and badgering one America’s greatest success stories,” the Kentucky Republican told the committee. “Tell me what Apple has done that is illegal?”

“If anyone should be on trial here, it should be Congress,” he insisted. “I frankly think the committee should apologize to Apple. I think that the Congress should be on trial here for creating a bizarre and Byzantine tax code that runs into the tens of thousands of pages, for creating a tax code that simple doesn’t compete with the rest of the world.”

Apple has amply demonstrated the absurdity of our tax code by borrowing $17 billion to avoid paying taxes twice on money it has earned overseas. Apple is essentially engaging in an arbitrage in which it will pay less than 2% a year in order to avoid paying 35% on any overseas profits it might otherwise repatriate. When such a huge arbitrage exists (otherwise known as a "wedge" to economists) it is a sign of markets and regulatory structures that are seriously dysfunctional and inefficient. This is a compelling argument for reforming our tax code and sharply reducing the corporate tax rate. At the very least, the U.S. corporate tax rate should be no higher than it is in majority of the countries in which our businesses compete, and we should never impose a tax on money that has already been taxed in another jurisdiction.

Corporations should be indifferent to repatriating money earned overseas; they should never be penalized for doing so.

In an ideal world, the corporate tax rate should be zero and there should be no deductions. If Tim Cook made any mistake in his testimony earlier this week, it was in being overly generous in suggesting a compromise in which the corporate tax rate would fall to 20%. If there must be a compromise, then tax reform should employ a static-revenue-approach in which a lowering of the corporate tax rate is offset by the elimination of deductions.

I'd like to think that Apple came out ahead in this congressional battle, if only because it has logic on its side. I'd also like to think that this has been very instructive for the electorate, and that it has therefore advanced the cause of tax reform.

U.S. Tax Competitiveness Stinks

Today the Tax Foundation released its 2014 index of International Tax Competitiveness. Of the 34 countries ranked on the basis of "more than forty variables across five categories: Corporate Taxes, Consumption Taxes, Property Taxes, Individual Taxes, and International Tax Rules," the U.S. came in #32, only a few points ahead of notoriously tax-loving France. 

The chart above shows my representative sampling of 20 of the countries included in the index.

Key findings:

Estonia has the most competitive tax system in the OECD. Estonia has a relatively low corporate tax rate at 21 percent, no double taxation on dividend income, a nearly flat 21 percent income tax rate, and a property tax that taxes only land (not buildings and structures). 

France has the least competitive tax system in the OECD. It has one of the highest corporate tax rates in the OECD at 34.4 percent, high property taxes that include an annual wealth tax, and high, progressive individual taxes that also apply to capital gains and dividend income. 

The ITCI finds that the United States has the 32nd most competitive tax system out of the 34 OECD member countries. 

The largest factors behind the United States’ score are that the U.S. has the highest corporate tax rate in the developed world and that it is one of the six remaining countries in the OECD with a worldwide system of taxation. 

The United States also scores poorly on property taxes due to its estate tax and poorly structured state and local property taxes. 

Other pitfalls for the United States are its individual taxes with a high top marginal tax rate and the double taxation of capital gains and dividend income.

As the study notes,

Taxes are a crucial component of a country’s international competitiveness. In today’s globalized economy, the structure of a country’s tax code is an important factor for businesses when they decide where to invest. No longer can a country tax business investment and activity at a high rate without adversely affecting its economic performance. In recent years, many countries have recognized this fact and have moved to reform their tax codes to be more competitive. However, others have failed to do so and are falling behind the global movement.

This goes a long way to explaining why the U.S. economy has been struggling in recent years.

Today's WSJ has an op-ed that sheds even more light on the issue.

To be sure, not all the countries that rank higher in the index have stronger economies. Indeed, the U.S. economy is doing better than most these days, although it is only managing to post annual growth of slightly more than 2%.'

If there's any surprise here, it's that the U.S. economy is not doing worse. We are still relatively prosperous in spite of our onerous and burdensome tax code. This speaks volumes to the inherent dynamism of the U.S. economy, which is rather adept at overcoming adversity. If we only freed the economy from its tax shackles, it's hard to imagine how much better we could be doing.

We need serious and far-ranging tax reform. Now.

Effective tax rates are highly progressive

There's a lot of chatter these days about whether the rich pay a high enough tax rate. Warren Buffett comes to mind, as do the recent attempts to shame Mitt Romney for paying only 15% of his AGI in tax.

Confusion arises only if we look at part of the picture. For example, everyone who is employed pays social security tax and personal income tax. But only those with investment income pay capital gains and dividends tax. And in order for investors to receive capital gains and dividend income, the companies they have invested in—with after-tax dollars—need to pay a corporate income tax. Consider, for example (and I'm simplifying), a worst-case scenario person who is self-employed, whose income puts him in the top Federal and California income tax bracket, and who has substantial income from investments. He pays 35% federal income tax, 9% state income tax, a 15% social security tax, and a 2% medicare tax. Any income he receives from his investments—which were originally made with after-tax dollars—is effectively what the companies he owns have earned after paying a 35% corporate income tax, and on top of that he must pay 15% of what is distributed to him—he might be paying an effective tax on his total investment income of as much as 45%. Depending on how the numbers stack up, this unfortunate person could be paying an enormous effective tax rate—well over 50%—on his total income.

When Warren Buffet says he only pays a 15% effective tax on his income, that's because his income mainly comes from capital gains and dividends, and he is completely ignoring the fact that the companies he owns must pay a corporate income tax of as much as 35% before he can receive those gains and dividends.

Fortunately, we do have access to facts that do not distort or color the picture. The chart below uses the numbers as crunched by the Congressional Budget Office. The effective total tax rate shown is the ratio of total federal taxes (income, social security, corporate, excise) divided by comprehensive household income. As Greg Mankiw notes, our tax system is highly progressive: "the rich face average tax rates more than twice those of the middle class, and about seven times those of the lowest quintile." And these effective tax rates include all the benefits of whatever deductions may have been available to individuals and companies along the way.

Greg Mankiw also has a nice summary of how progressive our tax system actually is:

1. The U.S. personal income tax is generally progressive, and substantially so. Click here to see the numbers. The average tax rate for tax returns with over $1 million in income is 25 percent. The average tax rate for returns with income between $50,000 and $75,000 is 7 percent.

2. It is arguably better to use an average tax rate that is all-inclusive. That is, we should include not only personal income taxes but also payroll and corporate income taxes. CBO analysts regularly do that. They find a substantially progressive tax system, as I have pointed out before.

3. If we added transfer payments (which are essentially negative taxes), we would find an even more progressive fiscal system. Those data are harder to come by, as data on transfers are rarely integrated with data on taxes.

4. It make little sense to aggregate payroll taxes with personal income taxes and ignore corporate income taxes.

Delaying tax cuts is ballooning the deficit

Trust politicians to do the opposite of what they should do. The overriding problem that is keeping Congress from achieving true, growth-friendly tax reform is concern that lower tax rates would mean a larger budget deficit. Consequently, politicians are trying to "pay for" lowering some taxes by raising others and/or reducing allowable deductions. Instead, they should be focusing on the urgent need to cut taxes in order to reduce the deficit and strengthen the economy.

I discussed this in greater detail in a post last month (Not cutting tax rates is boosting the deficit). Here's the short version of the story: Since February 2016, when there first emerged a growing consensus that the corporate income tax rate was too high and needed to be cut, revenues from corporate and individual income taxes have flatlined, while federal spending has continued to increase. As a result, the deficit has jumped from $405 billion to $683 billion. The logical explanation for the huge shortfall in revenues (despite the fact that tax rates have not fallen and income and profits have continued to increase at healthy rates) is that people and companies have been actively engaged in minimizing their tax liabilities by deferring income, not realizing capital gains, postponing investments, and accelerating deductions. Why? Because there is a reasonable chance that by doing so they will be able to take advantage of lower tax rates in the future. By inference, this strongly suggests that if Congress manages to cut tax rates, then federal revenues will surge and the deficit will decline, and the economy will benefit from increased investment, spurred by lower corporate income tax rates and increased business investment.

Here are some updated charts which fill in the story:

Chart #1

Spending has been rising at a 4-5% annual rate for the past several years. Revenues, however, have gone flat since Feb. 2016. This is notable, because since then, personal incomes and corporate profits have continued to rise, and there has been no cut in anyone's tax rate. A static forecasting model would have projected continued increases in income tax revenues.

Chart #2

The revenue shortfall can be traced to the individual and corporate income taxes. Together, these two important sources of federal revenue have been flat to slightly down since Feb. 2016. Meanwhile, payroll taxes have been increasing at a steady 5% annual rate, which is exactly in line with wages, incomes, and higher contribution limits. Payroll taxes are very difficult to avoid or postpone.

Chart #3

Chart #4

As a percent of GDP, federal spending and revenues are not terribly out of line with historical norms, as Chart #3 suggests. As Chart #4 shows, the federal budget deficit is not out of the range of what we experienced from the mid-70s to the mid-80s.

Chart #5 

In nominal dollar terms, today's budget deficit has grown from $405 billion in the 12 months ended Feb. 2016 to $683 billion in the 12 months ended Oct. 2017. That's an increase of $278 billion, or 68%. At this rate it is going to be a problem fairly soon. Bear in mind, however, that the main driver of the increase in the deficit is the unusually slow growth (especially given that the economy has been growing) in corporate and individual income tax revenues. This could improve quite rapidly if tax rates on corporate and individual incomes are reduced in a meaningful fashion.

People and businesses respond to incentives; that is at the heart of all economic analysis (or at least it should be, but the CBO unfortunately refuses to believe it). Since the chances of lower tax rates are appreciably greater than zero, people and businesses have an incentive to minimize their tax liabilities, and the unusually slow growth of federal revenues supports this thesis. If Congress keeps dragging its feet on this issue, or if a cut in corporate taxes is postponed until 2019 (as the Senate is stupidly proposing), then the deficit is going to get worse, investments are going to be postponed, and the economy is likely to weaken.

The weakness in federal revenues is also a good indication that tax rates on businesses and individuals are too high. The fact that US corporations have avoided repatriating as much as $3 trillion in overseas profits is very strong evidence that corporate income taxes are too high. As my mentor Art Laffer taught me, tax rates that affect behavior in inefficient and uneconomic ways are by definition too high. The best tax rate is the one that people are content to pay, and are least likely to avoid paying. We all know that taxes are a fact of life. But when the marginal rate on corporate profits is 35-40%, and the marginal rate on individual income is 50-65% (as is the case today, including state taxes), taxes are obviously too high, because evasion is high (because the rewards to tax evasion are huge), and revenues are low.

Laffer Curve strikes again: lower tax rates produced more revenue

The results of last year's Trump tax cut are starting to roll in, and they should not be surprising to students of the Laffer Curve or readers of this blog. As I noted last October, not cutting taxes rates is boosting the deficit:

Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, revenues from corporate and individual income taxes have flatlined, despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.

Indeed, there was zero growth in federal revenues beginning in February 2016 through the end of last year. Further, as I predicted back then, "if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue." And it is happening.

Today's April Treasury report showed that April tax receipts not only set an all-time record, but were fully 12% higher than last April's receipts. People and corporations had been postponing income and accelerating deductions for the 22 months leading up to last December's landmark tax reform, and now they are beginning to realize that income and stop postponing deductions. Tax receipts are once again growing, and there is every reason to expect more of this for the foreseeable future.

Chart #1

As Chart #1 shows, individual income tax receipts have jumped this year, led by very strong receipts in April. Corporate income tax receipts are still soft, but that's not too surprising considering the huge reduction in the corporate tax rate. In any event, individual income tax receipts account for the lion's share of federal income, and they have once again turned up in decisive fashion. 

Chart #2

As Chart #2 shows, spending has been rising at a fairly constant rate (about 4% per year) since 2015. On a rolling 12-mo. basis, federal revenue has risen at a 3.4% rate over what it was a year ago, and it could easily be recording 5-6% rates of growth going forward. With just the tiniest bit of spending restraint, we could see the budget deficit hold steady or decline between now and year end.

Chart #3

As Chart #3 shows, the federal government's finances are very dependent on the health of the economy. They always deteriorate during and after recessions, and they almost always improve during periods of growth. The recent increase in the budget deficit is anomalous in that regard. But when seen through the lens of the Laffer Curve, it is understandable and thus likely temporary.

The Laffer Curve can be summed up as follows: people respond to incentives, especially changes in tax rates. When there is talk of a future reduction in tax rates, it is reasonable to expect tax revenues to decline in anticipation, then subsequently rise once the rates have been cut. Business investment was weak in anticipation of a reduced business tax rate, and now it should be stronger, with the result being more jobs, more income, more profits, and more revenues to Treasury.

The one thing to worry about is the spending side. Spending discipline unfortunately is lacking in today's Congress, and the unchecked growth of entitlements promises to wreak havoc with federal finances in coming years.

Not cutting tax rates is boosting the deficit

It's pandering season again, with politicians and journalists wringing their hands about how cutting taxes will be a windfall to the rich and result in higher deficits. The truth, however, is that by NOT cutting taxes the federal government is losing money and the economy is suffering from sluggish growth. Cutting taxes would almost surely result in a significant boost in revenues and stronger growth. How do I know this? Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, revenues from corporate and individual income taxes have flatlined, despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.

It's amazing: rising incomes, rising profits, and soaring asset prices have resulted in no increase in revenues to the federal government, even though tax rates weren't cut. How could that possibly happen? Simple: people are rational, and they respond to incentives. Given the incentive that tax rates may be reduced in the future, individuals and corporations have apparently taken steps to reduce their current tax liabilities by delaying income, accelerating deductions, postponing investments, and postponing the realization of profits.

Consider these simple facts: S&P 500 trading volume has plunged over 40% since early last year. One reason stocks are up is that people are increasingly reluctant to sell; on the margin they would rather postpone the realization of their gains in order to minimize their current income tax liability. I can assure you that has been a powerful motivator for me, and I'll wager that there are millions of investors who would agree. It's no wonder that NYSE member firms report a 25% increase in margin balances since Feb. '16 (from $436 billion to $551 billion) after no increase over the previous two years. Need income but don't want to pay capital gains taxes? Just don't sell anything and instead add to your margin balance.

Here are some charts which fill out the story:

The chart above shows the rolling 12-month totals of federal spending and federal revenues. Spending has been increasing steadily for the past several years, roughly in line with the growth of the economy. Revenues, however, stopped growing early last year. As a result, the 12-month deficit has increased from $405 billion in February 2016 to $665 billion in September 2017. That's a whopping increase of over 60%!

The chart above shows the major sources of federal revenues (it excludes things such as excise and customs taxes, and miscellaneous revenues, all of which are down somewhat). The only revenue category that has been increasing steadily for the past few years is Payroll Taxes (i.e., income tax withholding), by about 5% per year. That's very much in line with the growth of wages and salaries, which have been increasing at a 3.8% annual rate since Feb. '16. The thing that is unique with payroll taxes is that individuals don't have much discretion over their reported income. If their salary goes up, their withholding is going to go up as well. But individual income taxes are different. They are impacted by deductions, which can be shifted in time, as well as capital gains taxes, which can be legally postponed indefinitely, simply by not selling an appreciated asset. The rich can employ a variety of strategies to postpone or defer their income.

As it turns out, revenues from individual income taxes have experienced zero growth since Feb. '16, despite ongoing growth in personal income and sharply rising stock prices. Corporate income tax revenues have actually declined by about 10% since Feb. '16, despite an 8% rise in trailing, after-tax EPS over the same period. If you were the head of a large corporation and you thought there was a good chance of a meaningful cut in corporate income taxes, wouldn't you take all available steps to postpone income and accelerate deductions? Is it any wonder that US corporations have refused to repatriate trillions of overseas profits? 

So, despite ongoing growth in the economy and in incomes, plus surging stock prices, federal revenues have declined by about 1% of GDP since early last year, as the chart above shows. A static model would have projected a significant increase in revenues. No one (especially the OMB, which is still enamored of static forecasting models) expected federal revenues to be flat over the past 18-19 months.  But that's what happened.

As the chart above shows, the rolling 12-month federal budget deficit has increased from $405 billion in  Feb. '16 to $666 billion in Sep. '17. Relative to GDP, the federal deficit has increased from 2.4% to 3.4%. And it's ALL due to zero growth in tax receipts, which occurred despite no reduction in tax rates and sizable increases in incomes and capital gains. 

It's only reasonable to conclude that the reason federal revenues have failed to materialize as would have been expected is that people and corporations have taken meaningful steps to postpone income, accelerate deductions, and postpone the realization of capital gains. And they have done all that because they have been thinking there was a decent chance of significant tax reform. 

It's a safe bet that if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue. Tax reform would unleash a wave of profit-taking, a surge of capital gains realizations, a massive redeployment of capital to more productive uses, more investment (reducing taxes increases the after-tax returns to investment, thus prompting more investment), more risk-taking, more work, more growth, and ultimately reduced budget deficits. I'm not talking ideology, I'm just talking basic common sense.

But won't the rich get the bulk of the benefit from lower tax rates? Sure, because the top 10% of income earners pay about 70% of all income taxes, and half the working population pays zero income tax. Anyway, wouldn't you rather let a rich person keep more of his money, instead of giving it to the politicians in Washington? Who do you think would spend a million dollars more productively: a rich person who is already consuming as much as he or she wants, or a politician, who would love to buy votes? When the rich keep more of their hard-earned money, they almost certainly will invest most or all of it, and that's what creates jobs and prosperity. When politicians get a windfall of revenues, they will spend it, and don't forget that over 70% of every dollar that Congress spends goes out in the form of transfer payments (i.e., money given to people who haven't worked for it). 

Congress needs to cut taxes in order to boost revenues and stimulate the economy. Quickly! We can't afford to wait.

UPDATE: Art Laffer has made this same point repeatedly over the years when explaining the mistake that Reagan made in phasing in his tax cuts. If you promise that tax rates will fall in the future, you only weaken the economy today. When lower tax rates make sense, as they do today (especially corporate tax rates) rates need to be cut ASAP, otherwise capital will go dormant, awaiting the lower rates.

Assessing the market's assumptions

In order to have a view on whether the market is attractive or not, it's essential to consider the assumptions that are reflected in market pricing. What follows is a review of a variety of key market-based indicators that provide insights into the assumptions the market is making about the future. Taken together, these indicators suggest that the market is still quite cautious and concerned about the future. Nowhere is there any indication that the market is priced to optimistic or rosy assumptions about economic growth, inflation, interest rates or corporate profits. Indeed, most indicators reflect a market that is already discounting a deterioration in corporate profits, sharply rising yields, and/or higher corporate tax rates. What this suggests is that if the future turns out to be less problematic than the market is expecting, then there is still a lot of upside potential in equity prices.

This chart compares the spread on 5-yr swaps (a measure of the credit risk of generic AA-rated banks) to the spread on 5-yr A1 Industrial corporations (a measure of the credit risk of generic industrial corporations). Swap spreads have been trading at "normal" levels for most of this year, but industrials are still trading at levels that are elevated in an historical context. This means that the market still worries (not a lot, but more than it would if the outlook were healthy) about the viability of large industrial corporations over the next several years. 

This chart compares spreads on high-yield bonds to spreads on investment grade corporate bonds. Credit spreads are a good measure of the perceived default risk of corporate debt, and are generally correlated to the health of the economy—spreads tend to rise around recessions, and fall during recoveries. As the dashed green lines show, the current level of spreads is substantially above the levels that have prevailed during economic expansions. This implies that the market is still quite skeptical of the economy's ability to thrive.

Credit default swaps tell a similar story to that of credit spreads in general: the market's perception of default risk is still substantially higher than it was prior to the onset of the 2008 recession.

In theory, the price of a stock is the discounted present value of its future after-tax profits, and thus a function of three variables: interest rates, tax rates, and profits. Therefore, there should tend to be an inverse correlation between the level of yields and the price of a stock; the higher the level of yields, the greater the discount on future cash flows, and vice versa. This chart shows how the value of stocks (the blue line, which is the ratio of the S&P 500 index to nominal GDP) compares to the level of 10-yr Treasury yields (the red line, which is shown with the y-axis inverted). When yields were low and relatively stable in the early 1960s, the economy was strong and stocks were well-priced. As yields rose in the 1970s, stock prices fell relative to GDP, and subsequently rebounded as yields declined in the 1980s and 1990s. Since 2000, however, yields have continued to decline, but stock valuation has fallen. This implies that stocks are priced to the assumption that yields will rise, future after-tax profits will decline, and/or tax rates will rise significantly.

This chart compares actual market capitalization (using the S&P 500 as a proxy) with a theoretical measure which capitalizes current after-tax corporate profits using the 10-yr Treasury yield as a discount factor. This model of equity valuation has worked pretty well for many decades, but has clearly broken down in recent years. One interpretation for this is that the market expects yields to rise, profits to fall, or tax rates to rise, or some combination of the three. However you look at it, though, the market is priced to some pretty big and unpleasant assumptions.

The VIX index of implied equity option volatility is a good measure of how nervous the market is. It typically peaks during market crises, as noted in the above chart. Today the Vix is trading around 18, which is substantially higher than the 10-12 level which has prevailed during periods of relative tranquility. This implies that the market is still pretty nervous, and that the future is still clouded by uncertainty (e.g., fears that tax rates will rise, government regulatory burdens will rise, and/or that the economy will suffer a relapse).

This chart compares the level of the S&P 500 with the Vix index (which is inverted, to show that a lower level of risk typically corresponds to a higher level of equity prices, and vice-versa). The Vix has returned to its pre-crisis levels, but the equity market has not, despite there having been a full recovery in corporate profits (in fact, after-tax corporate profits are currently at an all-time high).  This suggests that the market is still discounting profits at a higher-than-normal rate because of a general lack of confidence in the future.

This is a chart of the market's expectation for the level of the Fed funds rate one year in the future, as derived from Fed funds futures contracts. Currently, the market expects the funds rate to average just under 0.3% in Dec. '11. This implies that the market assigns a very high probability to the Fed keeping the funds rate target at 0.25% for all of next year. That, in turn, is likely to happen only if the economy remains relatively weak and inflation remains very low.

This next chart compares the yield on long-term BAA corporate bonds (blue line) with the earnings per share (i.e., earnings yield) of the S&P 500 (red line), as of Nov. '10. Earnings yields are now noticeably higher than corporate bond yields, a good indication that equity valuations are relatively cheap. (Normally, corporate bond yields should be less than earnings yields, since bonds are senior in the capital structure to equities and thus less risky.) After-tax earnings on the S&P 500 stocks now represent a "yield" of just under 7%, which also happens to be the average of the past 50 years. Corporate bond yields, in contrast, are currently 5.7%, which is 300 bps less than their average of the past 50 years. If it weren't for the market's expectation that after-tax earnings are very unlikely to maintain current levels, much less increase, stocks would be considered an incredible bargain by historical standards. Which is another way of saying that the market is assuming that profits will deteriorate and/or corporate tax rates will rise.

Gold traditionally has been a refuge from political, monetary, and economic risks. That it is trading at all-time nominal highs and close to all-time real highs is evidence that the market's perceived level of risk is unusually high. 

Jobs growth is disappointing, but the tax plan is encouraging

Monthly jobs data are by nature volatile, and they can be revised significantly for up to two years, so you can't give one or even several months of numbers much importance. I like to track the trend in jobs growth over 6- to 12-month periods, since the monthly volatility tends to wash out. By that standard, private sector jobs growth has slowed from 2.5% three years ago to about 1.5% now, and shows no sign of improving despite lots of good news from the stock market. If it weren't for a modest uptick in labor productivity (which has picked up from a low of -0.4% in the year ending June 2016 to 1.5% in the year ending last September), the economy would not be keeping pace with the 2.2% annualized growth rate that it has experienced since the recovery began in mid-2009 (in the year ended last September, the economy registered only 2.26% growth). In effect, a recent, modest increase in productivity—which remains miserably low—is offsetting a slowdown in jobs growth, and the result is continued sluggish growth. Things could be worse, but it's hard to reconcile the ebullience of the stock market with the weak pace of hiring.

To be sure, GDP growth has averaged about 3% in the past two quarters, and there is reason to believe it could could be at least 3% in the current quarter. But until we see a credible increase in the pace of hiring, it is premature to expect a sustained and/or impressive increase in overall growth. That most likely will require successful tax reform. But in the meantime, there are still several encouraging indicators which suggest that the economy is unlikely to enter a recession for the foreseeable future: business investment has picked up a bit, the ISM surveys show impressive results, and real yields are increasing (but only very gradually). Details can be found in the following charts.

The chart above shows the monthly change in private sector jobs. I focus on the private sector, since that is the economy's engine of growth. As the green line suggests, there hasn't been any sustained improvement in the pace of jobs creation for a long time.

As the chart above shows, public sector jobs haven't grown for a long time. This is actually good, since it means that the public sector is shrinking relative to the rest of the economy, and that acts as a tailwind to growth.

As the chart above shows, the growth rate of private sector jobs has been tapering off for the past three years. The current pace, about 1.5% per year, is the slowest we have seen since the recovery got underway. By itself, this is a disappointing indicator. At the very least, it reinforces the fact that the current recovery has been weak because business investment has been weak. Companies are generating healthy profits, but they are not investing much for the future. Without a pickup in investment we are very unlikely to see any pickup in jobs growth or in productivity.

As the chart above shows, private sector investment hasn't grown much at all for the past 10 years. This is one of the root causes of the fact that the current recovery has been the weakest ever.

The October ISM manufacturing survey declined a bit from September, but is still at very strong levels. This strongly suggests that GDP growth in the current quarter will be at least 3-4%. If so, that in turn would be a good indicator that labor productivity continues to improve.

The much larger service sector of the economy is also showing very positive readings in the October ISM survey. The Eurozone is doing well also. We are in a synchronized global upturn, and that is very good.

The manufacturing sector must be feeling fairly optimistic, since a solid majority of those surveyed report increased hiring plans. This bodes well for future jobs growth.

Real yields on 5-yr TIPS have tended to track the economy's real growth rate, as the chart above shows. Real yields have been in a modest uptrend for the past few years; I take this as a sign that the market is very reluctant to price in a strong recovery. According to the bond market, the outlook for the economy has improved only very modestly in the past year or so. No sign of exuberance here! Also, no sign of great expectations for tax reform. The market is still very cautious about the growth outlook.

So what about Trump's tax reform proposal? It looks good, but it could be better. It's very business-friendly (e.g., cutting the corporate tax rate significantly, allowing for immediate expensing, shifting to a territorial system that taxes profits only at their source, and eliminating or limiting many deductions). But it's tainted by keeping a very high rate on top income earners (and a new, even higher rate on those who make more than a million), and by not reducing the tax on capital gains and dividend income. However, these negative effects are somewhat offset by the phaseout of the death tax, the elimination of the alternative minimum tax, and the indexation of tax brackets by future inflation.

Trump's proposal effectively shifts a lot of the corporate tax burden to individuals, which in principle is a good thing, because in theory there should be no tax on businesses. Whatever tax businesses do pay is effectively passed on to consumers, employees, and shareholders—better and more efficient to tax them directly than indirectly. The top rate for individuals is there purely for political purposes; it will do nothing to stimulate investment or the economy because it fails to increase the incentives of the most successful to invest, take risk, and work harder. That's like hobbling those most capable of creating new jobs. It will also mean that those in the middle class who strive to reach upper class status will face a very steep marginal tax rate curve, thus creating new burdens for the middle class. And by creating very different top rates for individuals and corporations, it will result in myriad efforts to arbitrage the difference (e.g., by switching from S corp to C corp status).

It will, however, very likely result in more investment in the US, since it sharply increases the after-tax returns to corporate risk-taking in the US relative to other countries. Lots of capital that has fled high US business tax rates will likely return, with the net result being to increase the ratio of capital to labor in the US. That in turn would have the salutary effect of boosting wage income, because when you add capital to an economy you automatically make labor relatively scarce, and that has the effect of boosting wages. (If you want to invest more in an economy, you need to hire people to run the business.) If this tax proposal passes, we can expect to see more overall growth in the economy, more jobs creation, PLUS higher real incomes for the vast middle class. Unemployment is low, so a significant increase in the demand for labor is almost certain to require higher real wages. Rising real incomes would be a very welcome thing for everyone.

True tax reform requires the elimination of deductions and a lower and flatter tax rate structure. This proposal goes part way on the deduction front and a long way on the corporate tax front. Unfortunately, it makes the individual tax rate structure steeper and more progressive. It's a shame that Republicans couldn't propose something worth doing on all fronts without first caving to potential political opposition. But I won't let the perfect be the enemy of the good. This proposal beats the heck out of doing nothing!

Weak Q1 growth, but stronger growth to come

First quarter GDP statistics were disappointing, with real growth of only 0.7% annualized (real GDP increased by a mere $29 billion in the quarter, almost a rounding error). However, real growth for the 12 months ended March was 1.9%, only modestly less than the 2.1% annualized growth rate for the current business cycle expansion. More interesting, perhaps, was the rate of inflation as measured by the GDP deflator (the broadest measure of inflation available): 2.3% annualized for the first quarter and 2.0% for the past 12 months. By this measure, the Fed has achieved its target inflation goal, and is fully justified in raising short-term interest rates. The brightest spot in the quarter was a 12% annualized jump in gross private fixed investment, since weak business investment has been the root cause of the current recovery's dismal, 2.1% annualized pace of growth. This may mark the beginnings of a pickup in growth in the years ahead, especially if Trump is able to slash the corporate tax rate as he proposes.

As the chart above shows, real GDP growth has essentially been on a 2% growth path since the middle of 2009. That's about one percentage point below its long-term growth path, and the "gap" between the two is now a bit over $3 trillion. That's a disappointing result, to be sure, but it also implies that the economy has tremendous upside potential, and that is extremely encouraging. As long-time readers will  know, I consider that the current recovery has been weak primarily due to rising tax and regulatory burdens and a dearth of business investment (and the two are most likely closely entwined). Rebuilding confidence, reducing the barriers to business investment and risk taking, and increasing the after-tax rewards to investment will thus be critical to closing the GDP gap. The potential rewards to successful growth-oriented policies are hard to overestimate.

Real gross private domestic investment (shown in the graph above) grew at a 3.7% annualized rate from 1966 through 2007, over which time real GDP growth grew at a 3.1% annualized rate. From the peak of the last business cycle in 2007 until March of this year, private investment has managed to post only 1% annualized growth. It's no wonder then that growth in the current expansion has been only 2.1%. Without more investment, there will be a scarcity of jobs, and a scarcity of the tools (machines, computers, software) necessary to boost the productivity of those who are employed. Investment is the key to prosperity, and so far, in the current business cycle expansion, it has been in scarce supply.

A subset of real gross private investment is gross private fixed investment, shown in the chart above. Largely driven by strong residential investment, it jumped at a 12% annualized rate in the first quarter.

As the chart above shows, inflation as measured by the GDP deflator (the broadest possible measure of inflation) was 2% in the 12 months ended March 2017. Forget deflation. The issue now is whether inflation is likely to accelerate from its current 2% pace. It's also significant that despite the sluggish growth of the past 6 ¾ years, inflation has on balance remained well above zero, a result that runs counter to the Phillips Curve theory of inflation, which holds that weak growth and lots of unused capacity tend to depress inflation. Inflation is a monetary phenomenon, not a function of growth.

The key to the future prosperity of the US economy is business investment. Only the private sector can create prosperity; the proper role of the public sector is to uphold the rule of law, ensure personal freedom, protect private property, and maintain the peace—not to create jobs. Prosperity is the result of people working smarter and harder—and taking on risk in the process. In order to get more prosperity we need more investment, and Trump's tax proposals—while far from ideal—go a long way to incentivizing private sector investment.

Lowering the tax rate on big and small businesses to 15% would significantly increase the after-tax rewards to business investment. One simplistic example: currently a business gets to keep 65 cents on every dollar of profit; under Trump's proposal a business would get to keep 85 cents on every dollar of profit. That works out to a 30% increase in the after-tax rewards to running, starting, and expanding a business. (It also suggests that reducing the corporate tax rate to 15% could boost the stock market—which is the present value of future after-tax profits—by 30%.) When rewards increase to such a significant degree it is only reasonable to expect to see a big increase in business investment, which in turn would result in more jobs, more income, and an expanding tax base. Cutting tax rates needn't result in reduced tax revenues, and cutting the corporate tax rate is the most logical place to start if you want to stimulate the economy. And by the way, we need to continue to cut regulatory burdens and simplify the tax code; shrink the government, and give the private sector the room and freedom to grow.

UPDATE: John Steele Gordon yesterday wrote forcefully (and in much greater depth than I do here) about why Trump's tax proposals would be very good for the economy. Trigger warning: he criticizes those who oppose the proposals.

End the corporate income tax

Richard Rahn, a clear, level-headed thinker, wrote a nice article in The Washington Times last week titled "Ending the Corporate Tax." I like it because it neatly summarizes all the pros (which are few) and cons (which are many) on the issue of whether corporations should be taxed, in a way that just about anyone can understand. It's an important issue, especially as Washington these days is torn between those who want more taxes to fund even more government and those who want less government and lower taxes, while the most pressing concern is finding the best way to foster a healthier economy with more jobs. Here's an excerpt:

Economists dislike the corporate income tax because it reduces productive labor and capital and is an additional tax on income that has already been (or will be) taxed. Politicians love the tax because it is largely invisible to most voters.

If a corporation has to pay higher income taxes, it will have less money for research and development, expansion and job creation. The money invested in corporate stocks has already been taxed at least once when it was earned, and it will be taxed again when it is paid out in dividends or sold for a capital gain. How many times should the same income be taxed?

Ask yourself, who is likely to spend the money in a way that will bring more human satisfaction and create more jobs — corporate executives trying to make money by producing goods and services people want, or politicians and government bureaucrats trying to enhance their own power?

As most good economists and knowledgeable others understand, the world would experience a better allocation of resources and more job creation if the corporate income tax was abolished. Fights over which jurisdiction gets to tax and how much it can tax would disappear. The so-called revenue loss would be made up by taxes on the dividend and capital gains increases, and by the extra economic growth and employment that would result from ending the corporate tax.

Bullish charts: Manufacturing and corporate profits

The bullish case for the economy (and by extension the stock market) is getting stronger. Here are some charts using recent data releases that tell the story. Manufacturing activity has definitely picked up, and corporate profits are not only strong but rising, leaving equity valuations only moderately above average. All of this is symptomatic of an economy that is slowly but surely ramping up its growth engines, and an equity market that is cautiously pricing all of this in.

Chart #1

Chart #2

Chart #1 compares the ISM manufacturing index with the quarterly annualized growth of GDP. The manufacturing index is about as strong as it has ever been, and in the past, numbers like this have been consistent with GDP growth of at least 4-5%. Expect Q3/18 to be at least 4%, which in turn would make year over year growth in GDP the strongest in 13 years. Meanwhile, Chart #2 shows that the service sector remains quite healthy as well, more so than in the Eurozone.

Chart #3

Chart #3 shows the ISM new orders index, which is also rather strong. The October 2016 reading was 53.3 (just before the November '16 elections), and it has since jumped to 65.1. This is a good sign that business confidence has surged and that businesses are ramping up spending on new plant and equipment. This is the seed corn of future productivity growth and an excellent portent of a stronger economy to come.

Chart #4

Chart #4 compares the ISM manufacturing index to its Eurozone counterpart. Things aren't looking so good overseas of late, which is unfortunate. But this could simply be a reflection of the fact that with the big drop in corporate tax rates in the U.S., businesses are pouring resources into the US at the expense of Europe, where tax rates are still high.

Chart #5

Chart #5 shows the ratio of after-tax corporate profits (as measured by the National Income and Product Accounts, which in turn are based on data submitted by corporations to the IRS) to nominal GDP. By this measure, corporate profits have rarely been so strong. This is of course due in large part to the reduction in corporate tax rates. Skeptics will say that lower tax rates have simply lined the pockets of the fat cats, and that little or none of this will trickle down to the little guy. I think this is a very short-sighted way of looking at things. What is the first thing that corporations do when they find that their profits are growing? From my experience, having known and worked with many senior corporate executives, increased profits are the trigger for increased investment. No one wants to leave profitable activities unexploited.

Chart #6

Chart #6 compares the yield on BAA corporate bonds, which I use as a proxy for the overall yield on all corporate debt, to the earnings yield (the inverse of the PE ratio) of the S&P 500, which I use as a proxy for the earnings yield of all corporations (i.e., the rate of return on a dollar's worth of investment in US corporations). As the chart shows, the past decade or so has a lot in common with the late 1970s; during both of those periods corporate bond yields and equity yields were very similar. During the boom times of the 80s and 90s, however, the earnings yield on stocks was much less than the yield on corporate bonds.

If the economy was humming along and confidence was high, you would expect the earnings yields on stocks to be less than the yield on corporate bonds. Why? Because corporate bonds have the first claim on corporate earnings—it's safer to own bonds than it is to own equity. Equity investors have a subordinate claim on earnings, but they are generally willing to give up current yield  in exchange for greater total returns.

The fact that earnings yields and corporate bond yields are roughly equal these days tells me that investors aren't too confident that corporate profits will remain as strong as they have been for much longer. That's a sign of risk aversion, and risk aversion has been one of the hallmarks of the current business cycle expansion. I've been arguing for a while that risk aversion is slowly on the decline, and I expect that to continue.

Looking ahead, earnings yields will probably stay flat or decline (i.e., PE ratios will probably remain steady or rise), while the yield on corporate debt should rise in line with rising Treasury yields, which in turn will be driven by more confidence and less risk aversion.

Chart #7

Chart #7 shows the current PE ratio of the S&P 500. This is calculated by Bloomberg using 12-mo. trailing earnings from continuing operations. At just under 21 today, PE ratios are somewhat higher than their long-term average.

Chart #8

Chart #8 shows the PE ratio of the S&P 500, but using the NIPA measure of all corporate profits instead of reported GAAP earnings. Here we see that equity valuations are only slightly higher than average, and far less today than they were during the "bubble" of 2000. 

Chart #9

Chart #9 shows the difference between the earnings yield on equities and the yield on 10-yr Treasuries. That's a measure of how much extra yield investors demand to bear the risk of equities instead of the safety of long-term Treasuries. In the boom times of the 80s and 90s, investors were so confident in the value of equities that they were willing to accept an earnings yield that was substantially below the interest rate on Treasuries. For the duration of the current recovery, however, that has not been the case at all. That's another way of appreciating just how risk averse this recovery has been.

Chart #10

 

Chart #10 shows the PE ratio of the S&P 500 using NIPA profits (instead of GAAP profits), and Shiller's CAPE (cyclically adjusted price to earnings ratio) method of calculation. (Current prices divided by a 10-yr trailing average of after-tax quarterly profits.) Here we see that PE ratios are only slightly above their long-term average. That's another way of saying that equities are far from being over-valued.