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Adventures in Tax Cuts and Net Income
Saturday, March 16, 2019

Avid readers of the Calcbench blog know that we’ve been watching corporate financial data closely here to understand a complicated, subtle question: How much has the sweeping corporate tax cut enacted at the end of 2017 been responsible for growth in net income?

Economists have pondered that question too, wondering whether the tax cut was a sugar high that goosed corporate earnings in 2018 — with the implication that after the sugar high wears off (say, in 2019), growth in net income might stall.

As companies file their annual reports for 2018, we can now start to answer that question. Somewhat to our chagrin, the answer is more complicated than we expected.

In theory, you would see the sugar high in a company where pretax earnings from operations remained flat or fell, but because the company paid so much less in taxes, net income would rise anyway. That is, the company’s net income didn’t increase because sales were growing or costs were kept in check; net income only grew because Uncle Sam decided to take less in taxes.

So if Washington had not enacted that tax cut in 2017, and the company paid 2018 taxes at the same effective rate as it did in 2017 — then net income might have held steady or fallen, but it wouldn’t have grown. That would be the sugar high.

Do we see that phenomenon at play when comparing 2018 to 2017 numbers? Yes, but with an asterisk. And that asterisk says a lot about how financial analysts need to look at a company’s numbers carefully if you want to get a correct read on its situation.

Example: IBM

A good example of this situation is IBM ($IBM). We hopped over to our Data Query page and pulled up Big Blue’s earnings before taxes, income tax provision, and net income for both 2017 and 2018. The results were as follows in Figure 1, below.

As we can see, IBM’s pretax earnings actually drifted downward last year, but its income tax provision plummeted by more than $3 billion — an amount larger than $2.98 billion increase in net income.

Therefore, all of IBM’s growth in net income can be ascribed to the company paying less in taxes. And sure enough, when you look at IBM’s numbers on the Company-in-Detail page, they’re pretty mopey. Revenue, gross profit, and expenses for 2018 are all within 1 percent of 2017 numbers. That’s what stagnant growth looks like.

The tricky part, however, is in IBM’s effective tax rate. Yes, technically speaking, if IBM paid a 49.5 percent tax rate again in 2018 — that would have meant an income tax provision of $5.6 billion, and net income essentially unchanged at $5.73 billion.

Except, why was IBM’s effective tax rate that high in the first place? Because its effective tax rate in 2016 was only 4 percent (thank you again, Data Query page), and its effective tax rate in 2018 is 23.1 percent. Clearly IBM’s effective tax rate fluctuates quite a bit.

So you can’t assume that without the corporate tax cuts arrived in 2018, IBM would have faced the same higher effective tax rate as 2017, and therefore stalled on net income growth. The 2017 effective tax rate may have been an artificially high number itself.

How would you unravel that mystery? By studying IBM’s numbers on our Company-in-Detail page, and then tracing the tax provision line-item back to our Interactive Disclosure page, which lets you see the narrative explanation for that 49.49 percent.

Sure enough, when we trace the line-item back to the source, we find that IBM recorded a one-time charge of $5.5 billion in fourth-quarter 2017 — the famed “deemed repatriated earnings” tax that so many firms paid that quarter, as part of corporate tax reform. That $5.5 billion charge accounted for 48 points in that 49.49 percent.

More or Less Sugar?

IBM shows us the importance of tax management to a company’s bottom line — not really one-time sugar high this year, as much as an ongoing effort to minimize tax payments every year, which can leave net income growth divorced from operational reality.

We’ll keep looking at the sugar high phenomenon here, and try to draw broader conclusions about how real it may be.

Calcbench subscribers, meanwhile, can zigzag from our Data Query page, to the Company-in-Detail page, to the Interactive Disclosure page — all to connect the numbers companies report to the narrative they offer.

Then you can see how much those things do, or do not, align over time.


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