Capital expenditures are not meeting expectations
The priorities of the middle market may not match its opportunities.
Despite expectations that capital expenditures would increase as a result of the Tax Cuts and Jobs Act of 2017 (TCJA), just 38 percent of middle market executives report that they have plans to increase the dollar volume of capital investments over the next three years as a result of the act. Among those middle market firms, however, spending plans differ: A higher percentage of larger businesses (45 percent) than smaller businesses (34 percent) expect an increase in the dollar amount of capital investments. While disappointing, this is not necessarily surprising considering nine out of 10 executives polled in the 2017 Q4 RSM US Middle Market Business Index (MMBI) said their level of capital expenditures was sufficient.
A window opens
Among the organizations surveyed, only C corporations get the sharply lower federal income tax rate of 21 percent, down from 35 percent. The S corporations in the survey, along with the remaining limited liability corporations, sole proprietorships and others, are pass-through entities, meaning profits from the business flow through to the business owner’s personal tax return. The TCJA, however, offers an attractive bonus depreciation rate of 100 percent for qualified assets—but only until Dec. 31, 2022. While the 21 percent rate is a favorable factor in the current taxation of C corporations, the bonus depreciation incentive isn’t as valuable to them as it is to pass-through entities, who don’t get the lower tax rate.
“The middle market’s reticence to invest in their business, despite the tax reform stimulus, may be due in part to a lack of understanding on how certain provisions of the TCJA, such as bonus depreciation, could benefit their companies and provide opportunities to accelerate capital expenditures,” says RSM US Chief Economist Joe Brusuelas. “The survey results also indicate business leaders plan to spend more on attracting and retaining talent, yet could channel some resources to technology to improve productivity.”
A reluctance to spend
This seeming hesitance to invest capital sharply contrasts with the overall expectations of the current economic environment by middle market executives, who say they expect to expand hiring and increase compensation amid strong revenues and net earnings. With gross domestic product increasing at an annual rate of 4.1 percent in the second quarter of 2018 and unemployment hovering around 3.9 percent, a forecast of increased capital investment would be understandable, if not entirely justifiable.
However, there may be a number of reasons why economic forecasts—particularly those regarding capital expenditures—were too optimistic. As noted in a study by the Federal Reserve Bank of San Francisco, a fiscal stimulus such as the TCJA is less effective in times of economic growth (such as the one the country is experiencing now) than during downturns. Moreover, a tightening labor market is making it difficult for some companies to meet customer orders, let alone increase revenue. Survey participants indicate they plan to increase hiring, but it is unclear by how much, or what the effect would be on growth.
Given the complex nature of the TCJA, it is not surprising that details about its implementation still need to be worked out, even months after being signed into law. Inadvertent omissions in the wording of the law have forced some hospitality chains, for example, to postpone annual renovations to their restaurants until the flaws are corrected and they can take advantage of the intended tax incentives. The complexity of the tax law changes is evidenced by the fact that only half (52 percent) of middle market executives believe it will have a positive effect on their after-tax cash flow.
“It’s typical of a bill of this size that Congress needs to make corrections, and the IRS needs to issue interpretative guidance,” observes Patti Burquest, principal in charge of the Washington National Tax practice at RSM US. “The 1986 tax act was similar in scope, and it took several years to get the regulations issued as well as to make technical adjustments and corrections to various provisions.”
Meanwhile, current market conditions, including sustained levels of low domestic unemployment and escalating trade tensions resulting in the imposition of multilateral tariffs, may be adding to the cautious approach to capex spending.
“Anecdotally, we see that the tightening labor market as well as policy and financial market uncertainty tend to be the significant barriers to increased capital investments for middle market businesses,” Brusuelas says. “Without knowing the impact that any future tariff or trade policies will have on supply chains, for example, companies may be reluctant to make long-term strategic investments. Moreover, middle market executives may see the returns on investments in technology as too little for the effort and expense.”
Among middle market companies that anticipate seeing an increase in after-tax cash flow, the capex story is a little brighter. Nearly three-quarters of these business leaders state they will make capital investments, exceeded only by business leaders who plan to shore up their balance sheets. Increasing compensation, increasing investor rewards and hiring are the next most popular investments of the tax savings.
Investor returns are popular among larger businesses as well, with stock buybacks overall expected to reach a record $1 trillion this year. Such a short-term approach does little to boost the long-term value of a company and could even have a negative impact on the U.S. economy, according to a report by McKinsey & Company; surplus cash might be better spent on issuing dividends or increasing investments.
Spending extended rather than increased
Nevertheless, the topline MMBI and outlook for middle market businesses revenue remain robust.
“It may well be that the TCJA is helping maintain the current pace of investment and spending for a longer period than it would have otherwise,” says Jeff Johannesen, chief strategy and innovation officer at RSM US and the firm’s immediate past national tax leader. “Rather than seeing an immediate spike, the act may be prolonging long-term confidence in the current posture, rather than short-term, frenetic spending.”
To be sure, more than one-third of executives surveyed are planning to increase their capital investments. But these expenditures align with the unique circumstances of each company. “I don't think middle market executives are looking for a quick way to spend money,” Johannesen says. “They want to identify the best way to spend their money for the long term.”
So what is the best way? How the tax law may specifically affect a company’s growth and cash flow will depend on management’s specific priorities. However, for long-term viability, technology may be an industry-agnostic investment priority common to middle market companies nationwide.