When a tax payment is deferred, or a tax refund is accelerated, it’s the equivalent of a loan to the taxpayer. And what a nice loan it is! No collateral, no background check, no loan application, no interest charged, no bankers. And unlike other government-supported lending, no requirements to retain employees or limitations on dividends or executive compensation.
United Parcel Service Inc. reported in its second-quarter 10Q filing on August 4 that during the first six months of 2020, it deferred $370 million of employer payroll taxes and that for all of 2020, it anticipates that various provisions of the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) “will provide a temporary cash flow benefit of approximately $1.0 billion.” That’s a lot of government money to a company that appears to have no trouble accessing capital markets.
UPS — its stock a component of the S&P 500 — is ranked number 43 on the Fortune 500. Despite the deep recession, the company’s second-quarter revenues were $20.5 billion, up 13 percent from the second quarter of 2019. Its net after-tax profit was $1.8 billion, up 5 percent from the second quarter of 2019. If UPS hadn’t benefited from the $370 million of payroll tax deferral, it still would have generated $3.5 billion of free cash during the first six months of 2020.
On May 9 S&P Global Ratings downgraded UPS’s senior unsecured debt rating to A- from A on the belief that the pandemic would likely pressure the company’s full-year 2020 earnings (which so far hasn’t happened). But the A- rating is still comfortably investment-grade. (See table for bond ratings.) Moody’s gives UPS an A2 rating, comparable to S&P’s A rating, described as a “strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.”
UPS was not the only company with an investment-grade credit rating to benefit from significant CARES Act tax deferrals. Kroger Co. (Moody’s, Baa1) expects to defer $600 million of payroll tax payments in 2020. CVS Health Corp. (Baa2) deferred $225 million of Social Security tax payments in the quarter ending June 30. Tyson Foods Inc. (S&P, BBB+) estimates its deferral of the employer portion of Social Security tax payments in 2020 will exceed $160 million, and Progressive Corp. (AA) estimates it will defer about $130 million in 2020.
| Moody’s | Standard & Poor’s and Fitch |
|---|---|---|
Investment-Grade | Aaa | AAA |
Aa1 | AA+ | |
Aa2 | AA | |
Aa3 | AA- | |
A1 | A+ | |
A2 | A | |
A3 | A- | |
Baa1 | BBB+ | |
Baa2 | BBB | |
Baa3 | BBB- | |
Non-Investment-Grade (High-Yield, Junk) | Ba1 | BB+ |
Ba2 | BB | |
Ba3 | BB- | |
B1 | B+ | |
B2 | B | |
B3 | B- | |
Caa | CCC | |
Ca | CC | |
C | C |
March Madness
Well before the current recession, analysts were expressing concerns about corporate credit. “The average quality of borrowers has declined,” wrote economist Susan Lund of the McKinsey Global Institute in 2018. “In the U.S., 22 percent of nonfinancial corporate debt outstanding comprises ‘junk’ bonds from speculative grade issuers, and another 40 percent are rated BBB, just one notch above junk. In other words, nearly two-thirds of bonds are from companies at a higher risk of default.”
Similarly, former Federal Reserve Chair Janet Yellen said in December 2018 that “corporate indebtedness is now quite high and I think it’s a danger that if there’s something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector.” Figure 1 shows that from 2008 through 2019, U.S. corporate bonds outstanding as a percentage of GDP grew from 19.7 percent to 26.6 percent.
As shown in Figure 2, the S&P 500 stock index reached a peak on February 19 from which it began its record-breaking monthlong descent. Also shown in Figure 2, from mid-February to mid-March the spread between the interest rates on Treasury bonds and those on corporate bonds — a long-standing measure of credit market risk — more than doubled, from 2 to 4 percentage points.
On February 29 the first death in the United States from the coronavirus was reported. On March 6 more than 20 passengers on a California cruise ship tested positive for COVID-19. On March 11 the World Health Organization declared COVID-19 a pandemic. On March 13 Present Trump declared COVID-19 a national emergency.
Paralleling the bad pandemic news was the bad financial news. On March 10 Bloomberg News reported: “The coronavirus is threatening to expose the Achilles heel of the U.S. economy: heavily leveraged companies.” A March 11 headline in The New York Times read: “Coronavirus May Light Fuse on ‘Unexploded Bomb’ of Corporate Debt.” On March 23 the Wall Street Journal editorial board warned: “The window for providing liquidity to stressed businesses is closing faster than many realize. Markets face another tumultuous week, with many industries hard-pressed to find financing.”
It was in this panicky environment that the CARES Act was drafted. Congress had already begun work on the bill when another, smaller stimulus package, the Families First Coronavirus Response Act (P.L. 116-127), became law on March 18. Nine days later, after receiving a 96-0 vote in the Senate and voice vote approval in the House, Trump signed the CARES Act into law. In May 20 floor remarks, Senate Finance Committee Chair Chuck Grassley, R-Iowa, explained about the CARES Act: “My approach for the tax relief was to provide as much liquidity as possible and as quickly as possible.” With financial markets on such shaky ground at the time of passage, the provision of credit to businesses was certainly an appropriate goal of government policy.
Timing
But was adjustment to the timing of tax payments and refunds a good way to provide liquidity to business in a time of crisis? Two provisions of the CARES Act as well as contemporaneous administrative actions by Treasury provided pure timing benefits. Those changes did not reduce the income tax provision or the effective tax rate in accounting statements of companies.
The CARES Act also included provisions that combined the potential for permanent tax relief with timing benefits like those described above. To the extent these benefits provided permanent tax relief, they could reduce accounting effective tax rates.
Payroll Tax Deferral
The employer portion of the Social Security payroll tax in 2020 is 6.2 percent of up to $137,700 annually per employee. The CARES Act allowed employers to postpone all these remaining payments for 2020. One-half would now be due on December 31, 2021, and the other half on December 31, 2022. The great advantage of this approach to increasing cash flow is its simplicity. Not only was there no application process as with a conventional loan, but no additional tax forms had to be filed. The deferral is automatic. The employers simply delayed payment.
The disadvantage of this approach is that 6.2 percent of nine months of payroll is an arbitrary amount that may not correspond to the financial needs of a business. As with UPS, it may be far more than needed given what the market can provide. For other businesses that have access only to bank credit and whose needs cannot be fulfilled by the Paycheck Protection Program (either because they are too large or because they are not allowed a second loan under the program), the amount of payroll tax deferral may fall far short of what is needed (in which case they may need to adopt the alternative — namely, laying off workers and getting a permanent increase in cash flow equal to 100 percent of employment compensation).
Also disadvantageous from a financial perspective is that loaned funds are received in an unusual fashion: in even intervals over the remainder of 2020. Most employers in need would undoubtedly prefer receiving a lump sum upfront.
Accelerated AMT Credits
The Tax Cuts and Jobs Act repealed the corporate alternative minimum tax but allowed corporations to apply unused AMT credits against regular tax liability that could, subject to some limitations, be refunded through 2021. The CARES Act eliminated these limitations so that any of the remaining minimum tax credits may be used before 2021 by applying for a tentative refund.
Viewed as a loan program, this provision is poorly targeted. Only corporations that were subject to the AMT and had remaining AMT credits got additional cash flow. In particular, this CARES Act provision provided no benefit for corporations with less than $7.5 million in annual receipts because these small corporations were exempt from the AMT.
Income Tax Deferral
Section 7508A provides Treasury authority to delay return filings and tax payments in a federally declared disaster area. Because of the president’s March 13 announcement, the whole country was officially a disaster area. On March 18 the IRS issued Notice 2020-17, 2020-15 IRB 590, which allowed taxpayers to defer income tax payments (and payments of self-employment tax) due on April 15 to July 15. The maximum deferral for individuals and noncorporate businesses was $1 million and for corporations was $10 million. A Treasury press release stated that the notice would provide $300 billion of near-term cash flow to businesses and individuals.
On March 20 Notice 2020-18, 2020-15 IRB 590, expanded these benefits by removing the limitation on the size of deferral and allowing the deferral of estimated payments. It also extended the April 15 filing deadlines until July 15.
For most taxpayers, this was a simple way to get the equivalent of a 90-day loan equal to tax payments and estimated tax due. The great advantage of this deferral was its simplicity, speed, and widespread availability. However, it increased liquidity based not on a taxpayer’s financial distress (which might be either enormous or nonexistent) but on the amount of tax due. Taxpayers that overwithheld or overpaid estimated payments would get no benefit.
Mixed Temporary-Permanent Relief
Three provisions of the CARES Act accelerate tax relief with the possibility of providing a lasting tax benefit. All three provide temporary retroactive relief from revenue-raising provisions of the TCJA: (1) temporary reinstatement of net operating loss carrybacks for losses incurred in 2018, 2019, and 2020; (2) repeal through 2020 of the excess business loss limitations on noncorporate taxpayers in place since 2018; and (3) a temporary increase in the limitation on interest deductions from 30 percent to 50 percent of adjusted taxable income.
These provisions can provide more than temporary benefits because in the absence of CARES Act relief, the losses and deductions limited by the TCJA could be carried over, but those carryovers might never have been used if the CARES Act was not enacted. In the case of NOLs, the losses (or the businesses themselves) could have expired before they were used. In the case of the excess business losses, the individual taxpayer (often with multimillion-dollar losses) could die before all losses under the TCJA’s $500,000 annual limitation were used. In the case of the interest deduction limitation, the business might never reduce interest sufficiently to use carryforwards of unused deductions.
Of course, taxpayers prefer the possibility of tax reduction over mere tax deferral. And these provisions are somewhat better targeted than the aforementioned pure deferrals. Firms with tax losses are more likely to benefit from them, and those businesses can be expected to correlate with businesses in need of government financing.
But still, these proposals can be far off the mark of matching government-provided liquidity with private sector need for financing. Because the business loss proposals retroactively repeal TCJA provisions to the date of enactment of that legislation, businesses and business owners with losses in 2018 and 2019 that are now financially sound may qualify for large benefits. And for businesses experiencing losses in 2020, extra cash flow may not be arriving quickly, but months after returns and additional filings are made — at the earliest, at the beginning of 2021.
Rebound
Throughout its history, the Federal Reserve has purchased Treasury securities to increase bank reserves and the supply of money. On March 23 it announced that it would do something it had never done before: It would purchase corporate bonds. The salutary effect on the bond market was large and rapid. With the Fed providing a backstop, confidence was restored, and investors seeking alternatives to risky stocks and near-zero yields on Treasury securities flocked into the bond market. As shown in Figure 2, the spread between interest rates on corporate and Treasury bonds declined markedly over the following weeks. Not only were businesses able to borrow again easily, but new bond issues took off at a record pace.
The unprecedented Fed action restored the moribund credit market to health and more. An April 9 Wall Street Journal headline read: “Fed Moves Spark Corporate Bond Rally.” In the April 16 New York Times, a headline declared: “Bonds Started to Falter. Then, the Fed Came to the Rescue.” And on May 1 CNBC was reporting that “the corporate bond market has been on fire during the coronavirus crisis.”
Since late March, more than $800 billion in corporate bonds have been issued. Data just released by the Fed on September 21, presented in Figure 1, shows that outstanding corporate bonds as a percentage of GDP jumped from 27.6 percent to 32.7 percent in the second quarter of 2020.
It is interesting that the mere announcement on March 23 of the Fed’s plan to buy corporate bonds restored the markets. In fact, the Fed didn’t actually begin purchasing until May 12 and even then in relatively small amounts. As of September 18, the outstanding value of the Fed’s holding of corporate bonds was $12.8 billion. In testimony on September 22, Fed Chair Jerome Powell told members of the House Financial Services Committee that the “announcement effect was strong, quickly improving market functioning and unlocking the supply of hundreds of billions of dollars of private credit.”
2020 Hindsight
Knowing what we know now, we can say that the provision of liquidity through the tax system for large creditworthy corporations like UPS turned out to be unnecessary. The stock price of UPS is now 50 percent above its highest level in March. The credit markets with opportune assistance from the Fed made it easy for these firms to obtain funds. Even many businesses in troubled business sectors, like the airlines, can issue new debt.
But at the time leading up to passage, economic uncertainty was enormous. It was difficult to discriminate between businesses that would continue to prosper and those that would flounder during the recession. In fact, it seemed possible that all businesses could suffer significant financial stress. Because of regulatory changes after the 2007-2009 financial crisis, we knew financial institutions were well capitalized. But fears about the soundness of corporate credit were widespread. And nobody could know how well the Fed’s unprecedented activity in the corporate bond market would work.
So to provide liquidity through the tax system, as arbitrary as it may have been in targeting businesses that needed it, may well have been a worthwhile policy, especially considering the low cost of Treasury borrowing. The 90-day deferral of income tax payments probably injected about $400 billion of liquidity into the economy. The annual rate of interest on a 90-day Treasury bill in April was generally less than 0.2 percent. So the cost to the treasury of this deferral was approximately $200 million (equal to 0.2 percent times $400 billion times 0.25 years).
The payroll tax deferral was also worth approximately $400 billion with an average duration of approximately two years. The Treasury yield curve in April was practically flat. Yields for securities with two years left to maturity were only about 0.25 percent. So the cost to the treasury of this deferral was approximately $2 billion (equal to 0.25 percent times $400 billion times two years). The AMT credit provision was much smaller than either of these. The total financing cost to the treasury of less than $3 billion doesn’t seem like too much for the additional liquidity provided in a time of crisis.
That being said, in a perfect world it may have been preferable if there were some attempt to give special consideration to businesses that were particularly in need of credit. These could be identified by their declining sales revenue (as with the employee retention tax credit). And it might have been better if extra liquidity was provided to businesses that cannot issue their own securities but must borrow from banks. We know that historically, small and midsize businesses suffer more job losses than large businesses during recessions and that they have more difficulty obtaining credit than large businesses (often because banks raise their underwriting standards during a recession). The slow and unsuccessful rollout of the Main Street Lending Program demonstrates that it is difficult for even the mighty Federal Reserve to provide ready credit to businesses without access to credit markets.