Warnings: This Tax Incentive Is Distorting the Profit Picture


U.S. stocks are edging higher this morning, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average up 0.22% and 0.14%, respectively, at 10:05 a.m. EDT.

Through a tax lens, darkly
Corporate earnings must fall, because profit margins cannot remain near historical highs -- this has been among the bears' refrains during the rebound in earnings (and stock prices) in the aftermath of the credit crisis. That's a broad, straightforward argument that invites plenty of complex, nitty-gritty questions regarding how the structure of corporate profitability has evolved over past decades and, consequently, whether or not one should expect margins to revert to their mean.

On a near-term basis, however, there is a clear reason why U.S. company profits may be inflated: a tax advantage.

In a terrific piece of reporting, The Wall Street Journal's Scott Thurm found that one of the major contributing factors to the 6.7% rise in S&P 500 earnings during the first quarter was an extension of the research credit and other tax breaks in January, as companies set aside 5.6% less money for taxes.

The previous extension of the tax credit expired in 2011, so companies were unable to benefit from it last year, flattering 2013's year-on-year comparisons.

The article cites several specific examples in which the tax credit made a dramatic impact on companies' effective tax rate, including Intel and Google. In the case of Intel, the chip maker's tax rate fell to 16.3% in the first quarter from 28.2% in the prior year period. The company itself said the extension of the research tax credit was responsible for the "substantial majority" of the decline.

Unless this tax credit is renewed -- it's set to expire this year -- it will produce headwind for year-on-year comparisons next year. That's unwelcome when the consensus already calls for heady 12.5% growth in S&P 500 earnings per share in 2014.

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The article Warnings: This Tax Incentive Is Distorting the Profit Picture originally appeared on Fool.com.

Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on LinkedIn. The Motley Fool recommends Google and Intel. The Motley Fool owns shares of Google and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published