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July 5, 2012
The Economic Case for Unlocking Foreign Profits

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By Martin A. Sullivan -- martysullivan@comcast.net

The WIN America Campaign did not win. The group formed solely for the purpose of securing a repeat of the one-time tax holiday for repatriated foreign profits has little chance of success anytime in the foreseeable future.

"For the time being, WIN has ceased lobbying activities given that we're headed into election season," a spokesperson for Cisco, a prominent member of the coalition, told The Hill on April 24 (Bernie Becker and Kevin Bogardus, "Coalition Pushing for Corporate Tax Holiday Reins in Lobbying").

That leaves a huge stockpile of retained earnings, much of it in the form of cash and cash equivalents, that is unavailable for dividends to shareholders, share repurchases, and the acquisition of domestic companies. A recent estimate from JPMorgan puts the total at $1.7 billion, up from $1.3 billion a year ago (Emily Chasan, "At Big U.S. Companies, 60% of Cash Sits Offshore: J.P. Morgan," The Wall Street Journal, CFO Report, May 17, 2012). Several major acquisitions by U.S. corporations have used foreign cash outside the grasp of the IRS to purchase foreign businesses, including Microsoft's $8.5 billion acquisition of Skype in 2011 and Johnson & Johnson's $19.7 billion acquisition of Synthes completed last month (Bill Rigby, "Investors Slam Microsoft's Skype Deal," Reuters, May 10, 2011; Antoine Gara, "Johnson & Johnson's Synthes Deal Revives Foreign Tax Debate," Forbes, June 14, 2012).

No Second Holiday

Like the Bush administration before it, the Obama administration opposes a stand-alone repatriation holiday. Republican presidential candidate Mitt Romney supports a second holiday. But if Romney wins the November 6 election, the chances for passage will not change appreciably. That's because the two critical obstacles in the way of another repatriation holiday have nothing to do with who resides in the White House.

The first obstacle is the large upward revision of the estimated revenue cost of the provision since it was first enacted in 2004. In a detailed April 2011 letter to House Ways and Means Committee member Lloyd Doggett, D-Texas, the Joint Committee on Taxation reported that a repeat of the temporary 85 percent dividend exclusion (yielding an effective rate of 5.25 percent) would result in an estimated revenue loss of $78.7 billion over 10 years. That estimate assumes an effective date at the beginning of 2011. An updated estimate with a 2013 or 2014 effective date would probably be significantly higher.

There may have been a time -- such as during the middle of the last decade, or during 2009 or 2010 when stimulus was still in vogue -- when Congress may have simply issued more debt to pay for the provision. But with tolerance of more federal debt now at all-time lows, a second holiday would require painful offsetting tax increases or spending cuts.

The second obstacle is the well-documented failure of the 2004 holiday to achieve the intended economic objectives. The lobbying effort for the first holiday centered entirely on the argument that the induced cash inflows would cause repatriating firms to invest and hire more in the United States. But subsequent research showed that no significant new investment materialized, and there were even reports of beneficiaries cutting domestic jobs. In a much-cited paper, three academic economists reported:


    Higher levels of repatriations . . . were not associated with increased domestic capital expenditures, domestic employment, or research and development expenditures. . . . Even firms that increased contributions to Congressmen responsible for drafting the [repatriation provisions of the American Jobs Creation Act of 2004] and that belonged to a lobbying coalition that asserted that the tax holiday would allow them to increase domestic investment did not significantly increase their domestic expenditures. [Dhammika Dharmapala, C. Fritz Foley, and Kristin Forbes, "Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act," Journal of Finance, June 2011.]

It is possible that the original repatriation holiday did give the economy a boost. But as the JCT pointed out in its 2011 letter, those economic benefits simply have not been observed because "it may be that a $300 billion repatriation barely registered in an economy with more than $10 trillion in 2005." The effects would be particularly difficult to measure if the holiday spurred investment and job creation by businesses other than those directly benefiting from it. But the important point for political purposes is that the public and Congress can clearly see that the first holiday did not work as advertised. In their zeal to gain enactment, corporate chieftains all but promised that their companies would create jobs, and they broke that promise.

Unlocking Foreign Profits

Since at least 1986, economists have known that corporate financial decisions could suffer from what they call the "principal-agent problem." In that year, Michael C. Jensen of Harvard Business School wrote an influential paper arguing that corporate CEOs (agents) do not always take actions that are in the best interests of shareholders (principals). Shareholders, of course, want maximum returns on their investment. But managers often have other goals. More specifically, because prestige and compensation are often tied to firm size, they have an incentive to engage in empire building. To increase size, as well as to help avoid takeovers, CEOs will want to acquire other firms even when those acquisitions do not maximize shareholders' return. (See Michael C. Jensen, "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, 1986.)

Jensen's theory is supported by empirical evidence. Economists and financial analysts frequently use changes in stock values before and after acquisition announcements to measure the benefit to shareholders of proposed deals. A study published in 1999 finds that acquisition announcement returns are significantly lower for deals in which acquiring firms have excessive cash reserves (Jarrad Harford, "Corporate Cash Reserves and Acquisitions, 1969-1997," Journal of Finance, Dec. 1999).

To overcome that market failure, tax policy probably should tilt in favor of distributions over retained earnings. But in fact the opposite is true. Even when the statutory tax rates on capital gains and dividends were equalized in 2003, two tax provisions provided capital gains a lower effective rate than dividends: the deferral of tax on unrealized gains and the complete forgiveness of tax on gains at death. Over the years, the favoritism that tax law gives to undistributed over distributed profits has been a recurring theme in the taxation of corporate profits.

More recently -- say, over the last decade -- it has become increasingly apparent that flaws in our international tax rules also play a significant role in hindering corporate distributions. As multinationals book an increasing share of their profits outside the United States, and the foreign effective tax rate on those profits drops, corporations cannot get large portions of their retained earnings into the country without paying large amounts of U.S. tax. If they do not return those profits to the U.S. parent, they cannot pay dividends to their shareholders. The Dharmapala, Foley, and Forbes study provides strong empirical evidence of this. It shows that when the U.S. tax on repatriated profits declined, distributions to shareholders in the form of both dividends and share repurchases increased. That study reported estimates of between 60 and 92 percent of all repatriated profits being used for shareholder payouts.

Everybody knows that the deferral of U.S. tax on foreign profits locks out distributions to the U.S. parents. But the Dharmapala, Foley, and Forbes study shows that deferral also has the indirect effect of locking out distributions from the parent to shareholders. If U.S. international tax rules reduce distributions to shareholders, they can increase the "agency costs" that Jensen was describing in his 1986 paper. A recent paper by three academic economists examines whether the lockout of foreign profits by U.S. tax rules actually does increase agency, and it has some striking results (Alexander Edwards, Todd Kravet, and Ryan Wilson, "Permanently Reinvested Earnings and the Profitability of Foreign Cash Acquisitions," Rotman School of Management Working Paper No. 1983292, June 27, 2012).

The authors find that before the tax holiday, foreign acquisitions by U.S. firms with lots of trapped foreign cash generated significantly lower announcement period returns than foreign acquisitions by firms without trapped cash. They also found that during the tax holiday, when firms were repatriating cash and distributing it to shareholders, the inordinately low announcement period returns for firms with trapped foreign profits shrank significantly. That is strong evidence supporting the idea that international tax rules increase agency costs and that the tax holiday provided economic benefits through a reduction in those costs.

As Edwards, Kravet, and Wilson point out, their findings were consistent with anecdotal evidence in the financial press. In 2011 Microsoft acquired Skype, which was headquartered in Luxembourg, enabling it to use trapped foreign cash to make the acquisition. One financial analyst described the acquisition this way: "Microsoft made this bone-headed deal not because it was the best fit available for the company. They made the deal because it was a tax-efficient shot in the arm. If you're a Microsoft investor, this should scare you." (See Eric Bleeker, "Microsoft's Quarter: One Big Tax Dodge," Daily Finance, July 22, 2011.)

In retrospect, it is striking that Congress in 2004, in its proscribed uses of funds repatriated during the first holiday, and the Bush administration, in its outright opposition to the holiday, would place so little value on shareholder distributions. After all, just one year before, Congress had reduced the top tax rate on dividends from 35 percent to 15 percent. In 2003 dividends were revered as cleansing agents for corporations -- like Enron -- that had bad accounting. More generally, dividend relief was viewed as uncorking bottled-up profits that CEOs wanted to keep under their control even when it was not in shareholders' interests.

No doubt part of the reason for avoiding the Jensen free cash flow theory was marketing. If repatriated funds were going to be used to build factories and pay workers' salaries, that had far more appeal than delivering cash to mostly affluent corporate owners in the hope that benefits would trickle down to the rest of the economy. Another reason for avoiding that line of reasoning could have been reticence on the part of advocates of the holiday to bad-mouth the bosses paying their fees. Jensen's theory basically says dividends are good because left unchecked, egomaniacal CEOs will spend cash on projects that destroy shareholder value. It is hard to imagine, no matter how desperately CEOs want access to foreign retained earnings, that they would be willing to spend millions of dollars telling Congress and the public that they violate their most basic mission of acting in the best interest of shareholders.

Lockout Problems

The pernicious economic effects from the lockout of foreign profits are not limited to the redirection of funds from distributions to acquisitions described by Jensen. There is an additional distortion resulting from the tax law tilting heavily in favor of foreign over domestic acquisitions. The first distortion was quantified by researchers Edwards, Kravet, and Wilson, who measured differences in announcement period returns. The latter distortion, resulting in an inefficient gap in the before-tax returns between acquisitions of domestic and foreign firms, cannot be detected in movements of announcement period returns (which are after-tax measures).

If a U.S. corporation wants to purchase a domestic business using retained foreign earnings, it must repatriate those funds and pay residual U.S. tax. Because corporations book a great deal of these funds in tax havens, the effective rate of U.S. tax on the funds can easily be as high as 25 percent. If the U.S. corporation uses foreign retained earnings to purchase a foreign business, no repatriation is required and no U.S. tax is due. In these circumstances, a U.S. corporation must pay $20 billion for a U.S. business that outside the United States would cost only $15 billion. Because of taxes, U.S. corporations have a large incentive to buy foreign firms even when they have less before-tax value. That distortion results in too much investment in less efficient foreign businesses.

That inefficiency clearly reduces overall international economic output. But what are the effects specifically for the U.S. economy of tax rules that encourage U.S. corporations to purchase foreign over domestic businesses? Could it be that in addition to the overall loss in output, there is a shift in the distribution of income between nations as a result of these deals?

There is no easy answer to that question. A 2007 study by the OECD stresses that the productivity and competitiveness of acquired firms usually increase, but often at the expense of reduced employment at the acquired firm (OECD, International Investment Perspectives: Freedom of Investment in a Changing World, Chapter 4, 2007). Some of those management and research jobs may be shifted to the acquiring company, but the empirical evidence is not clear. The country of the acquired firm may benefit from technology transfers from the parent, but there also may be technology transfers in the other direction. Another factor to consider is the wealth transfer to the country of the acquired company if there is a boost in the acquired firm's stock price when the deal was announced and shareholders reside in that country.

A central argument made by advocates of a territorial system for the United States is that it would remove the tax bias in favor of foreign acquisitions of U.S. firms ("Eaton Migrates to Ireland: Will the U.S. Now Go Territorial?" Tax Notes, June 11, 2012, p. 1302, Doc 2012-12279, 2012 TNT 112-2). Underlying this line of reasoning is the assumption that foreign acquisition of U.S. firms will result in headquarters service and research jobs migrating to the foreign jurisdiction where the new parent company resides. If that were the case, symmetry would suggest that tax-motivated U.S. acquisitions of foreign firms will create U.S. jobs.

In reality, there are probably few clear generalizations that can be made about the distribution effects of cross-border acquisitions. The point stressed here is that advocates of territorial taxation who argue that foreign acquisitions of U.S. firms hurt the domestic economy cannot in their advocacy of a repatriation holiday argue that the reverse -- the U.S. acquisitions of foreign firms by U.S. corporations -- is also detrimental to the United States.

Back to Square One

As mentioned at the outset, the big push for a second repatriation holiday has hit a logjam. Unless someone can find an offset to the estimated $78.7 billion revenue loss, or a way to reduce that estimate, the proposal has only the slimmest hope of advancing. Given the considerable resources and influence of the corporate lobby supporting the change -- including the U.S. Chamber of Commerce and the Business Roundtable -- this is an impressive political achievement for Democrats and liberal groups opposing the holiday.

But it is a hollow victory. From a policy standpoint, it has done little more than return us to the status quo. Nobody should be content with a tax system that provides large tax incentives to keep $1.7 trillion from coming home. All parties should be able to agree at the outset that eliminating, or at least significantly reducing, the lockout effect should be the goal of any international tax reform. Sure, many authorities on tax policy -- including the Treasury Department -- argue that any repatriation holiday is misguided. But any antipathy of tax experts to unlocking foreign profits in the context of a stand-alone temporary tax reduction for repatriated profits should not predispose us to discount the problems caused by lockout.

Another difficulty stemming from the repatriation holiday debate is the sudden prominence of the idea that the lockout effect serves as a deterrent to aggressive profit shifting. It is more than just a policy argument in a set of talking points. It is the one reason for the huge enlargement of the JCT's revenue estimate. Given its critical role in achieving their objective, opponents of the repatriation holiday and territorial taxation might grow content with lockout as a partial solution to our massive transfer pricing problems.

That would be a mistake for two reasons. First, lockout causes damaging economic distortions. Second, as a deterrent to profit shifting, it is an awkward and indirect approach that often misses the target. The extra tax burden on repatriated profits does nothing to discourage profit shifting when there is no intention of bringing those profits back to the United States. It can trap foreign profits even when those profits were not inappropriately shifted out of the United States.

Another way of thinking about the problem with this approach is that it is like locking the exits to keep out entrants. If you want to keep the fox out of the henhouse, you simply should keep him from ever getting in. You don't make it easy for him to enter and then trap him inside. If you want to prevent the shifting of profits out of the United States, it would be far better to use methods that directly prevent exit rather than making it difficult for those profits to return.

International Reform

In recent years, progress on international tax reform has been hamstrung by the diametrically opposing viewpoints of the powers that shape policy. On one side are U.S. multinationals that, of course, want a tax cut. They are lobbying for a territorial system that has minimal base preservation rules. They claim it would put them on a level playing field with multinationals based in other countries that have territorial systems. But the absence of base preservation rules would not only allow rampant profit shifting to tax havens to continue, it would probably make it worse. Therefore, that approach is a significant revenue loser.

At the other end of the spectrum, the Obama administration wants to raise taxes on U.S. multinationals. From the beginning of his term, President Obama has proposed several measures to reduce transfer pricing abuse and raise taxes on foreign-source income. Most recently, the White House has suggested a minimum tax on foreign profits. The White House seems indifferent to a territorial system, perhaps because it does not want to confuse its message. "Unlike Governor Romney, I want to close the outsourcing loophole in our tax code," the president told his audience in Durham, N.H., on June 25.

The shouting match between the two sides is getting us nowhere. Neither is offering proposals that would result in realistic political outcomes. There is no revenue for big multinational tax cuts. And with concerns about rising inequality, cutting taxes on multinationals' profits is not a priority for most voters. As for Obama's revenue raisers, most of them didn't receive serious congressional consideration even when Democrats controlled both chambers of Congress. There is no chance they will become law in the foreseeable future.

And while the White House may cling to the goal of moving the United States to a system in which deferral is largely eliminated -- something that the Kennedy administration couldn't achieve 50 years ago -- the reality is that most other countries have moved to territorial taxation. Most recently, the United Kingdom and Japan adopted dividend exemption systems in 2009.

Given all these uncomfortable political and economic realities, it is hard see how any international tax overhaul can be significantly different than the proposal outlined by House Ways and Means Committee Chair Dave Camp, R-Mich. Under his plan, 95 percent of dividends from foreign subsidiaries would be exempt from U.S. tax. All pre-effective-date, tax-deferred foreign earnings would be taxed at a low tax rate, whether or not repatriated, over an eight-year period. And new antiabuse rules would greatly scale back profit shifting out of the United States. They include thin capitalization rules that prevent U.S. companies from borrowing in the United States to finance exempt overseas operations and rules that would make low-tax foreign income from intangibles subject to current U.S. tax.

From a policy perspective, there is a lot to like. First, the Camp plan eliminates the lockout effect on current retained and future foreign profits. Second, it would put real restraints on the increasingly rampant transfer of profits to tax havens.

From the political perspective, the result is reasonable because both sides gain and lose. Multinationals would get access to trapped foreign profits, but in return they could no longer book excessive amounts of future profits offshore. Most of all, they would have to give up hopes for an international tax reform that reduced their taxes. After years of hype from their lobbyists about the possibilities, that surely would be a bitter pill to swallow.

But Obama and other Democrats would have to concede that the guiding principle of U.S. tax policy is no longer capital export neutrality in which foreign and domestic profits of U.S. companies are taxed at equal rates. No longer would there be any pretense that the United States should tax foreign profits, except in situations in which improper avoidance of U.S. tax is suspect.

Translated into economic terminology, multinationals want the effective tax rate on foreign profits to be as low as possible -- in many cases, even below zero. Obama wants the foreign rate to be as close as possible to the U.S. statutory rate. The Camp plan takes an intermediate path by setting the tax rate of foreign profits equal to whatever rate prevails in a foreign jurisdiction.

Obama and Democrats should be content with that rate. Professor Reuven Avi-Yonah, who has been as harsh a critic as anyone of multinational excesses, understands this. "I believe it is worthwhile to adopt the Camp proposal even though it includes a limited version of territoriality and departs from the principle established in 1913 that U.S. resident taxpayers should be subject to tax on all of their income," he wrote in May ("Vive la Petite Difference: Camp, Obama, and Territoriality Reconsidered," Doc 2012-8261 ).

Although the textbooks tell us we have a worldwide system, it is so fraught with loopholes that most companies pay zero U.S. tax on foreign profits, and, because of profit shifting, many pay negative effective tax on foreign profits. That's why territorial proposals are often scored as revenue losers. Instead of reflexively opposing any territorial proposal, Democrats may want to begin carefully studying the details of a territorial system that are necessary for preventing abuse.

Business should be content with an effective rate equal to the foreign rate, because to do otherwise is to ask for a tax subsidy from the U.S. treasury. Even if other governments are granting these extremely generous terms to their multinationals, there has to be a limit. Zero U.S. tax on properly measured foreign profits can hardly be considered socialism.

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