Senator Orrin Hatch, chairman of the Senate Finance Committee, is focusing on an important aspect of the agenda for corporate tax reform — — allowing U.S. corporations to receive a deduction for dividends paid to their shareholders. That deduction would eliminate double taxation of corporate profits distributed as dividends; instead, these profits would be taxed only to shareholders, not at both the shareholder and corporate levels.
Although Senator Hatch has not disclosed the details of his proposal, a corporate deduction for dividends paid has several advantages. But such a proposal would raise financial and political challenges that would have to be addressed.
Apple issued $12 billion of U.S. debt in April, which gave the company a domestic cash infusion that allowed it to keep more earnings overseas. Last month PfizerPFE attempted to acquire AstraZeneca, a transaction that would have made Pfizer a subsidiary of the U.K.-based company. These were useful examples in the taxation classes I teach at MIT’s business school, but the real-world implications of these decisions are troubling. Even worse, legislators have responded with proposals that seek to prevent companies from escaping the U.S. tax system.
The U.S. corporate statutory tax rate is one of the highest in the world at 35%. In addition, the U.S. has a world-wide tax system under which profits earned abroad face U.S. taxation when brought back to America. The other G-7 countries, however, all have some form of a territorial tax system that imposes little or no tax on repatriated earnings.
To compete with foreign-based companies that have lower tax burdens, U.S. corporations have developed do-it-yourself territorial tax strategies. They accumulate foreign earnings rather than repatriate the earnings and pay the U.S. taxes. This lowers a company’s tax burden, but it imposes other costs.
For example, U.S. corporations hold more than $2 trillion in unremitted foreign earnings, a substantial portion of which is in cash. This is cash that currently can’t be reinvested in the U.S. or given to shareholders. As a consequence, companies are borrowing more in the U.S. to fund domestic operations and pay dividends. Another potential effect is that companies invest the earnings in foreign locations.
Since the onset of the global financial crisis in 2007-08, the administration and the Federal Reserve have implemented policies explicitly designed to spur investment, grow GDP, and reduce unemployment. These actions haven’t worked — certainly not as expected.
The weapons of choice to boost the U.S. economy have been low interest rates, deficit spending, and increased money supply through the Fed’s balance-sheet expansion to over $3 trillion. Yet almost five years later, GDP growth has been anemic at below 2% and at times negative, and aggregate domestic investment is about where it was in 2004, and considerably below the 2006-2007 level.
Optimists believe it’s still too early and that we have spent too little. More of the same would eventually produce good fortune — at least, that’s the hope.
S.P. Kothari is deputy dean and professor of accounting at the MIT Sloan School of Management. He is the author, with Jonathan Lewellen and Jerold Warner, of ”The Behavior of Aggregate Corporate Investment”.
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Academic studies have shown that over the past few decades, public firms are increasingly holding large amounts of cash. Curiously, much of this build up in cash savings can be attributed to cash saved from seasoned share issues, which are sales of equity by already public companies.
I examined the share-issuance cash savings of a large number of U.S. firms over a 38-year period. In the 1970s, $1.00 of issuance resulted in $0.23 of cash savings, yet in more recent years, that same $1.00 of issuance resulted in $0.60 of savings. Over my sample period, the amount of cash saved from share issuance increased at an average rate of 2.5% per year.
So what is going on here? My initial reaction was that the firms were issuing shares because their stock was mispriced, thereby taking advantage of naive investors. However, after digging deeper, I found that this was most likely not the case. It turns out that there are good economic reasons for firms to hold onto cash and even to issue shares for the purpose of cash savings.
Consider an emerging pharmaceutical company with a promising pipeline of projects. The company is still early in its lifecycle so its profits are marginal and its cash flows are volatile. The company spends a large amount on R&D and plans to continue doing so in the future. Because the company generates little cash flow, it depends on capital markets to finance its R&D spending.