Tax Myth: Why Companies Will Not Repatriate Overseas Cash

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As with seemingly every election cycle, tax reform is a hot topic, as though a carrot that dangles in front of the horse. Whether you’re in favor of larger or smaller taxes, its a discussion that is important to have. The goal of this preliminary tax discussion is to separate the narrative from the reality.

With President Trump’s election there has been discussion of getting rid of the interest tax deduction for mortgages, as well as the border adjusted tax. Both of these would be a tax on consumption which would negatively affect the consumer.

However, despite the rhetoric, the key point needed to be reinforced is the tax code cannot easily be modified. If a boarder adjusted tax is proposed, retailers will lobby, complaining their business would be hurt by this change. It’s easy to cut taxes on the middle class or raise them on the rich; however, the complex nature of the tax code, which causes a hassle to most Americans, always stays.

Individual Tax Promises

As was mentioned, President Trump had several promises on taxes during the campaign. He wanted to lower the rates, lower the number of brackets, and simplify the code. For corporations, he wanted to lower the tax rates and get rid of deductions. The problem is politicians talk about how great the plan is without getting to the specific deductions which would be eliminated, as part of the simplification process. Until you see a politician discuss why he/she wants to get rid of certain deductions, radical reform won’t happen. In other words, the chances are slim to none.

Corporate Tax Promises

Another issue which is being discussed is that the US corporate tax rate is too high. However, most corporations don’t pay the 35% statutory rate. Some actually pay a higher rate at times, but overall, most pay a lower rate. As you can see below, the effective corporate tax rates paid by U.S. firms is similar to comparable countries.

If deductions are removed and the rate is lowered slightly, there wouldn’t be a difference in the money changing hands from the private sector to the government. Simplifying the code makes sense, but the chart below ruins the narrative that US businesses are being strangled. The way some businesses are hurt is if their competitors get subsidies or if regulations are stringent.

Repatriation Tax Holiday Reality

While reforming the tax code will be tough, the one glimmer of hope is the repatriation tax holiday. That’s when the capital US companies have overseas can be brought back to the US at a temporarily lower rate than the statutory corporate tax rate. It’s a politically feasible option because it increases revenues since no taxes were being paid on the money overseas, while lowering tax rates which fiscal conservatives like, and the money is brought back to the US which can theoretically be used to invest in production, creating jobs.

In 2004, this was tried with the overseas money that was brought back to the US taxed at 5.25% instead of the usual 35%. Over $300 billion was brought back to the US in repatriated earnings, but the money went to stock buybacks instead of new investments despite incentives against doing that. As you can see from the chart, buyback authorizations increased 158% in 2004.

Stock buybacks are great for equity shareholders, but they harm small businesses. Buybacks from improved capital flows create an indirect form of growth as shareholders become richer. Shareholders can take that wealth and invest it somewhere else. In some of our articles, we talk about the perils of buybacks, but that’s in reference to firms taking out leverage to buy back shares. This flow of capital isn’t a bad thing; however, it failed to stimulate the real economy, which is different from financial markets.

The idea of the repatriation tax was to get corporations to invest their money one way, but they had other ideas. As you can see from the chart, the firms repatriating money didn’t hire new workers.

One of the potential reasons why corporations may not have increased labor is because it’s difficult to spend a giant inflow of capital which comes all at once. Primarily however it revolves around short-term versus long-term benefits. Buying back stocks and artificially increasing the value of equity in the short-term creates a greater benefit than investing in the long-term. Given that most executives are compensated in the form of stock options, this makes the decision a no brainer. The improvement in capital may have helped some firms make strategic investments, but firms can’t just randomly dump money unnecessarily into R&D or expansion, especially if they see no room for growth with their current business models.

Currently, there is about $2.6 trillion overseas. Unfortunately, the results of the next repatriation holiday will be worse than in 2004. That’s because firms are borrowing money against their overseas capital to move it back home. The chart below is the BBB corporate bond yield. Borrowing costs have fallen, making issuing debt easier.

In 2004, the BBB yield was about 4%, making a 5.25% repatriation tax reasonable to pay. Now the BBB yield is about 3% and the repatriation holiday Trump mentioned was 10%. The numbers don’t add up. Most of this cash will stay overseas as it’s cheaper to borrow against it than pay the tax.

Conclusion

Hopefully, we dispelled any myths you have about the tax code. The goal is to educate you on the truth in an unbiased way. Now that you know what is happening, you will be one step closer to predicting the outcomes. For investors it’s important to know, a repatriation tax cut to 10% wouldn’t boost buybacks as much as it did in 2004 (as a percentage of the total cash overseas), thereby not providing a substantial benefit to the economy as is touted by politicians.

Disclaimer: This content is for general informational and entertainment purposes only and should not be construed as financial advice. You agree that any decision you make will be based upon an independent investigation by a certified professional. Please read full disclaimer first on Time Money.

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