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American Accounting Association

Ben Haimowitz (212-233-6170)

Would a tax holiday on corporate earnings abroad spark a domestic economic revival? Not likely, study suggests

Would a tax holiday on overseas earnings of U.S. multinational corporations give a badly needed boost to the national economy?

Fifty-two of 87 Republicans newly elected to the House last year think so, and are urging their leadership to support legislation to that effect "to stimulate the economy and get Americans back to work." And a corporate group that includes such powerhouse companies as Microsoft, Apple, Cisco, Google, and Pfizer contends such a bill will produce a gain of as much as $1 trillion for the U.S. economy. As two of the group's CEOs put it in an article in The Wall Street Journal, "the amount of corporate cash that would come flooding into the country could be larger than the entire federal stimulus package, and it could be used for creating jobs, investing in research, building plants, purchasing equipment, and other uses."

How likely is it that such predictions will come to pass on a scale required to have major economic impact? Not very likely, suggests a new study in the current issue of The Journal of the American Taxation Association, a publication of the American Accounting Association

This unwelcome conclusion derives from an analysis of an earlier tax holiday on foreign earnings mandated by the so-called American Job Creation Act (AJCA) of 2004. The bill temporarily reduced taxes owed by American multinational firms on earnings abroad from the standard rate of 35% to 5.5% and resulted in the repatriation of an estimated $312 billion.

But the new research finds that the AJCA mostly benefited relatively mature firms that had had the means to invest and create jobs all along without the financial boost the legislation provided. AJCA did not even significantly advance a less intensely promoted purpose of the bill -- to enable companies battered by a recent recession to strengthen their balance sheets.

"In essence, the corporate rich got richer, and, although the corporate needy and financially stretched may not have gotten poorer, they derived relatively little advantage from the bill," explains Lillian F. Mills a professor at the University of Texas at Austin, who carried out the research with Susan M. Albring, an assistant professor at Syracuse University, and Kaye J. Newberry, a professor at the University of Houston.

In the words of the study, "The provisions of the AJCA tax holiday suggest the intended recipient is a U.S. multinational facing financial constraints...[a firm that has been] precluded from investing in positive return projects due to high debt costs [and that] could use the newly available internal funds for this purpose." In other words, "beneficiaries of the tax holiday may not have been the intended target companies."

Comments Prof. Mills: "None of the many studies of AJCA has been able to document the major increase in investments and jobs that was the main selling point for the legislation. What they found, instead, was an upsurge in corporate stock repurchases, an activity associated with lack of investment opportunities and of primary benefit to company shareholders rather than to the economy as a whole. Our research nails down a key reason for these findings by focusing on whether companies faced financial constraints."

The study begins with a comparison of two hypothetical companies that each earn $1 billion abroad but one of which "prospers domestically and faces few debt covenants" while the other "runs short of cash and faces restrictive debt covenants." The latter company regularly repatriates cash earned abroad "because it is cheaper for the parent to accelerate the repatriation tax than to pay higher debt costs (e.g., higher interest rates or costs associated with technical violations of covenants). When the tax holiday occurs, the first firm responds by repatriating the $1 billion in cash; the second cannot, because it has already been repatriated."

Focusing on a sample of 421 American multinationals for which requisite extensive financial data is available, the professors find that what they hypothesized bears a striking resemblance to how companies, in fact, responded to AJCA. Thus, firms that repatriated foreign earnings during the tax holiday (an average of about $952 million each) had significantly fewer restrictive covenants on their private debts than non- repatriators did and were far more likely to have access to the bond markets.

Among holiday repatriators, 6% had bond ratings of AA- or better as compared to only 1% of firms that did not repatriate; an additional 25% of holiday repatriators had bond ratings of A+, A or A-, compared to only 7% of non-repatriators.

Over all, "access to public debt is associated with a 13-percentage point increase in eligible foreign earnings repatriated during the holiday," the professors conclude. This and other findings "suggest that firms with fewer external debt constraints had more flexibility to fund domestic operations with debt financing versus repatriating foreign earnings...However, we find little evidence of debt repayment, [a finding] consistent with firms' primarily using the repatriated funds (or freed-up cash ) for stock repurchases."

Is there a way to write legislation that will produce a different outcome? Prof. Mills is doubtful. "The AJCA specifically prohibited the use of repatriated funds for stock buybacks, but there is little doubt that companies repurchased shares on a large scale, if not directly then by using the tax break to free up other funds that could be used for buybacks." Further, with credit as tight as it is today, she says, a reprise of the AJCA could accentuate the gap between the corporate haves and have-nots even more than the 2004 legislation did.

Better than another holiday, she believes, would be permanent lowering of corporate tax rates that would stimulate more domestic start-ups and even attract start-up investment from abroad.

The study, entitled "Do Debt Constraints Influence Firms' Sensitivity to a Temporary Tax Holiday on Repatriations?" is in the fall/winter issue of The Journal of the American Taxation Association, published twice a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include The Accounting Review, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, and Auditing: A Journal of Practice & Theory.



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