Glen Vasel Professor of Finance; Director of the Heizer Center for Private Equity and Venture Capital
The American Jobs Creation Act (AJCA) of 2004 temporarily lowered the tax rate paid on income that American firms bring back from their foreign subsidiaries to the United States. Congress said it gave businesses this tax break in order to stimulate domestic investment, and indeed, during the two year window more than $300 billion was repatriated to the United States in response to the law. However, according to research by Mitchell Petersen, a professor of finance at the Kellogg School of Management, many of the firms made little incremental domestic investment. In addition, the law resulted in a substantial tax savings for many multinational businesses and a huge loss to the U.S. Treasury.
A few of the firms studied—those short of cash—spent most of their repatriated funds approved investments, Petersen says. The other firms also invested, but not incrementally. “It was the same level of investment we would have expected absent a decision to repatriate the foreign income,” he explains.
The government taxes foreign earnings of U.S. firms only when they are repatriated, Petersen explains. This creates incentives for firms to leave money in countries that have lower tax rates. One of the rationales for Congress to pass the AJCA was the knowledge that U.S.-based multinational firms had huge amounts of cash stockpiled in their foreign subsidiaries. In addition, legislators were looking for ways to change the tax code to increase domestic investment. “If you were sitting in Congress and you could pass a law that you could argue will both increase domestic investment and in the next couple of years raise tax revenue, that’s a home run,” Petersen says.
The AJCA allowed firms to exclude 85 percent of repatriated foreign income, but only if they created a plan to reinvest money in the United States for certain purposes: worker hiring and training, infrastructure, research and development, capital investments, or stabilizing the corporation’s finances for the purpose of job retention or creation. Although this seemed like a good idea on the surface, Petersen said, a crucial assumption underlying the law was flawed. Firms do not invest in the United States for two reasons: either they do not have good investment opportunities, or they have opportunities but not enough money to take advantage of them. The government assumed that all firms were in the second group.
Petersen and his co-author Michael Faulkender, an assistant professor at the University of Maryland, suspected that if a firm could already fully fund its domestic investments, the AJCA would not have any effect on its investments or employment. To test their hypothesis, they examined whether financially constrained firms—those that were least able to generate internal funds or inexpensively access external capital markets prior to the act—reported significantly higher levels of investment and employment relative to the financially unconstrained firms that also repatriated foreign earnings under the act. They also investigated how much income was repatriated under the AJCA.
Petersen and Faulkender searched 10-K filings for the years 2004, 2005, and 2006 and identified 1,246 firms that discussed the AJCA in at least one year’s statement. At the average firm, there was little increase in investment as a response to the AJCA tax incentives. “About three-quarters of the money that was repatriated was brought back by firms that were able to finance their investments internally,” Petersen says. “Their taxes were lowered, by completely legal means, but there was no increase in investment.”
On the other hand, about 25 percent of the firms were unable to finance their investments with internal funds. Petersen says those firms invested “a large fraction” of the money that they brought back.
He notes that even an elementary consideration of financial theory should have suggested to the government that the AJCA would not affect a firm’s investment if it could access external capital or generate enough internal domestic capital to fully fund its domestic investments. “To argue that having these firms bring back money will increase investment assumes that the lack of investment is driven by the supply of capital, not the demand for capital. Any Finance 101 student understands that distinction, but when you read the law, it seems like that distinction is missing.”
Petersen offers an example of the problem with the AJCA. “Is Microsoft not investing more in the U.S. because they don’t have any money in their checking account or because they are not able to raise money from the public capital markets? No. They’ve got all the money they need. For tax policy changes to make a real difference in investment, they need to be targeted to the kinds of firms that have more projects than they are able to finance.”
Hard To Follow the Money
Regarding the AJCA’s requirement that businesses create a domestic reinvestment plan, Petersen observes, “The way the law is written, it’s hard to believe that it’s a binding constraint. So Congress correctly gave up trying to track whether the dollar that came home from a foreign subsidiary was actually spent on a factory in Ohio. Since money is fungible, it’s hard to target investments in corporations that are raising money from a lot of different sources and spending money in a lot of different places.”
Because there was some increase in investment, it could be argued that the AJCA was good public policy, Petersen acknowledges. Nevertheless, because only a small proportion of funds had the desired effect, he believes the law was poorly designed. In addition, he says, “this is an expensive way for the government to borrow, which is effectively what it was doing. Because the lost revenue won’t be counted as debt, it could be a politically appealing way to raise funds, but in the long run it is not financially efficient. You’ll get an extra $25 billion today, but nowhere in the statements of the federal government will it say you don’t get $50 billion three years from now.”
Petersen concludes that in this research, he and his colleague asked a narrow question: did the AJCA do what it was designed to do—increase domestic investment? “But the bigger issue, and what I’d like people to take away, is that when we think about designing laws, especially tax laws, an understanding of basic finance is very important.”
Related reading on Kellogg Insight:
Faulkender, Michael, and Mitchell Petersen. 2012. Investment and Capital Constraints: Repatriations Under the American Jobs Creation Act. Review of Financial Studies, November, 25(11): 3351-3388.
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