Oct. 13, 2011
U.S. multinational companies (“MNCs”) currently hold an estimated $1.4 trillion in foreign earnings overseas, an amount that has been growing and will continue to grow without a change in the current corporate tax structure. In this paper, we assess the effects of a one-time reduction in the tax rate applied to the repatriation of foreign subsidiary earnings on spending, output and employment in the U.S. economy.
We assume that under such a policy change U.S. MNCs will have the opportunity to repatriate their foreign subsidiary earnings at reduced tax rates comparable to those provided under the 2004 Homeland Investment Act (“HIA”). Using that assumption, and analyzing firm-specific characteristics for a large group of multinational companies currently holding large cash balances abroad, we estimate that a similar policy change today will lead firms to repatriate about $1 trillion more in foreign subsidiary earnings than they will under current tax rates. We further estimate that after accounting for taxes, $942 billion will be available for use by the repatriating companies.
About this Report:
This paper was published jointly by the New America Foundation and the Berkeley Research Group (BRG), an independent research and consulting firm. The paper was conceived, researched, written and edited by BRG. Funding for the work was provided to BRG by TechNet, a bipartisan political network of business leaders that promotes the growth of technology-led innovation. TechNet is a participant in Win America, a nonpartisan campaign working to bring home repatriated earnings held overseas by American companies. The paper's lead author, Dr. Laura D'Andrea Tyson, an economist and former chair of the President's Council of Economic Advisers, is a member of New America's board of directors.
The channels through which these funds will affect spending and investment in the U.S. economy are identified in Figure 1.
Firms that decide to participate in a new opportunity to repatriate foreign subsidiary earnings at discounted tax rates can use the earnings they repatriate in two ways: they can distribute them to their shareholders in the form of dividend payments and share repurchases; and they can use them directly to fund their domestic economic activities or to reduce their debt. An individual firm’s choice concerning how much to distribute to shareholders and how much to use internally will depend on the extent to which the firm is capital constrained.
A tax reduction on repatriations effectively reduces the cost to a participating firm of using its internal capital held abroad to invest in profitable economic activities in the United States. Economic and finance theory predicts that this cost reduction will not increase such investments unless a firm is capital constrained. That is, unless a firm is constrained in its ability to raise capital to finance profitable investments from external capital markets (through equity or debt) or from other internal sources (domestic cash balances), the availability of repatriated foreign subsidiary earnings should have no impact on the firm’s domestic investment activities. Theory also predicts that an efficiently managed firm that is not capital constrained will distribute most of its repatriated foreign subsidiary earnings to its shareholders, most likely in the form of share repurchases.
Using firm-specific data and a widely used measure of capital constraints (the Kaplan-Zingales index), we rank the firms most likely to participate in a new one-time reduction in the tax rate applied to repatriated foreign subsidiary earnings by the extent to which they are capital constrained. We identify as capital constrained the one-third of firms that are the relatively most capital-constrained based on the Kaplan Zingales index, and we assume that these firms will use repatriated funds directly for internal purposes. Based on this assumption, we estimate that capital-constrained firms will account for about 26% of total repatriations triggered by a one-time reduction in the tax rate applied to them. This estimate is consistent with estimates of the share of repatriations by capital-constrained firms relative to total repatriations by all firms that responded to a similar tax reduction in the 2004 HIA.
Based on studies of how capital-constrained firms used the funds they repatriated in response to the HIA, we estimate that between 39% and 78% of the cash repatriated by capital-constrained firms in response to a new temporary tax reduction on repatriated foreign subsidiary earnings will be used for new investment. Based on our assumption that capital-constrained firms will account for 26% of the total amount repatriated, we estimate that these firms will use between $96 billion and $191 billion of their repatriated foreign subsidiary earnings for new business investment spending. Using standard macro relationships between investment spending, aggregate demand and employment, we estimate that this increase in investment spending will increase GDP by between $138 billion and $276 billion and will create between 1.0 and 2.0 million new jobs.1
Based on the assumptions described above, we estimate that 74% of the amount repatriated in response to a temporary tax reduction on repatriations will come from firms that are not capital constrained. We assume that these firms will distribute all of their repatriated cash to their shareholders in the form of dividend payments and share repurchases. Based on this assumption and on the fact that about 17% of U.S. equities are held by foreign investors, we estimate that about $581 billion in after-tax qualified dividends will be distributed to U.S. shareholders.
Shareholders can use the repatriated cash they receive through dividends or share repurchases for two broad purposes: to increase their consumption or to increase their holdings of alternative financial securities (or reduce their debt). Studies of the HIA acknowledged that shareholders likely used the funds they received through dividend payments and share repurchases either for consumption or for re-investment purposes, but these studies made no attempt to measure the size of these effects or their implications for aggregate spending, output and employment.
Standard finance theory predicts that individual shareholders will treat dividend payments and share repurchases as a change in the composition of their investment portfolios, not as a change in the value of their portfolios. According to this prediction, individual shareholders will use such distributions to purchase financial securities to rebalance their portfolios. Many empirical studies, however, have found that a surprisingly large fraction of distributions to individual shareholders is used for consumption. These studies indicate that the return to individual shareholders of repatriated cash will increase consumption spending and that the consumption effect will be larger from dividend payments than from share repurchases.
Using a variety of studies and alternative approaches, we estimate that between $0.26 and $0.40 of each dollar of cash returned to individual U.S. shareholders in the form of dividend payments or share repurchases will be used for consumption spending. We refer to these estimates as the marginal propensity to consume (MPC) from such payments to shareholders.
According to current data, about 33% of U.S. corporate equity is directly held by individual U.S. shareholders (or households), with the remainder held under institutional management, mainly in pension funds and mutual funds. We assume that the distribution of the shares of repatriating firms between households and institutions is the same as the overall distribution of shares; and we assume that the distribution of repatriations via dividend payments or share repurchases will directly affect consumption only to the extent that the funds are distributed directly to households (i.e., we assume that institutions or professional investment managers will re-invest the cash received from repatriating firms and that these distributions will not induce current consumption).
Based on available data, we also assume that about half of all individual holdings of the equity of repatriating firms is held in personal retirement or other tax deferred accounts. Since withdrawals from such accounts for consumption purposes are subject to tax penalties, we assume that repatriated cash flowing into these accounts from dividends or share repurchases will not generate any material increase in consumption. Under these conservative assumptions, we calculate that of the $581 billion in repatriated cash distributed to U.S. shareholders, approximately $192 billion will go to U.S. households rather than to institutions and about half of that will go into retirement or tax deferred accounts, leaving about $96 billion to households for consumption or reinvestment purposes.
Under these assumptions, and assuming a MPC range between 0.26 and 0.40, we expect that between $25 and $38 billion of repatriated cash distributed to U.S. shareholders will be used for consumption. Based on the distribution in equity holdings among U.S. shareholders, this consumption will be skewed to higher income U.S. households, but it will nonetheless stimulate aggregate demand.
In addition to the direct effects on household consumption that arise from the return of repatriated cash to individual shareholders, we estimate an additional wealth effect on consumption from a likely increase in the share prices of repatriating firms resulting from what we call the deferred tax liability effect and the agency effect. We estimate that together these effects will generate an increase in U.S. shareholder equity wealth of about $159 billion. Using a standard marginal propensity to consume of 0.03 out of incremental equity wealth, we estimate that this increase in equity wealth will increase consumption spending by an additional $5 billion.
Using a range of macro multipliers from several macro models, we conclude that the expected increase in investment spending by capital-constrained firms and the expected increase in consumption spending by shareholders caused by a significant increase in the repatriation of foreign subsidiary earnings triggered by a temporary reduction in the tax rate applied to such earnings will have the following effects:
- An increase of $178 billion to $336 billion in GDP;
- An increase of 1.3 million to 2.5 million jobs; and
- An increase of $36 billion in corporate tax revenues as a result of the increase in repatriations occurring during the period the temporary tax reduction applies.
Figure 2 contains our estimates of the overall magnitude of the effects of a temporary tax reduction on repatriation on spending, output and employment along with the intermediate channels through which these effects will occur. Like the effects of other temporary tax policies to stimulate the economy, the effects of a tax reduction on repatriation will take place gradually, so the estimates in Figure 2 should be interpreted as total effects over approximately 1-2 years from the time the policy is enacted. Some effects are likely to occur relatively quickly. For example, the wealth effect arising from an increase in the equity values of repatriating firms should begin to take effect quickly and will continue as repatriating firms efficiently employ their repatriated earnings. It is also likely that increases in consumption resulting from increases in cash distributions to shareholders in the form of increases in dividends or share repurchases will occur relatively quickly. In contrast, new investment by capital-constrained firms and new investment resulting from an increase in demand for primary and secondary financial securities may take place over a longer period of time, with significant lags between enactment of the tax reduction, an increase in repatriations, and subsequent increases in real investment and employment in the U.S.
Figure 2 does not include estimates of any effects on investment spending, output and employment that will result from the re-investment of repatriated cash by shareholders into alternative financial assets. According to our calculations, shareholders will use up to $556 billion of the repatriated cash they receive for this purpose, so these effects are likely to be substantial. Unfortunately, they cannot be quantified with existing models. In lieu of quantitative estimates, we discuss the theoretical and empirical evidence in support of our conclusion that the use of repatriated cash to purchase primary and secondary financial securities will lead to further increases in investment spending and larger increases in output and employment than those shown in Figure 2. We also discuss how the channels through which these purchases are expected to increase business activity are analogous to the channels through which the Federal Reserve’s QE2 policy was expected to stimulate such activity.
In addition to the positive macroeconomic effects from the use of repatriated cash, either by the firms themselves or by their shareholders, a temporary tax reduction on the repatriation of foreign subsidiary earnings will generate significant and immediate tax revenues at a time when the federal budget is under severe pressure. These revenues – including both the corporate taxes paid on the repatriated cash and any dividend and/or capital gains taxes paid by shareholders on the amounts returned to them – could be used to finance additional job-creating measures, such as the creation of an infrastructure bank, an initiative that enjoys broad support in the business and labor communities and that is one of the key proposals of the President’s recent jobs package (The American Jobs Act or “AJA”).
The growth in employment and output, as well as the potential for stock market increases that we expect to result from the repatriation and return of cash to shareholders, may have an even wider beneficial impact through positive effects on business and consumer confidence. As a result of the deepest recession in postwar history and an anemic economic recovery with high unemployment, both business and consumer confidence are currently hovering near record lows. Many economists believe that low confidence is itself contributing to the economy’s weakness. For example, in a recent report Mark Zandi warned that sometimes sentiment can be so harmed that businesses, consumers and investors freeze up, turning a gloomy outlook into a self-fulfilling prophecy. This is one of those times.”2
It is likely that the increases in business activity, employment and spending we anticipate from a significant increase in repatriations in response to a temporary tax reduction will boost business and consumer confidence. Rising consumer confidence is associated with both increases in economic activity and stock market gains. And an increase in the demand for U.S. equities resulting from the use of repatriated cash to purchase secondary market securities should lead to higher stock market values. The linkage between higher stock prices, higher consumer confidence and economic growth has been explicitly referenced by Chairman Bernanke in his evaluation of QE2:
“[a]nd higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”3
Finally, we argue that a temporary reduction in the corporate tax rate on repatriations would be a beneficial interim step on the path to corporate tax reform. The U.S. has the second highest corporate tax rate (behind Japan) of the 34 developed OECD countries. The U.S. is also the only OECD country with a worldwide corporate tax system that taxes the dividends earned by the foreign subsidiaries of U.S. MNCs at the full domestic corporate tax rate (less applicable foreign tax credits) when the dividends are repatriated. All of the other OECD countries have territorial corporate tax systems that exempt the dividends earned by the foreign subsidiaries of their MNCs from all or most domestic corporate taxes. There is widespread agreement among economists and tax experts that the combination of a high corporate tax rate and a worldwide system puts U.S. MNCs at a disadvantage to their competitors headquartered in other countries and discourages investment and job creation in the U.S. For these reasons, both the Obama Administration and many members of Congress are calling for comprehensive corporate tax reform to reduce the corporate tax rate, broaden the corporate tax base, and move toward a territorial system. We support such a reform. However, we believe that it will take considerable time to reach the political agreements necessary to get it done. In the meantime, we support a temporary reduction in the corporate tax rate on the foreign subsidiary earnings of U.S. MNCs as an interim measure, one that would be consistent with the goals of long-term corporate tax reform and would generate significant benefits for the U.S. economy.
Given the current U.S. tax structure, in the absence of a reduction in the tax rate on repatriations, the amount of foreign subsidiary earnings held abroad by U.S. MNCs will continue to grow and will be invested abroad. Thus, the opportunity cost of a temporary tax reduction on the repatriation of these earnings is low; without such a reduction, most of these earnings will not come back to the U.S., will not be subject to the U.S. corporate tax, and will not be available to boost consumption, investment and employment through the channels identified in this paper.
Based on our analysis, we believe that a temporary reduction in the corporate tax rate on repatriations is likely to provide a powerful boost to aggregate spending and confidence at a moment of economic vulnerability. Such a policy change would also complement other policies designed to increase jobs and output, such as President Obama’s current jobs (AJA) proposals.
1 We also evaluated the effect on the economy under the assumption that only the 10% most capital constrained firms as measured by the Kaplan-Zingales index would use repatriated earnings internally. Under this more conservative assumption, the increase of U.S. GDP would be between $71 and $141 billion and the new investment by these firms would create between 520,000 and 1.03 million new jobs.
2 See Mark Zandi, “An Analysis of the Obama Jobs Plan,” September 9, 2011.
3 Ben Bernanke, Op-Ed piece, November 4, 2010, Washington Post.
To read the complete paper, click here.