Monday, May 6, 2013

Meddling Misalignment

My view of government is that it should be like the referee in a tennis match.  It should sit above the action and observe the play on the court to make sure the rules are evenly applied and it is a fair match for both sides.  Government should be there to call it if a ball is hit out of bounds or if someone steps over the line. It should not be taking sides on who wins and loses.  It certainly should not be on the court trying to play the game.

Another view that I hold strongly is that everything in the world is about incentives.  Human beings will behave according to their self-interest. Therefore, incentives drive the world. If the incentives for people are properly aligned, you will get the result you want.  If the incentives are not properly aligned, you will get poor results.  Whenever you get a poor result it is likely that you will find that the underlying incentives were not aligned properly.

If you are looking for a perfect example where our system in not properly aligned and our government has left the referee chair look no further than the recent story that Apple Computer is borrowing $17 billion in order to pay dividends to its shareholders.  By the way, that is the largest issuance of corporate bonds in the history of the United States.  That is not chump change.

What is interesting is that Apple has almost $150 billion in cash sitting on its balance sheet.  So why are they borrowing money to pay a dividend when they are already awash in cash?  Something is not right.  Clearly the incentives are misaligned.  What is the story?

First, Apple's cash hoard is almost all sitting overseas in foreign bank accounts.  Why would they do that?  It has to do with U.S. tax policy.  Even though almost every other country in the world now observes a "territorial" system of taxation, the United States continues to observe a "worldwide" system.

What does that mean?

Under a territorial system the rule is that you pay taxes only in the country where the income is earned.  For example, if a Japanese company makes money in Germany, it is taxed in Germany.  Japan does not tax the income earned in Germany when the money is transferred back to Japan.

The United States follows a worldwide philosophy of taxation.  It taxes all income earned by U.S. corporations and individuals no matter where that income is derived.  Of course, the foreign country where the income is earned also wants their share.  Therefore, a U.S. corporation doing business in Germany first must pay taxes in Germany and then it also must pay taxes in the United States when it repatriates those earnings to the United States.

To prevent double taxation the United States provides a credit for any foreign taxes paid on the income overseas. Thus, for example, if the corporation pays a 30% tax in Germany on its profits and repatriates the income to the United States, the income is taxed again at the U.S rate of 35%.  A credit for the German tax of 30% is allowed so that the U.S. company ends up paying the full 35% rate-effectively 30% to Germany and 5% to the U.S.

Corporations are not bringing cash back to the United States because of this system.  The United States now has the highest corporate tax rate in the industrialized world.  Therefore, the current tax system has created an incentive for U.S companies to keep cash they have earned overseas rather than bringing it back to this country where it could be invested for the good of our economy.  By leaving the money overseas it will not bear the higher U.S. tax until it is brought home.  However, few large companies are bringing the cash home because of the high U.S. corporate tax rate.

A report last year by JP Morgan Chase & Co. estimates that U.S.-based companies had $1.7 trillion in accumulated offshore profits.

The U.S. tax system is clearly outdated, uncompetitive and its incentives are not aligned with the modern global economy.  Liberals suggest that U.S companies should pay current U.S tax on foreign profits rather than when these profits are repatriated.  However, such thinking simply ignores the realities of the world today.  All that would do is make U.S. companies even less competitive in world commerce.  The only logical answer is to have the U.S tax system more closely aligned with the rest of the world by lowering corporate tax rates and moving towards a territorial system.  This would remove the disincentives to bringing this cash back to the United States.  More cash in the United States means more capital, investment and jobs over the long term for our citizens.

The incentive should be to bring money back to this country, not keep it sitting outside the country.  The current law of our federal government is doing exactly the opposite and it should be no surprise we are getting a bad result.  This is why Apple is not bringing billions of dollars back to the U.S. to pay dividends ( a large portion of which would be paid to U.S. shareholders who pay U.S taxes).

Instead of bringing that cash back home they are borrowing the money to pay the dividends.  Why? Because of the inordinately low interest rates which are a direct result of the Federal Reserve's monetary policy.  Let's look at the math.  If Apple brings the cash back they have to first pay tax at 35% before they can pay dividends to their shareholders.  Alternatively, they can borrow money at 3% or less (which is also tax deductible) and leave the money overseas with no tax.  That is a difference of around 33% (after considering the tax deductibility of the interest expense.  On $17 billion, that is almost a $6 billion advantage. What would you do?  It does not take a Wharton MBA to figure that one out.

All of this is caused by government directed distortions to what should be the natural order of the affairs of commerce.  Government is both meddling and muddling to cause this result.  It is meddling by keeping interest rates artificially low to bail out banks and borrowers (the biggest being the federal government itself). It is also muddling along by keeping an outdated tax system in place that might have made sense in the mid-20th century but is totally out of sync for the 21st century global economy.  The rest of the world has moved to much lower corporate tax rates and we have stubbornly kept ours high.

Government long ago left the referee's chair.  They are trying to pick the winners and losers and the outcome of the game instead of making sure the game is fair.  In addition, the incentives in the system are totally misaligned and government doesn't seem to have a clue of what this is doing to harm us over the longer term.

Stop the meddling.  Cease the misalignment.  Get in the referee's chair and let the system work as our Founders intended it to.

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