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That didn't take long

In 2004, Congress enacted a temporary dividends received deduction for U.S. multinationals that repatriated foreign earnings. Under the temporary DRD, the tax rate on dividends from foreign subsidiaries effectively was lowered from as high as 35 percent to just 5.25 percent, but only for dividends during a 12-month time window.

Every tax expert I know whose views on this proposal were sounded - except for those being paid to support it - thought it was a bad idea, despite the acknowledged case for permanently lowering the tax on U.S. multinationals' foreign earnings. The problem lay in the provision's being temporary, and thus creating lock-in when the rate went back up because people would anticipate and wait for the next tax holiday.

As it happened, there was an extraordinary level of response to the tax holiday, more than experts or revenue estimators had expected because it had been thought that companies with lots of perfectly legal and effective tax planning tricks might not be sufficiently worried about the repatriation tax even to pay 5.25 percent to get their earnings home for tax purposes. It's also generally thought that the claim that the repatriations would create U.S. jobs proved predictably bogus. (See Lisa M. Nadal, "Bailouts Disguised as a Tax Cut?", 121 Tax Notes 1230, 12/19/08.)

As Nadal notes, the same companies that successfully pushed for the tax holiday in 2004 are now already seeking a reprise. That didn't take long.

In an important sense, the policy here is entirely backwards even apart from its temporariness, which Nadal suggests could be rationalized this time around in terms of the ongoing liquidity crisis in the U.S. economy. (For myself, in order to accept the liquidity argument for another tax holiday, I'd need to see good evidence that it cost-effectively addresses the credit crunch despite being aimed at just a small clientele of U.S. companies that happen to have trapped foreign earnings that they want to repatriate.)

What makes the policy backwards is that the case for exemption (or a low U.S. tax rate) for foreign source earnings is strongest for new investment, not old investments that have already been made. Retroactively exempting the profits from old investment creates a transition windfall without actually changing the past anticipated incentives, which by now are water under the bridge. A temporary rate cut for dividends, unlike a permanent one, is pretty much guaranteed to apply only to old investment.

True, enacting two tax holidays in 5 years would tend, all else equal, to lower the expected future U.S. tax rate on new investment, since why couldn't the holidays just keep on happening. But counting on holidays is a distortionary and uncertain way to reap tax savings, and who knows if they'll actually keep coming as the U.S. heads out of the recession at some point (one hopes) and ever closer to the point of long-term fiscal distress.

I'm on the verge of writing a book or article on U.S. international tax policy, and one point I want to emphasize in it (akin to the same point made by "new view" skeptics concerning corporate integration) is that in theory there should probably be negative transition relief - i.e., the transition gain from escaping the expected level of tax on past outbound investment probably ought to be eliminated by a one-time tax or its equivalent. (For more on these sorts of transition issues, see my 2000 opus, if I may call it that, When Rules Change.)

But from an interest group standpoint, the bad stuff creates the strongest political pressures for a favorable change, precisely because it plays out in targeted transition gain rather than generalized improvement of incentives.

Full post as published by Start Making Sense on December 15, 2008 (boomark / email).