Kellogg Insight: A taxing question

Why did the American Jobs Creation Act lower taxes but fail to spur domestic investment?

By Beverly A. Caley

	Mitchell Petersen

In today's economy, most individuals would welcome a tax break. But, not surprisingly, such things come at a cost.

In 2004, Congress instilled the American Jobs Creation Act (AJCA), a law that temporarily lowered the tax rate on income that American firms earned from foreign subsidiaries. Designed to stimulate those firms' domestic investment, the tax break generated more than $300 billion in repatriations during its two-year window.

However, according to research by Mitchell Petersen, the Glen Vasel Professor of Finance, and Michael Faulkender of the University of Maryland, firms' domestic investing did not significantly increase as a result of the tax break.

"It was the same level of investment we would have expected absent a decision to repatriate the foreign income," Petersen explains. "About three-quarters of the money that was repatriated was brought back by firms that were able to finance their investments internally. Their taxes were lowered but there was no increase in investment."

For the study, Petersen and Faulkender searched 10-K filings for 2004-2006 and identified 1,246 firms that discussed the AJCA in at least one year's statement. Most firms showed little increase in domestic investment as a response to the AJCA tax incentives. Firms that were short on cash spent most of their repatriated funds in approved investments. Other firms invested, but not at a rate that was incremental to their tax gains.

The problem, Petersen explains, is that the law was based on a flawed assumption. Congress assumed that if firms had extra capital to invest in domestic opportunities, they would do so. Congress believed that a lack of investment is driven by the supply of capital, not the demand for capital. That's not the case, Petersen says, citing Microsoft as an example.

"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?" he says. "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 can finance."

One could argue that AJCA was good public policy, but the law was poorly designed, Petersen notes.

"Because the lost revenue won't be counted as debt, it could be a politically appealing way to raise funds. But 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."

So what's the lesson here? "When we think about designing laws," Petersen says, "especially tax laws, an understanding of basic finance is very important."