Beware the Retained Earnings Tax

By December 13, 2010Economy, General, Taxation

President Obama meets with heads of large corporations Wednesday at the White House. Reading through recent news and commentary, one suspects a tax on retained earnings may be mentioned. Let’s hope the CEOs are prepared to quash that idea.

Wall Street Journal, Dec. 13, “Obama Woos CEOs as Frictions Ease“:

The administration wants to persuade U.S. companies to unleash some of the $1.93 trillion in cash and other liquid assets in their treasuries. Cash as a share of total assets is at the highest level it has been in a half-century, the Federal Reserve said last week. Mr. Obama wants the nation’s biggest companies to invest that money in expansion and new hires in the U.S. But business leaders are slow to do so, in part due to uncertainty over taxes and coming regulations connected to the health-care overhaul and other initiatives.

President Clinton, Dec. 10, at the White House:

Keep in mind, ultimately the long-term answer here is to get the $2 trillion, which banks now have in cash reserves uncommitted to loans, out there in the economy again, the $1.8 trillion in corporate treasuries not now being invested out there in the economy again. I think this is a net-plus.

And the tax proposal was run up the flagpole last week in a Dec. 10 Washington Post op-ed by Mihir A. Desai, a professor at Harvard Business School, “Tax U.S. companies to spur spending“:

If chief executives and chief financial officers are goaded into spending that cash, the economy could benefit from a significant stimulus that, unlike stimulus measures relating to government spending, would stem from decentralized actors responding to private information and incentives.

Consider the potential effects of a temporary 2 percent tax on corporations’ “excess” cash holdings. With the returns on their cash holdings approximating zero, managers would have to explain to their investors why earning a negative 2 percent return would make sense as opposed to either investing or disgorging that cash to shareholders.

History is instructive when it comes to the harm of that idea. Amity Shlaes, July 9, 2010, Washington Post, “Obama threatens to follow in FDR’s economic missteps“:

In 1935 he signed legislation known as the “soak the rich” law. FDR, more radical than Obama in his class hostility, spoke explicitly of the need for “very high taxes.” Roosevelt’s tax trap was the undistributed-profits tax, which hit businesses that chose not to disgorge their cash as dividends or wages. The idea was to goad companies into action.

The outcome was not what the New Dealers envisioned. Horrified by what they perceived as an existential threat, businesses stopped buying equipment and postponed expansion. They hired lawyers to find ways around the undistributed-profits tax. In May 1938, after months of unemployment rates in the high teens, the Democratic Congress cut back the detested tax. That bill became law without the president’s signature.

Ira Stoll at the Future of Capitalism blog points us to a new paper (abstract) by Ellen McGrattan of the Federal Reserve Bank of Minneapolis on the role that tax increases had in worsening the Great Depression.

Many theories have been proposed for the large contraction of the 1930s and the slow recovery thereafter. Absent in the theories of [Milton] Friedman and Schwartz (1963), [Ben] Bernanke and Gertler (1989), Cole and Ohanian (2004), and many others is any role for fiscal policy in this decade. This paper challenges the conventional view that fiscal policy played little or no role. Tax rates on dividends rose significantly during the decade and, when fed into the basic growth model, imply a large drop in tangible investments and equity values. In the later part of the 1930s, tax rates on undistributed profits were introduced and led to another dramatic decline in tangible investment.

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