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October 20, 2011



I just figured I'd point out that, as much as corporations make decisions for tax reasons, I cannot imagine a real-world scenario in which shareholders would countenance a business decision that reduced ROI. The CEO would be likely to lose their position (e.g. Fiorina).

Also, in the short to medium term it seems like our bigger concern is to start to spend savings rather than add to them. It seems like lots of earnings are just being parked.

Nathan Smith

What kind of business decision that reduces ROI do you have in mind? The merger of companies A and B? But it wouldn't reduce ROI, because the tax advantages of the merger should raise the joint price of AB shares, since they increase joint after-tax income. So shareholders would get capital gains.

I'm not sure if you meant the advice about "spend savings rather than add to them" to be directly responsive to the argument in the post or not. Of course I was making a point about long-run policy. But if we want to get earnings to be invested, circulated, put to use, the last thing we want to do is threaten higher taxes on the rich. That's just saying "Heads you lose, tails the government wins" who are in a position to spend, and risk, money. Why should they invest if they think the Occupy crowd is going to persuade politicians to take their gains?


Popular backlash is one of the risks elites run by not conducting themselves (and the world's affairs) more responsibly. The risk for that backlash to be misguided is something bankers and corporate managers ought to bear in mind when considering, say, their political reaction to moderate increases in upper-bracket tax rates or financial regulations--or their personal decisions when in positions of power.


If company B is consistently losing money, it's less than worthless as a going concern, and an executive at A who implemented a takeover without expecting to change its operations to be profitable would probably be sued by shareholders.

As for the second item: If you think that taxes will rise in the future, then you want to shift profits to the present rather than 'waste' the low-tax period by reinvesting in future profits. If you think that taxes have already risen to their long-term level, then there's no tax incentive to 'bank' profits rather than reinvest them. Over the long term, of course, higher tax rates do theoretically reduce the incentive to work hard or whatever, but I don't see how it reduces the incentive to save or invest. By the time one is doing either of those, the income has been taxed, unless of course one is investing in one's own operations, in which case it may not be taxed.


@Scott: While it is, of course, within bounds to offer moral commentary on those who legally misuse their position, it seems worrisome to use 'backlash' as a tool of political intimidation. Yes, ruling classes always have to placate the masses to some extent, but if that's the terms in which we insist on seeing the problem (rulers and the ruled), I think we're blinding ourselves. Perhaps the financial elite are not helping*, and perhaps they have not 'paid their fair share' or whatever, but I think it's dangerous to jump to the conclusion that they are the *source* of the problem(s).

I will admit that the way the economy works is being really tough on a lot of people, and it's not because those people are bad, or lazy or whatever (though that can certainly be the case). But, I don't think the logical conclusion is that it's necessarily because of malfeasance or incompetence in leaders (though that can also certainly be the case). Personally, I think this era was always going to be hard, and even the best policy and the best, most active intentions are not going to save the pain and unfairness entirely. I know it's a bit hackneyed to say it, but it doesn't help if we allow things to descend further into factionalism.

*And to this I will agree, politically speaking. At the same time, it's easy to underestimate the benefits provided by modern financial products, so we definitely still want bankers to do their thing and continue to evolve the art of finance.

Nathan Smith


But of course we're not talking about a case where Company B is consistently losing money. Company earnings shift from year to year. Company B might have an expected earnings stream with positive net value, but have a negative income in a given year.

To the extent that you have an ability to shift profits between years, for example through how you account for depreciation of capital, then yes, if you expect taxes to rise you'll shift profits forward. It's an interesting question whether the healthy profitability of firms in the past couple of years reflects this kind of behavior. However, that's not what I'm talking about. Higher expected future taxes reduce the incentive to *take risks,* because you have to take the downside but the upside gets taxed. Productive investments, and especially innovation, tend to be risky. So expected future tax rises encourage people to play it safe, which is not conducive to economic growth.

The tech sector is a partial exception, because it tends not to involve a lot of up-front capital.


@Nato: Meh, it was an intemperate and emotional comment.

I do wish, though, that the leaders of our financial industry would act with a greater sense of responsibility towards the broader economy.

Nathan Smith

Wow! THAT was intemperate and emotional for you? You must be a pretty calm guy. :)


"Company B might have an expected earnings stream with positive net value, but have a negative income in a given year"

Then ultimately they'll end up with the same tax liability as without a merger, except now with M&A costs as well.

"...you have to take the downside but the upside gets taxed." The downside is a write-off, though. It's only helpful if you eventually start making profits against which to apply the losses, but if you were going to fail, it wasn't because of taxes paid on non-existent profits.

Nathan Smith

No, Nato, they will not end up with the same tax liability. And the point about how tax affects risky investment is that the NPV of a risky investment is reduced by capital taxes more than the NPV of a safe investment. Consider an investor who has a choice between two investments, Investment 1 and Investment 2. (He has enough money for only one of the two.) Each investment might work out well (Upside) or badly (Downside). Below are the probabilities and payoffs, and calculations of the NPV.

Investment 1
Upside, p=50%: $1M profit
Downside, p=50%: $0 profit
NPV (ignore discounting, no tax): $500,000

Investment 2
Upside, p=10%: $10M profit
Downside, p=90%: -$500,000 profit
NPV (ignore discounting, no tax): $550,000

Now what happens if there's a capital gains tax of 50%?

Investment 1
Upside, p=50%: $1M * (1 - 50%) = $500,000 after tax
Downside, p=50%: $0 profit (no tax applies)
NPV: $250,000

Investment 2
Upside, p=10%: $10M * (1 - 50%) = $5M profit after tax
Downside, p=90%: -$500,000 (no tax applies)
NPV: $50,000

You see, the 50% capital gains tax reduces the NPV of the relatively safe investment (where the worst case scenario is to break even, but the upside is much smaller) by only 50%, but reduces the NPV of the risky investment by 90%. The reason is that the tax regime is *asymmetric*: if you make profits, you pay taxes on them, but if you make losses, the government does not reimburse you. That's one of the ways that capital taxation distorts capital allocation.

Nathan Smith

Actually the 50% capital tax reduces the NPV of Investment 2 by a bit more than 90%.


"if you make losses, the government does not reimburse you."

Yes they do. It's called loss carry forward and carry back. Thus, the p=90% case results in a loss carry worth $250,000, assuming taxes remain the same.

Nathan Smith

No, they don't. Loss carryback and carryforward is a *tax deduction.* You won't simply recover cash from the government because you operated at a loss. It may mitigate the problem (though it could make it worse in some ways since the loss carry forward and carry back is a valuable asset which may motivate otherwise inefficient mergers) but does not eliminate it.

Nathan Smith

In the case mentioned, loss carry forward and carry back is ignored. We cannot say how it would affect the problem, because we don't know enough information about the investor and his other tax liabilities.


"In the case mentioned, loss carry forward and carry back is ignored. We cannot say how it would affect the problem, because we don't know enough information about the investor and his other tax liabilities."

But in the real world, investors typically have tax liabilities. If one plays only one round of the prisoner's dilemma, then one should rationally always sell out one's partner, but that's a terrible strategy in any interesting game theory, which considers more than one round. Considering just one round of investing seems similarly irrelevant when considering what motivates real investors. As you note, loss carry is a valuable asset that can motivate mergers, which also means its an asset that affects shareholder NPV. Feel free to discount it, if it suits you, but ignoring it seems tendentious or naive.

Nathan Smith

Certainly they make a difference but the basic point, that capital taxation distorts corporate finance, stands. See here: http://www.nber.org/chapters/c11353.pdf. Or here: http://www.jstor.org/pss/2327640. Also here: http://www.jstor.org/pss/797993.


"the basic point, that capital taxation distorts corporate finance, stands"

Oh, certainly. I'd never argue otherwise. However, the examples on offer are extremely misleading as to the magnitude and nature of those distortions. There's a very material difference between a 90% reduction in NPV and, say 56%, as the answer would be if we accounted for loss carry with a 20% discount. If they are supposed to tell us something about real world market distortions, they are egregiously deficient.


Er, a 61% reduction in NPV, not 56%. I made the same mistake Nathan did.

Nathan Smith

I'm not sure whether a 20% discount would be regarded as realistic. It might be too high or too low, and I'm sure it would depend on the kind of investment. (If the "losses" consisted in in-kind investment of labor, as might tend to be important in the case of start-ups, I think loss carry forward doesn't apply.) Remember, though, that this is only *one* way that capital taxation distorts corporate finance-- the bias in favor of debt over equity is another, and there may be more that I don't know about. I'm not sure, in general, how important specialists think these distortionary effects are. I think the primary case against capital taxation is that it depresses the savings rate by raising the opportunity cost of future consumption relative to present consumption. Suppose you earn $100K, and pay income tax of 25%. If you consume it immediately, you can consume $75K. If you save it for the future, you pay taxes again on the returns, dividends and capital gains. This raises the price of future consumption in terms of present consumption and discourages saving, and therefore capital formation. This may actually hurt *workers* most, because scarcer capital lowers their marginal productivity, while it may raise that of capital. Of course, various tax-free investment vehicles have been set up to mitigate the problem, but it's still there to some extent.


are you sure that a 20% discount real?

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