What helps the real economy?

(hat tip ataxingmatter)

Start Making Sense notes:

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.