Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?

Chapter 9 The Artful Dodgers

Chapter 9 spells out a number of flaws in our tax system that have led to major distortions in our financial system. Also addressed are explanations on  how these flaws have encouraged American companies  to “engineer” schemes to their advantage in order to  reduce income taxes they would otherwise have to pay. Observations are then presented documenting some of the unintended consequences that these financial engineered tax avoidance measures have had on companies that have used them. Discussed are some of the perverse outcomes that have been observed and how they have  contributed to the 2008 financial system melt-down.

In preparing the summary of this chapter, it became necessary to reorganize the material into a more cogent narrative. This material is now organized under the following topics: “Tax Inversions”; “Tax Code Biases Favoring Debt”; and “The Fall-out From Over-leveraging of US Business”.

Tax Inversion Schemes

Tax inversion schemes have become a popular way for American corporations involved in international commerce, to lower the corporate income taxes that they would otherwise have to pay the US treasury.

Tax inversions generally involve American corporations who  are  domiciled in the US that operate globally and earn substantial profits outside of the US. These corporations  would normally have to pay 35% of their non-US earnings into the IRS as part of their overall US corporate income liability.

To avoid such tax liability on non-US earnings, many of these American companies employ a scheme called a tax-inversion whereby they first acquire a foreign  company that is domiciled in a country with a substantially lower corporate income tax rate, (such as Ireland, The Netherlands , or The Cayman Islands). They then have to move their corporate offices to that country, leaving in place, their actual US operations.

This  corporate structure allows the non-US earnings to treated as taxable income that is exempt from US corporate income tax, and subject to the tax rates that are imposed where the company’s corporate offices are now domiciled. However, the cash generated by these off-shore after tax earnings cannot be repatriated to support US operations without subjecting them to the higher US tax rates. These off-shore earnings are retained by the company’s corporate office, and if  distributions of these off-shore earnings are to be made to the company’s  US shareholders the company is often forced to borrow the funds to be distributed, using its retained off-shore after-tax earnings as collateral.

Increased Use of Tax Inversions

In recent years, at least fifty  American corporations have done tax inversions, twenty of which have occurred between 2012 and 2014. These fifty deals were estimated to have cost the US Treasury  $19.46 billion and provide $1 billion in fees paid to Goldman Sachs and three of  the other US mega-banks who helped these American  companies in establishing these tax inversions.

Several  actual tax inversions scheme examples are presented in this chapter in order to demonstrate how tax inversion schemes work, to highlight  the tax savings that were obtained, and to report on the adverse impact these tax inversion schemes may have had on  the companies that were involved. The following are summaries two prime examples.

Pfizer: This American pharmaceutical giant bought a Dublin-based drug firm, Alergen, in order to access and market Alergen’s big new drugs. This strategy was used by Pfizer so that it could avoid the risks and costs of conducting its own R&D in order to replicate drugs Alergen has already patented. A tax inversion scheme was then implemented by Pfizer that involved acquiring Alergen and moving Pfizer’s corporate headquarters to Dublin. This  tax inversion scheme is expected to reduce Pfizer’s annual corporate tax bill by  $21 billion per year, as all of its non-US earnings would be subject to Ireland’s 12 percent corporate tax rate as opposed to the 35 percent rate that American corporations would normally have to pay.

Apple: The tax inversion schemes that this giant intellectual-property company is employing is also based on an Irish domicile for its corporate offices. This has allowed Apple to hoard billions of after-tax dollars overseas and provide collateral for low-cost debt that Apple uses to support  its stock buybacks and inflate the value of its stock. Similar strategies are allegedly being pursued at Facebook, Google.

Consequences

Also presented in this chapter are some of the consequences that have resulted from using this form of international tax arbitrage. One major consequence is that tax inversions that have already been used by US corporations have facilitated the sheltering of $2.1 trillion in taxes on their non-US earnings. Many critics of tax inversions, view these schemes as “selfish capitalism”. These critics also consider US corporations who employ such schemes as “biting the hand that feeds them”, claiming that these same companies have benefited from innovative products and technologies they had developed, using research that was funded by US government grants and indirect subsidies.

Some other critics of tax inversions are even more concerned that hording cash offshore has had a perverse impact on companies using tax inversions because their retained earnings are not being reinvested to support  further R&D, or for expanding their operations in the US and creating more jobs. Instead, these off-shore retained earnings are being used to pursue further financialization, by using these funds to enhance shareholder value instead of growing their business in ways that would help America’s real economy.

Similar Schemes

Two more tax inversion schemes were presented that illustrate the extent some companies will go to avoid taxes.

 The ‘Irish Sandwich”

One such similar scheme, is called the “Irish Sandwich”. It has been used by a number of Big Pharma companies who have extensive operations in the US and operate on a global scale. These companies generate revenues from patent royalties earned in any number of countries outside the US.

By using an Irish Sandwich tax inversion scheme, it requires that a second overseas subsidiary be set up in Ireland to collect these non-US royalty payments  and the cash collected from sales in other countries are accumulated into the accounts of this Irish subsidiary. In this way, US corporate taxes do not have to be paid by the US parent. Instead corporate taxes that are paid, are levied by the Republc of Ireland at their much lower tax rate.

The “Dutch Sandwich”

Also discussed is another tax inversion scheme having its own perverse incentive. This maneuver called the “Dutch Sandwich”, that encourages American companies  who have set up Irish subsidiaries and who do business in other EU member nations,  to establish subsidiaries in those countries as well. This Dutch Sandwich scheme takes advantage of free transfer rules of the EU as it allows these subsidiaries the ability to make tax free cash transfers between each of its subsidiaries located in higher taxed jurisdictions within the EU, while depositing these earnings into subsidiaries located in Ireland or the The Netherlands, the two lowest tax jurisdictions in the EU.

Tax Code Biases Favoring Debt

Chapter 9 provides supporting arguments for the author’s conclusion that the US tax code not only encourages the use of tax inversions, it enables US corporations to obtain tax deductions for interest payments. In addition, it encourages corporate borrowing by allowing tax deductions for interest, while fully taxing dividend distributions that are made using corporate earnings.

Critics of the US tax code argue that the tax inversion loophole also encourages US corporations to hoard cash on overseas earning, while  discouraging reinvestment of retained earnings in the US economy. They also believe that the tax code’s bias toward giving favorable tax treatment to borrowers encourages  financialization  as  buying and selling assets to run up asset values can be achieved using cheap borrowed funds. They argue that added to this perversity is the incentive to take a tax deduction on these borrowing, makes borrowing for financialization even cheaper.

Over Leveraging of US Business

In 1970, consumer debt in America was 54 percent of US GDP. In the 1990s especially during the “dot-com boom” period,  consumer confidence was high and consumer credit and home mortgages were readily available. A spending spree commenced and home buying was encouraged. It  resulted in an explosion of home mortgage demand and related demand for furniture, appliances and autos soon followed, creating a demand for installment loans. And credit card use was actively promoted. This boom period also created a need for a secondary market for mortgages. Fanny Mae and Freddy Mac and big banks responded, which gave rise to  securitization of debt and development of all sorts of derivatives.

Exuberance prevailed in the stock market, encouraging both banks and non-banks into pursuit of financialization strategies, as  a pathway to higher earnings. Secondary markets for derivatives quickly developed  that attracted new players such private equity funds, hedge funds and pension funds.

Between 2000 and 2007 there was a doubling of  consumer debt. And housing prices continued to increase through 2007 in a run-up to the financial melt-down of 2008.

In 2008, housing prices had peaked just as the US economy began to slow down and unemployment rates increased. By that time consumers stopped spending and they were buried under mounds of debt.  Hardest hit were middle and lower-income people who began to default on their mortgage payments.  These defaults created large inventories of foreclosed properties followed by  a rapid drop in property values.

As property values began to fall below amounts owed on their mortgages the number of homeowners who had mortgages that were underwater drastically increase in a short period of time. This led to increases in mortgages that were considered sub-prime, and an increases in distressed properties that could only be sold at distressed prices.

And the mortgage-backed securities that were held by big banks and by  Fanny and Freddie Mac became toxic and it led to the Financial Crisis of 2008 that was triggered by the collapse of Lehman Brothers, a prominent investment bank. This let to a sudden drop in securities prices and a freeze-up of the financial system, which jeopardized the continuance of a number of  Too-Big-To-Fail Banks, their debt guarantors such as AIG, as well as a number of large US automobile companies.

Federal bailouts and quantitative easing on part of The Federal Reserve were used to arrest further collapse and economic depression.  But the ensuing debt-induced recession that followed is lingering as economic recovery has been anemic and is still ongoing to this day..

Are We At Risk For Another Debt-induced Crisis?

Ms. Foroohar opines that the answer is a resounding “yes”. This chapter also presents opinions of a number of prominent economists who agree that  this perverse cycle that led to the 2008 financial crisis and economic recession that followed, could repeat itself.  They  suggest that  the Federal Reserve’s money dump in this last “bailout” already planted seeds for another debt-induced crisis. They also concur that it will take more than the use of debt-fuels finance and loose credit to accelerate our current economic recovery.

And  they warn that if another melt-down occurs  any time soon, using a debt-fueled stimulus may not be enough to save the day the next time around, as we all still owe too much.  They point to the fact that 80 percent of world-wide financial assets are comprised of debt and that global debt is at unprecedented levels and this over-leveraged position is a major contributing factor to the anemic economic recovery we are still experiencing.

They also warn that this over-leveraged position is making the global  economy prone to economic stagnation, which could result in more bubbles bursting, and a recurrence in financial meltdowns and recessions.

As noted in this chapter, the only consistent winners in these chaotic times have been members of financial industry itself, as they make money moving money,  inflating asset values and running up the market value of their stock. A sad commentary indeed!

What Needs to be Fixed

In a word, “everything” In the last section of this chapter, Ms. Foroohar quotes two prominent economists who believe that “We must fundamentally rethink the financial system”. She then presents  a number of basic “fixes”.

Some are tax reform suggestions, such as: putting dollar limits on mortgage interest tax deductions; eliminating  such deductions on all but primary residences; eliminating tax breaks on non-essential business assets, such as yachts, corporate jets; and taxing passive income at rates comparable to ordinary income.

Also mentioned are a variety of proposals for closing tax loopholes that are believed to disadvantage companies operating in the real economy and encourage excess financialization of American business.  One proposal calls for closing  the corporate performance pay loophole by  limiting the corporate tax deductions only for regular salaried income, and not performance related pay. Another proposal is designed to reward savings rather than debt as it  would allow deductions for equity returns, as  well as  for debt.

Other sets of proposed changes are designed to increase “fairness” of the tax code. These changes include: increasing marginal tax rates on upper bracket income; taxing capital gains on a sliding scale based on asset holding period, with shorter holding period gains paying a higher tax; taxing US corporations on their off-shore earnings regardless of where they locate their corporate offices; and, instituting rules to limit the use of tax havens for avoiding taxes on foreign earnings.