Much of the recent debate on corporate inversions, when a company moves overseas to reduce taxes, has been framed as a battle of big corporations versus America. After the Treasury and Internal Revenue Service announced new regulations that led Pfizer to cancel its planned inversion with Ireland-based Allergan, President Obama characterized inversions as a way for U.S. companies to “get out of paying their fair share of taxes here at home.”
While this narrative is convenient for political rhetoric, it obscures a central fact: These corporations are owned by shareholders who, in theory, should reap the benefits of a lower corporate tax bill. In the case of Pfizer, tens of millions of American households—virtually anyone who owns an index fund or has a 401(k), IRA, or pension plan—own a small piece of the company, albeit unequally.
That doesn’t mean regulations on inversion aren’t warranted, but we shouldn’t forget that it’s shareholders who bear the burden of corporate taxes.
But this leads to a more basic question: Are inversions actually good for shareholders? In a recent paper, my colleagues Brent Glover of the Tepper School of Business at Carnegie Mellon University and Anton Babkin of the University of Wisconsin–Madison Department of Economics and I found that the answer is not a simple yes or no but depends on the specific shareholder.
As part of prior regulations aimed at discouraging inversions, the Internal Revenue Service requires shareholders to pay capital gains taxes at the time of inversion. Because this tax liability depends on when the shares were purchased, and many shareholders are exempt from these taxes, this cost is borne unevenly across shareholders.
Bad for long-term investors
So while many shareholders benefit from an inversion, we find that about 15-20 percent of shareholders are worse off. Inversions are especially bad for long-term investors, who have seen their shares appreciate significantly over the years, as well as those in higher tax brackets. Older Americans planning to bequeath shares to their spouses and heirs when they die are also hurt by these deals.
For certain shareholders, the cost of an inversion can be quite large. In one prominent example, former directors of Medtronic voiced serious opposition to the proposed inversion, which would have triggered a substantial personal tax liability for these longtime shareholders.
Across all inversions, we estimate that taxable U.S. shareholders lose about 1 to 3 percent on the value of their shares. This may sound small, but has added up to around $6 billion in extra taxes for these shareholders. In effect, shareholders are writing a large check to the government for the right to pay lower corporate income taxes in the future. These payments offset the government’s loss in corporate tax revenue by as much as 40 percent.
At the same time, tax-exempt and tax-deferred investors reap a nice return from inversion, about 4 to 7 percent. This includes millions of retirement accounts, pensions, and endowments across the country, as these investors do not pay taxes when an inversion occurs. Foreign shareholders also benefit, as they are generally exempt from U.S. capital gains taxes.
Benefits for some, not all
What’s unusual about inversions is that the shareholder benefits, or costs, vary so widely across individuals. With inversions, what’s good for the corporation’s bottom line turns out not to be good for all shareholders.
The personal tax cost of an inversion also explains why companies with large, powerful shareholders—like Facebook—would never consider inverting: It would require Mark Zuckerberg to cut a $13 billion dollar check to the government.
While inversion looks like a bad idea for Mark Zuckerberg, many CEOs stand to gain from this move. We find that the CEO’s wealth increases 3 to 4 percent, despite facing the personal tax consequences of inversion. This is in part because these CEOs, like many other executives, hold options that are treated more favorably for tax purposes than shares. This can put the interests of the CEO at odds with some groups of shareholders.
Lost in the outcry over the recent wave of inversions is that our tax code incentivizes U.S. multinational corporations to move abroad. Moving to a territorial tax system—where the U.S. no longer taxes foreign earnings—and a lower corporate tax rate would certainly reduce these incentives. Eliminating the maze of deductions could potentially offset these lower rates to maintain the current level of tax revenue while at the same time simplifying the tax code.
Lawmakers have known for years that the tax system is broken but have failed to act. Two decades ago, a prominent U.S. company, Helen of Troy, announced it would move to Bermuda for tax purposes. Rather than fixing the underlying problem, policymakers reinterpreted existing laws, making these deals taxable, with the hope of preventing future inversions.
Instead, the government has ended up punishing long-term and older taxable U.S. shareholders over the decades, while leaving foreign, short-term and tax-exempt investors untouched. This policy is not only unfair and arbitrary, it has also failed to stop inversions.
Read “The Cost of Keeping Companies in the United States” by Oliver Levine and Brent Glover in The New York Times.
Oliver Levine is assistant professor of finance and a Patrick A. Thiele Fellow at the Wisconsin School of Business
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