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Afterglow Of A Tax Holiday


Corporate America's latest tax break could provide a timely boost to the economy. On Oct. 11, Congress passed the American Jobs Creation Act of 2004. The law includes a provision to temporarily cut the tax rate on profits earned abroad and brought back home. According to economists Bruce Kasman and Robert Mellman at J.P. Morgan Chase & Co. (JPM), the repatriation of these profits could add a half percentage point to real gross domestic product next year.

The tax holiday, which will be in force until September, 2006, at the latest, is meant to address a quirk in the U.S. tax code. When a U.S. company operates over- seas, the profits earned are subject to local tax laws. If brought back home, the repatriated earnings are taxed at a 35% rate by the U.S. government, with companies getting a credit for taxes already paid abroad. If the local tax rate is less than 35%, American companies are better off keeping the profits abroad.

Under the new law, any profits booked prior to 2003 but still parked overseas could be repatriated in 2005 and subjected to a reduced 5.25% tax rate. But there is a catch. Companies must have a board-approved plan to use the money on such projects as research and development, hiring, paying off debt, and capital investment.

A survey conducted by J.P. Morgan Chase soon after the tax holiday idea was first hatched in early 2003 showed over 50% of respondents said they would repatriate nearly all their foreign profits if the plan were enacted. The bank expects that nearly $300 billion of a potential $500 billion in eligible earnings will be repatriated in 2005.

Once they return to the U.S., the funds could be used to create 200,000 jobs next year, say Kasman and Mellman, although other economists think the total could be considerably smaller. Even so, with high oil prices and a flagging global economy slowing the U.S. recovery, the tax break should provide some oomph.

Research and development has been credited as a key source of productivity growth in the postwar era. But a paper by New York University assistant economics professor Diego Comin to be published in the upcoming issue of the Journal of Economic Growth casts some doubt on the extent of R&D's power to enhance productivity.

Economists in the past have measured the correlation between productivity and R&D, defined by the National Science Foundation as research performed by people in the physical sciences. Those studies typically showed that R&D has accounted for 70% or more of the growth in productivity. But Comin noticed that past work overstated R&D's effect on productivity because researchers could not separate the gains coming from reengineering, such as a streamlined assembly process or a new inventory management system, from those generated by R&D alone.

To correct this error, Comin looked at postwar figures on R&D spending from the NSF, along with data on real GDP, productivity growth, and inflation-adjusted stock market returns. He narrowed his study to work that yielded a new product or capital good, since he says "the effect of R&D on productivity is embodied in these new goods."

He then adopted a two-step approach to measure R&D's effects on productivity growth. First, he determined what effect increased research outlays had on the growth rate of new technologies. To help simplify the process, Comin assumed that there were no barriers to undertaking R&D. Second, he computed how the growth rate of R&D-created technologies affected productivity. As research spending rose, the level of productivity also increased.

Comin's study estimated that R&D accounts for 10% to 20% of productivity's 2.3% annual growth rate since 1950. While that's much smaller than previous calculations, his number still represents a significant contribution in an era when companies are obsessive about cutting costs and improving efficiency.

As the year comes to a close, executives and economists are feeling less optimistic about the U.S. economy. But the Manufacturing Barometer from PricewaterhouseCoopers, a survey of management at 75 multinational manufacturers, found that respondents still see better days ahead for their own companies.

Although the respondents' optimism regarding economic growth in the U.S. and abroad is starting to wane, they expected, on average, that their own companies' revenues will grow by 9% in the next 12 months, up from a forecast of 4.4% as year ago.

The main reason is a revival in pricing power. The PWC survey showed that 45% of respondents said they increased prices in the third quarter, triple the 15% level from the previous year. The ability to boost prices is helping to lift margins despite rising costs. Nearly 50% of those surveyed said their gross margins had improved over the past three months.


Steve Ballmer, Power Forward
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