Execs pocket billions with Jobs Creation Act

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In 2004, the US Congress passed the “American Jobs Creation Act” which allowed a US company to elect, for one taxable year, an 85% dividends-received deduction with respect to qualifying cash dividends from its foreign subsidiaries, when such dividends were in excess of a base period amount and were reinvested in the US pursuant to a ‘domestic reinvestment plan’.

The mysteries of fungibility

Of course, Congressmen and women cannot be expected to understand that money is fungible and that there is no way to prove that a ‘domestic reinvestment plan’ was anything more than normal corporate investment that would have occurred without a tax incentive.

However, the Federal Reserve national flow of funds accounts (Table 102) indicate that in 2005 there was indeed a massive repatriation of US corporate earnings held overseas, as this graph shows:

US Profits Retained Abroad

Foreign profits retained abroad appear as red bars, while domestic profits are in blue.

In 2005, the red bars for foreign profits held abroad suddenly disappear, while domestic profits zoom upwards.

Where foreign profits went

Sometimes flow of funds analysis allows us to see clearly how money is deployed, and this is one of those times.

The next graph shows corporate domestic cash flows, stock buybacks, and cash dividends over the period 1995-2005.

Buybacks & Dividends vs. Corporate Cash Flow

The sudden jump in stock buybacks in 2005 reached record levels of $366 billion, up $224.9 billion over 2004.

In the same period, foreign profits retained abroad dropped $133.9 billion.

Buybacks up, dividends down

Although corporations increased stock buybacks, favoring executives holding stock options, cash dividends were slashed by 35%, or $124.1 billion, despite record profits and ample cash flows.

There is no indication that profits returning from overseas went into creating American jobs as Congress, in its supreme naiveté, expected.

Rather, the money went directly into the repurchase of stocks held by executives under option plans, and therefore, into executive pockets.

This was all very ‘tax efficient’.

The reduction in the amount of earnings retained abroad, plus the cut in dividends, amounted to $258 billion, which was suspiciously similar to the $224.9 billion increase in stock buybacks.

The perfect ‘crime’

The perfect crime is one that is not against the law at all and in which the victims do not even realize that they have been assaulted.

In this case, the ‘victims’ were millions of American long-term shareholders, holding retirement funds in tax-deferred mutual funds and who did not sell shares into this massive stock buyback in order to get their fair share of corporate profits.

Don’t expect Congressional hearings on this any time soon:

The Perfect Crime

• Gullible investors: Most Americans holding equity through 401(k) plans and IRAs, don’t understand that buybacks are a diversion of corporate profits for the benefit of option holders. Without buybacks, the sale of stocks held by executives would certainly force prices down, greatly reducing, or even eliminating, their profits. If the money had been used instead to pay dividends, these small investors would have received a fair share of profits.
• A Good Cover Story: The economy has been improving since 2001 as have been corporate profits. Executives are able to claim that their ‘reinvestment’ of foreign earnings in the US has contributed to this improvement, even if there was no effective ‘reinvestment’.
• The Fungibility Trick: Money is fungible. No one can say that a dollar invested in a ‘domestic reinvestment plan’ came from overseas or from ordinary company profits, or that a ‘domestic reinvestment plan’ was not simply something already on the agenda that would have occurred anyway.
• A Well-lobbied Congress: The American Jobs Creation Act of 2004 turned out to be a bonanza for Wall Street, especially large firms like Goldman Sachs that hold a privileged position in the buyback and foreign exchange markets and were able to report record earnings. Even the slightest attack on the buyback privilege will give rise to an army of well-paid lobbyists and academic flacks who will ‘prove’ that the practice is good for America.
• Dividend Insensitivity: The impunity with which Corporate America cut dividends, without even a whimper from millions of small investors or retirees, demonstrates the profound lack of sophistication of most shareholders under ‘Workers’ Capitalism’.

What this means for 2006

The American Jobs Creation Act of 2004 was a one-time deal.

Therefore, it would be reasonable to expect that in 2006 the practice of holding foreign earnings abroad will continue, until the next friendly Congress comes along and buys the idea of ‘creating American jobs’ and grants a new tax exemption on repatriated funds.

Sooner or later another recession will come along and political fraudsters know that ‘a good crisis should never go to waste’.

This suggests that in 2006, unless corporations figure some way to use overseas funds for domestic buybacks, there will be over one hundred billion dollars less that is available to sustain equity prices through buybacks.

Since the record level of buybacks in 2005 only managed to raise stock prices about 3%, this means that corporate management will really have to strain to scrape up enough money to maintain equity prices at current levels.

However, since management was able to get away with slashing dividends 35% in a good year, with no one batting an eye, this means that the dividend cookie jar is wide open and that further assaults on the savings of small shareholders may be expected.

The only other source of funds for buybacks (other than borrowing) is to tap into the giant cash flows created by depreciation reserves. This, of course, will mean selling short the future of American business, but why should anyone care?

All this suggests that, despite record profits generating rivers of cash, there are reasons to cast a jaundiced eye on the future of the US stock market as far as the ordinary investor is concerned.