Wednesday, September 8, 2010

Understanding Obama's New Tax Deduction Proposal for Business

John Carney points out one of two fundamental problems with President Obama's latest tax deduction proposal:
The Obama administration's proposal to allow companies to immediately write off 100 percent of new capital investment expenses through 2011 may not be as effective at jump-starting the economy as hoped.

Businesses now deduct capital expenses over years, according to various depreciation schedules embedded in the tax code.The Obama administration would let them take the deductions immediately. The hope is that this will prompt companies to stop "hoarding" cash and start spending on investments.

While it's tempting to applaud almost any reduction in the tax burden on American businesses, we're not sure this plan will work as advertised. In fact, it may be economically destructive.

The first thing to notice is that this is an example of economic central planning. The White House believes businesses are not spending enough on capital investments. But how on earth does the White House know the right level of investment activity?
The second problem is that you need profits to use the tax deductions. With the economy heading toward a double dip recession, tax deductions will be of zero value, if the profits aren't there.

Remember, analysts are now debating with Citi the huge tax deductions that sit on Citi's balance sheet as assets that many analysts believe Citi will never be able to put to use.

This tax deduction may turn out to be the same type of asset: valueless.

1 comment:

  1. Below is a speech I linked to by Fed GC Alvarez. I don't know how much is new information, and this is not my area of expertise. However, it seems (reading between the lines) that Wells Fargo was willing to outbid Citi for Wachovia b/c of a then-new IRS ruling that effectively allowed WF to take Wach's deferred tax assets as its own. Why wouldn't Citi have gone for the same deal? Some, if not all, of Wach's DTAs would count as regulatory capital. Was Citi advised at the time it was too weak to count further assumed DTAs toward reg capital? If so, what's changed that permits it to avoid write down of its own DTAs? Also relevant is that Basel III could make the issue moot as it would disqualify DTAs from qualification as reg capital. The solution, of course, is to securitize the DTAs so they can be sold to the Fed, and the proceeds used to buy TSYs.

    "Citigroup Proposal
    On September 29, 2008, Citigroup proposed to acquire most of Wachovia's assets and liabilities, including Wachovia Bank, and assume senior and subordinated Wachovia debt, in exchange for approximately $2.1 billion in Citigroup stock. Citigroup proposed that the FDIC enter into a loss sharing arrangement with Citigroup with respect to a pre-identified pool of Wachovia loans totaling about $312 billion. Under the arrangement, Citigroup would absorb the first $42 billion of losses on the pool, and the FDIC would absorb any additional losses. Citigroup would grant the FDIC $12 billion in preferred stock and warrants to compensate the FDIC for bearing this risk.
    Wells Fargo's Second Proposal
    On October 2, during the period Citigroup and Wachovia were negotiating a final merger agreement, the board of directors of Wachovia received a communication from Wells Fargo that included an offer from Wells Fargo to acquire all of Wachovia's stock by merger. Contrary to its original communication days before that FDIC assistance would be needed as part of a Wells Fargo bid, the new Wells Fargo proposal did not involve any direct financial assistance from the FDIC. Based on an IRS notice issued September 30, Wells Fargo had determined that certain U.S. federal income tax benefits resulting from the proposed Wachovia transaction would allow it to acquire Wachovia without FDIC assistance."