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How the economy really works

The latest economic controversy is something called corporate “inversions.” They occur when a U.S. domiciled corporation buys or merges with a foreign entity and moves their official headquarters out of the U.S. The media has painted this as almost criminal and the Obama Administration as “unpatriotic.” Most who get their news from sound bites believe that those corporations who plan to or have already accomplished inversion pay no U.S. taxes.

How the system works

It is important to understand that the U.S. is the only major country in the world to tax its citizens and entities on all of the income they earn, no matter where it is earned. Other countries only tax the income earned within their own borders.

In addition, the income earned outside the U.S. is only taxed when it is repatriated, and the tax rate is currently 35% less any credits that may be available from the payment of taxes to the foreign country where the income was earned. Income earned in the U.S. is still taxed at the ordinary corporate rate. Inversions do not impact these taxes.

Not that long ago, there was a political debate about “repatriation” of profits held offshore by U.S. multinational corporations (headquartered in the U.S.). Those profits are not taxed in the U.S. unless they are “repatriated,” i.e., brought “home” to be used in the U.S. Because the U.S. corporate tax is now the highest in the developed world, most of those profits haven’t been repatriated, and, thus, no taxes have been paid. And, in fact, as long as there are growth opportunities elsewhere in the world, they are unlikely to ever be repatriated.

There were proposals to temporarily reduce the tax rate on the repatriated profits to induce those multinational corporations to bring the money home, reinvest it in the U.S., and spur economic growth and job creation. But, because of political gridlock, nothing ever came of those proposals.

Furthermore, I am convinced that nothing will come of any proposal to close the “inversion” loophole. It all looks like political posturing in front of the November elections. I am pretty sure this is the case because on July 29, Windstream (WIN), a provider of broadband, voice and video services to consumers in primarily rural markets, revealed that it had IRS approval to turn its copper and fiber networks into a real estate investment trust (REIT), which pays no federal income taxes. AT&T and Verizon are expected to follow Windstream’s lead. Yet, despite the potential loss of a significant and real tax stream, there was not a single peep out of a single politician or the media.

Distorted view of the economy

Some of the apparent sentiment displayed in the attack on corporate “inversions” has occurred because politicians, and even most economists, have a distorted view of how the economy works.

The July 30 announcement by the Commerce Department that the GDP had grown 4 percent was welcome news, after the 2.1 percent contraction in the first quarter. If you look at that GDP breakdown, as a generality, consumption is 70 percent of GDP, government is 20 percent, and business 10 percent. But GDP only measures “final sales.”

If you believe that GDP is the most important measure of economic activity, then the logical conclusion is that policy should be aimed at either consumption or government spending. Because the “consumer” drives the economy, during any debate on tax cuts or tax rebates, worries emerge that if consumers save their refunds instead of spending them, the tax cut or rebate will have done no good for the economy. Both Presidents G.W. Bush and Barack Obama have echoed this sentiment.

Unfortunately, GDP, while very useful, produces a limited view of what is important in the economy. The fact is, most economic activity takes place well before the “final sale” of goods and services.

On July 25, the Bureau of Economic Analysis began to publish a series called “Gross Output.” This measures sales at all levels and includes all economic activity. For example, it measures the sales of mined ore to the steel mill, the sale of the resulting steel to the auto manufacturer, and then the final sale of the automobile. GDP only measures the latter.

When looked at this way, business to business sales represent 50 percent of total sales, consumer sales represent 40 percent, and government only 10 percent. Thus, policymakers have been missing the most important sector of the economy in their policy prescriptions —business — and overemphasizing the least important area: government. Of course, the importance of the business sector shouldn’t be a surprise. We know that sector creates nearly all of the jobs.


Looked at this way, there is an important policy lever that is hardly used, the lever to spur business. And, in fact, because business isn’t important in GDP, it has become politically correct to vilify it, and policy makers don’t see tax and regulatory policies that negatively impact business as important at all. And we wonder, with Sarbanes-Oxley and Dodd-Frank, why economic growth has been less than robust in this economic recovery.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor.  Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.  Robert is available to discuss client investment needs. Call him at (775) 284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV  89521.  Ph: (775) 284-7778.


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