Economics Puzzler of the Day

Gretchen Morgenson of The New York Times (hat tip Calculated Risk) reports that the recent Worker, Homeownership and Business Assistance Act of 2009 (which included the expansion of the homebuyer tax credit) included a curious tax break for money-losing companies:

“a tax break that lets big companies offset losses incurred in 2008 and 2009 against profits booked as far back as 2004. The tax cuts will generate corporate refunds or relief worth about $33 billion, according to an administration estimate.

“Before the bill became law, the so-called look-back on losses was limited to small businesses and could be used to counterbalance just two years of profits. Now the profit offset goes back five years, and the law allows big companies to take advantage of it, too.”

Morgenson focuses on the fact that some of the biggest beneficiaries will be the massive home-building companies that raked in huge profits during the height of the boom, and that they have no apparent plans to hire new workers. “After spending its $210,000, Pulte will receive $450 million in refunds. And Hovnanian, after spending its $222,000, will get as much as $275 million.” (If you’re not enraged by the behavior of some of these companies, you should read Chapter Five of Our Lot by Alyssa Katz.)

But leaving aside the link to home builders, here’s the puzzler: what’s the plausible economic justification for this tax break?

We generally allow tax loss carry-forwards, which means that if a company loses money in one year it can count that loss against the profit it makes the next year. I can think of a few plausible justifications for this policy. The first is that tax years are arbitrary and it’s more fair to tax profits without regard to specific timing. The second is that without such a policy, companies would have even more motivation to cook their books to smooth our their profits over time than they already do. The third is that this helps startup companies that tend to lose money early in their lives, and we want to help startups.

What about tax loss carry-backs, where you get to match losses this year against profits in previous years and claim a cash refund? I guess the fairness consideration still applies. The second doesn’t, or it’s much weaker, because the right incentive is already in place because of the carry-forward policy. The third doesn’t apply. Actually, the opposite applies. Either the company will turn a profit in the future, in which case it will be allowed to take advantage of the carry-forward. Or it will never turn a profit in the future, in which case this is a huge benefit — but why do we want to be helping companies that will never turn a profit again?

Finally, though, what happens when you switch from a regime without carry-backs to a regime with carry-backs? In this case, you end up writing $33 billion of checks to a group of companies that are selected solely on the basis that they are losing money now but made money in the past five years. Of all of the ways that the government could spend money to (a) stimulate the economy or (b) help people, how did this one make the cut?

By James Kwak

38 responses to “Economics Puzzler of the Day

  1. It’s institutionalized criminal sociopathy. No one has any responsibility to care about anything but himself, while all his incentives are to steal as much as he can.

    (Notice I didn’t say he lacks “incentive” to care. That a sense of responsibility isn’t its own incentive among these “leaders” and “public servants” is a gauge of the fundamental rot of the entire system and its entire cadre.)

    I linked to the Morgenson piece in the thread on the Gagnon post as an example of how by now this government is simply not capable of acting in any but a regressive, corporatist manner, and indeed, as we see in this case, or in the gutting of Sarbanes-Oxley, often in the most wretched, puling little ways.

    The sheer level of pettiness in their contempt for the people, for society, for democracy itself, is disgusting.

  2. It puzzles me that you didn’t mention financial services companies as the biggest beneficiaries of this legislation. Perhaps that was meant to be an exercise for the reader, if so, sorry to be a spoiler.

  3. Stuff like this is the reason why people are so angry. It just sucks the motivation right out of me.

  4. “Dammit, Jim, I’m a politician not an investor”

    Yet another reason to not pay your taxes comes April 15:

    Bailouts for automakers, bankers, homeowners, and now just plain bad managers.

    Devaluation and ZIRP for prudent savers and savvy investors.

  5. “But leaving aside the link to home builders, here’s the puzzler: what’s the plausible economic justification for this tax break?”

    The usual: If we help big business, they will help us.

    ;)

  6. The only reason I can think of to provide this of significance is that it is a liquidity provision measure and capital support measure to existing entities. It is more institutionalization of TBTF.

  7. lol Republicans. Would you oppose this policy if it were passed by a Republican administration?

    This is not a 33 billion dollar giveaway. If the gov is giving any money away, it’s the interest on the debt they might have paid down with the money. If the gov doesn’t allow this tax clawback, they’ll simply get less tax revenue from these same companies in the future, in exactly the same amount.

    I find it disturbingly partisan that so many on the right seem to understand demand-shifting perfectly when it comes to cash-for-clunkers (it’s not helping the auto industry! it just moves demand forward!) but then get conveniently stupid about it when it comes to shifting tax losses forward (they’re paying $33 billion to the worst companies! we would never have lost this money without this policy!).

    This policy is better summed up like this:

    – the gov gives up interest on the tax revenue it would have collected this year, up to the year it would have lost this revenue anyways

    – in exchange it gets to give a LOT of money, much more then it is paying, to American companies at a time of economic crisis

    I’d say that sounds like a no-brainer to me. In fact, it almost sounds like they are getting a tremendous bang-for-the-buck when you look at the true cost of the program vs the amount of money they are pumping into companies. It immediately lowers taxes, but has almost no impact on the long-term tax revenue collected.

    What is the problem again?

  8. ” Of all of the ways that the government could spend money to (a) stimulate the economy or (b) help people, how did this one make the cut?”

    That’s easy – find out who was behind it in Congress and/or the Executive, and then look for legal, and perhaps illegal, pay offs in the form of political donations, consulting jobs, board seats etc., etc.

    They’re probably just learning from what the pharmaceuticals have been doing.

  9. Just check the sign in sheet for visitors to Congressmen’s Washington DC offices. My guess is you’ll see a lot of visitors from the home-building companies friends on K Street. That should clear up the “puzzle”. If Morgenson is smart she will sniff that out further.

  10. Yes, typically these puzzles are quite a bit more traditional than what they look.

  11. The problem is that we’re providing taxpayer cash to an industry already in a state of massive oversupply, keeping bad investments on life support just because builders have the political pull to get it. Here is what SHOULD happen: Land and home prices continue to fall. Overlevered builders FAIL. Fewer homes get built. Supply falls to meet the lower demand level. Prices stabilize. Instead, we get zombie builders to go with our zombie banks.

  12. The argument on tax-loss carryforwards centers around the business being a “going concern,” i.e., something that will produce in the future.

    There is no implication that the Tolls and Big Cs currently around will do anything but take the monies, pocket it, and then declare bankruptcy.

    Surely, the bill addresses that possibility?

  13. You say “we’re providing taxpayer cash”, and while that evokes images of the gov stealing money paid by a sweet grandma sitting at home baking cookies right now, in fact, the taxpayer whose money is being given out can be identified much more concretely. The money being given out was paid by exactly the companies to whom it is being given.

    This is not a handout of free cash. It’s a refund of taxes that were paid on profits when those profits later disappeared. It’s a very fair thing to do. Company A makes 1 million dollars. It pays taxes on that million. Next year it loses 1 million dollars. The gov gives back the taxes paid and hopes that the company will survive the downturn to give people jobs and pay more taxes in the future. That’s reasonable and fair, whether you happen to like the company in question or not.

    Even the amount of the “give away” is doubtful. Unless the company getting the refund goes bankrupt, all this cash being “given away” would have been given out anyways. It just happens a few years later. So the true cost of the program is maybe 1/10th or less of the number being quoted in this column, while the impact of $$$ being given to companies in a weak economy is the full monty.

    Finally, you also suggest that the gov stay out of it and let all these weak companies fail. I’ve heard this view espoused by other free-market capitalists before. It has a very warm-and-fuzzy, one-to-rule-them-all feel to it (no gov ever! yeah!). AFAIK, this was tried before though and led directly to the Great Depression. Whether it would work in this case is a question that will never be answered, but it is clearly the view of the administration that this is not the road to travel right now. As disaster appears to have been averted, at least for now, I have a hard time arguing with them on this point.

  14. These tax “adjustments” should carry into the income statement, and thereby into determining bonuses.

  15. There is very little that is new about a corporate net operating loss carryback. The concept is that business cycle profits are not contained within a single year or group of years. For many years , back into the thirties, the rule was back three and forward five.

    The two year carryback rule was a compromise to allow extended carry forward periods. But back three and up five was around for quite a few decades.

    Congress did pass special exceptions allowing five year carrybacks for specific corporations. A notable one was a five year carryback for American Motors. That was more than fifty years ago. Of course the favored company is never mentioned. The law simply allows the exception to a company formed on a specific day in a specific state.

    I am a retired corporate tax officer.

  16. Still just as disgusting, don’t you think??

    It never ceases to amaze me, that whenever pandering Republicans yell out “No new taxes!!” and the easily duped (read teabaggers) coming running to the polls, people never seem to notice which politicians gave/voted corporations that don’t need it tax breaks. All this while the working man’s taxes remain the same and Republicans make nauseating grandstands about budget shortfalls.

  17. I was amazed as a student in the mid fifties at the massive extent of the politics of political paranoia and how political ignorance factors into the problem of the income tax. One certainly may manipulate the ignorance for political ends. Certainly the astute taxpayer does the same. But the income tax is an ultimate mischief maker. It is literally impossible to statutorily define net income and the carryback question goes to the very heart of the issue. What is the measurement period to determine a net income? The natural period of the business cycle is different for every business and kind of business. A great example from my own career was the natural business cycle of starting, constructing and completing a nuclear power plant. One can easily book profits that turn to a loss on a ten year project that breaks even. Just an example that actually happened. In reality, this project was treated for tax purposes on the completed contract method. Then, the rules changed in 1986. My point here is the project time factor and the morass of percentage completion for determining income recognition. There are huge changes that suddenly kill a long term job and sometimes it takes years to determine a mere change order in real life.

    Every business has a different natural cycle.

    The usual retort to the above question is that accounting principles allow the annual measurement. That is why we have such massive sets of regulations and cases in trying to arrive at a single number for a year. Taxable income after net operating loss carry forwards or effectively and amended tax return applying a net operating loss carry back.

    Add to the that the absolute fact that taxes are utterly adversarial if audited or litigated. The government against the taxpayer and the taxpayer against the government. The IRS is always adversarial in as powerful a manner as they can establish. They even choose to follow or not follow a line of cases until compelled to by the Supreme Court. Even then they
    construe the facts to their benefit and we do the same.
    The way it poorly works.

  18. Just an added thought. Bruce Bartlett and Stan Collender have a lot of good stuff about taxes on their blog. Their latest post busts a Republican in Virginia (Frank Wolf) for spending taxpayer dollars for self-promotion. http://www.capitalgainsandgames.com/blog/stan-collender/1253/rep-frank-wolf-spends-taxpayer-dollars-money-tell-us-he-wants-stop-spending

  19. in 2012 obama wants to say he reduced the deficit.

    so he probably wants to make the deficit really high now.

  20. Great stuff Jerry J. Hope you visit and post on “Baseline” more in the future.

  21. my understanding is that under current tax law there are ways a bankrupt company can sell its unused operating losses for use as tax credits anyway. anyone knowledgable care to comment?

  22. Monetarists (Austrian-school economists – think Ron Paul) would argue that letting businesses fail led directly to the mini-depressions of the late 1800s and of 1926-7. Monetarists would further argue that the Great Depression was caused by reflationary fiscal policies – just like Japan’s “lost decade(s)”.

  23. Gee, James, we’re all so surprised that, at every turn, we are assisting the oligarchs maintain the oligarchy. Talk about return on investment. Talk about screwing all of those individuals filing for bankruptcy and being foreclosed because of the supported economic tyranny of the oligarchy. This is just one more scary fact in a scary universe. Maybe we’d truly be better off in China. At least they are honest about hiding things and restricting freedom.

  24. I notice James has EconLog on the blogroll now. Our little James is so impressionable. The Yalies’ fetor is already starting to rub off.

  25. I think there is some clear value in both carry-forwards and carry-backs.. probably both on a diminishing-value scale. They help stabilize business cycles.
    What rankles, however, about this one is that it was directly purchased after-the-fact from politicians. I don’t know if there has ever been corruption in the US on the scale it exists today, The form is more subtle, not as crude as direct bribes of 100 or so years ago, but the amounts of public money involved are far greater.

  26. We will not really get a handle on the extent of actual net operating loss carry-backs to 2003 and 2004 by the big financial institutions until after release of the 2009 annual report. You certainly are able to get at least a peek at the banker fright from detailed analyses of the 2008 Annual Report Tax Provision details.

    I looked at quite a few big institution tax provisions 2008 annual report and many had a Currently Payable Federal Tax Provision and quite a few had Currently Refundable Federal Tax Provisions.

    It was clear to me though that there was sizeable repatriation of foreign earnings in 2008 which , of course, were fully provided for. The crisis hit in September and many net refundable current provisions were far less than one would expect and the deferred provisions were reductions. That suggests earnings were repatriated out of desperate need.

    Another aspect of the tax carry-back mine is that many big institutions had low currently payable provisions in 2003 due to carry-forwards from 1999-2001 losses being applied.

    While we will not know for sure until next spring but 2009 carried back to 2004 probably represents the big gold mine based on tax planning in 2009 .

    I fully expected a five year carry-back law change under the circumstances.

    On the other hand, the Federal Reserve Banks bought almost $800 bn of mortgage backed securities they carry at 100 on their books from member banks. The sale proceeds to the banks simply sit in their Reserve Demand Deposit Accounts earning 16 basis points. This suggests that the banks have little or no realized tax losses on the sale of these mortgage backed securities to the Federal Reserve Banks. They sold at par to keep frozen funds at the Fed unless the Fed sells these same assets back to the member banks. Barring settlement in currency, of course.

    There is a huge story here that has seen little investigation by the financial press.

  27. That’s why I said before Gretchen Morgenson needs to follow this up and see who wrote the tax break into the bill and who supported it and look for connection to the home-building lobbyists on K Street. I guess she (or her Editor) will drop the ball on this. “Follow up” stories are just for celebrity news now.

  28. The really big numbers in terms of carrying back to 2004 are the big financial failures that were bought by bigger institutions. I mean the corporate groups that disappeared into larger corporate groups. All of the failed corporate groups must have tried to recognize all the income they could and losses to insure maximum carry back ability in their consolidated final return. The corporate acquisitions would not close until all desired tax position triggers had been accomplished.

    I speak here of the dead mortgage giants and corporate groups like AIG. In all these cases the Federal takeover planning made sure the current affiliated group was not broken.

    In my view, it was the Treasury itself that most desires a five year carry-back. The Treasury and Fed understand that these big financial group tax refunds are back door financing to keep them going. A huge tax refund reduces direct funding via Congress and reduces the political gnashing of the teeth .

    Every takeover by the Treasury was deliberately structured to acquire less than 80 % of voting stock control. That 79.9 % stock deal is elementary tax planning. It is the chance to trigger hard inside basis on all kinds of foreign assets in particular offsetting triggered losses to the point where losses remaining just about cover carry-back availabilities.

  29. So the builders get cash in the form of a tax loss carryback. I get it. Doesn’t make it a good use of limited tax dollars in a glutted marketplace. Housing subsidies are what got us into this mess, remember?

  30. So what are you saying is the story here? Is it that the banks entered into fictional transactions with the Fed to boost their reserves? IOW, the Fed bought $800 billion of MBS at par to preserve both the solvency and capital ratios of the banks, when everyone knows those securities weren’t worth par. The loss exists somewhere, and at this point its on the balance sheet of the Fed. Are you saying the banks would like to somehow book the (imaginary) losses on these bonds for tax purposes?

  31. It depends on how you define fiction. Look at the Federal Reserve Bank Consolidated Balance Sheet this week. Member bank and primary dealer Reserve Deposit Accounts aggregate around $1.044 trillion compared to an average before September 2008 of less than $10 billion .

    Ask yourself this as a member bank this question. If we all took our deposit down to near zero, what property would we be given to pay us off? There are only two legal choices. Both are practically absurd from the traditional view of a cash or equivalent. Obviously, assuming enough currency was on hand, you could be provided with Federal Reserve Notes. But that would be moot because how could $1 trillion of FRN’s be used in the present banking system. The other solution is that the Federal Reserve Banks sell their mortgage backed securities plus some other assets and utilize the proceeds to wire funds to the banks taking down their reserve accounts. The banks must find a buyer for the entire $800 bn of mortgage backed securities they own and carry at 100. Even a small loss would destroy the Federal Reserve Banks entire equity of a little over $50 bn.

    My point here is to show that the present total of Reserve Deposits of member banks is really very much illiquid and only technically a cash and equivalent as shown in line 25 of Table 8- the combined bank balance sheets presented on the Fed website.

    Last week the Fed Table 8 Cash and Equivalents was $1.2 trillion including $1 trillion of Reserve Demand Deposits at the Fed.

    A lot of “frozen assets” are shown as cash and equivalents on the bank balance sheets.

    Look at footnote 4 on the Fed consolidated weekly balance sheet. ” Guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Current face value of the securities which is the remaining principal balance of the underlying mortgages”.

    If you go back to before September 2008, bank cash and equivalents on Line 25 in Table 8 were around $250-$300 bn with included Reserve Demand Account totals averaging less than $10 bn. That $10 bn tended to be covered by daily asset sales or currency issued and was very small.

    My sole point is to show that there is around $1 trillion of”practically frozen” liquidity on the banks books. That liquidity might be said to have been “a mere reclassification entry” on the bank’s books. Debit cash and equivalents $1 Trillion Credit illiquid Mortgage Backed Securities and Agencies $1 trillion.

    The Fed could do nothing more to stop the bank panic a year ago. It looks like the ploy worked due to the intervening asset ” Central Bank Liquidity Swaps”. The transaction was not fictional. The securities were bought by the FRB’s and sold by the banks. Just think of the freed up valuation reserves . Were these transactions really just a vast longer term repo where a legal sale occurred with a presumptive separate repurchase at par by the banks?

    At best this is a sequestered demand deposit.

    I am not a central banker but a retired tax accountant. I would love to be enlightened about why the post September 2008 Reserve Demand Deposit of member banks is a cash equivalent. Every accountant I raised this question with were stunned by the implications that these balances were not freely employable capital for any investment member banks cared to make. Certainly a small portion is freely employable… a very small portion at that.

    I have found nothing written on this conundrum since the FRB’s began buying mortgage backed securities.

  32. Who would be the best person to ask??? Someone with prior experience at the Federal Reserve or……….? It seems what you’re saying is true, but honestly 80% of it is over my head. Mike Konczal is good at crunching numbers, maybe you can e-mail him and see if he responds.

  33. For now let’s see what shows up here.

    Actually, the central bank transactions are not that difficult if the mind set is changed to the central bank being a bank for banks only.

    For starters, compare a simple commercial unsecured loan by a bank to a commercial customer. Normally it starts out with a credit to the customers checking account. A simple bookkeeping entry. Debit loan receivable from Customer $1 Credit Demand Deposit of customer $1 The bank does not need to cover the loan until the customer writes a check on his demand deposit account for $1. Then the bank needs live funds to transfer $1 to the bank of the payee of check.

    Well , all that happened at the Federal Reserve was that the FRB bought near $800 bn of mortgage backed securities and credited the member banks reserve demand deposit account.There it sits and sits and sits for a whole year now if you include the Central Bank Liquidty Swap period as well. Prior to September 2008 the FRB’s paid no interest. Special legislation was needed to pay interest. They pay 16 basis points. The FRB’s bought mortgage backed securities with an interest average somewhere around 4% or a bit more net of servicing costs held back.

    From a forensic accounting perspective you must note two things. First. The member banks are sitting on payments for $800 bn and not transferring the funds. Second. The interest spread is not showing up in the equity of the FRB’s. But , it is showing up most likely in the general demand deposit account of the Treasury. Virtually all FRB profits effectively escheat to the Treasury. The net interest spread on the mortgage backed securities should be around $ 10-15 bn and indeed the increase in the Treasury demand deposit account is commensurate with such an observation with an year over year increase of near $13 bn.

    Now , why would the banks forgo $13 bn in exchange for less than $1 bn? And not even take down their Reserve Demand Deposit account to as near to zero as possible? Prior to September 2008, the banks took down their Reserve Account to absolute minimum for the preceding 95 year history of the Federal Reserve System.

    I see no commentary on this and wonder why?

    As in my prior post, what property would the member banks receive if they took their reserve demand deposit account down to effectively zero as they always did before? In the past, outside of posted daily net clearings charged or credited to their account the member banks tended to turn in or settle out with currency.

    As an aside here, if the Federal Reserve loaned money to the bank, they would ship the value in currency to the bank to increase their vault cash as they did in 1933. Otherwise, the FRB sells Treasuries to settle the loan with proceeds from sale of the Treasuries. But these were always peanut numbers: low billions to millions and as a loan to a given bank. Here we have $1 trillion and counting from many banks as policy.

    It is an exercise in humor to go through what happens in very short order if indeed the member banks took out currency of $1 trillion. The humor goes well beyond the fact that printed currency stock on hand is less than less $200 bn.

    That leaves selling mortgage backed assets which is patently absurd since they would be required to be at
    100 . The only buyer would be the very banks trying to cash out their Reserve account.

    If you cannot draw down the funds in a bank account you have loan receivable and do not have “cash”.

    Would you consider a one year post dated payroll check as money in the bank? Well, the Federal Reserve Banks must now be doing just that.

  34. Fascinating how the simple mechanism of double entry bookkeeping reveals the illiquidity within the system. The so-called “massive” reserves at the banks aren’t being lent because they aren’t real. Any attempt to lend them AS CASH destroys the Fed’s equity account.

  35. This is of course a 33 billion dollar giveaway. The fact that the government will get less tax revenues from THESE companies in the future does not mean that the government will get less tax revenues in total, unless you believe that these companies are the only ones that are capable of ever building a home. This is a completely undeserved windfall for companies that mismanaged themselves into what should be extinction. This is the same kind of moral hazard that was created by saving the banks that should have failed over the last couple of years.

  36. The Fed’s equity would only be destroyed if they sold the mortgage backed assets at a loss. If the entire Reserve Demand Deposits were brought down to zero by sending cash to the banks, the Federal Reserve Notes outstanding would increase by a like amount. This is actually a permitted action because bank vault cash today considerably exceeds reserve requirements.

    The entry would be Debit Reserve Demand Deposits $1.044 Trn and Credit Federal Reserve Notes Outstanding $1.044 Trn.

    Of course , we are not China where there are almost no personal checking accounts. Consequently, the FRN’s would get deposited and turned back in by the banks . Thus,their Reserve Demand Deposit Account increases.

    There is an out here but it would take a law change allowing electronic funds for general circulation on the same basis as currency. I can find no central bank monetary system that allows general circulation of electronic funds. But , if it were allowed, those Reserve Demand Deposits would easily go to zero as fast as the banks could place the funds.

    When I discuss this with other Green Eyeshade types, I call these new general circulation electronic funds ” Electronic Gold Funds. All it takes is a parallel account the same as Federal Reserve Notes Outstanding.

    So , absent the ability of central banks to issue circulating electronic funds , the monetary system is frozen out of any action other than issuing currency and very short term other devices until the short term devices are absorbed by increased daily levels of outstanding Federal Reserve Notes.

    The reality is that the Federal Reserve is hog tied. The system was designed when US money needs were as heavily cash as China is now. I received a pay envelope and so did my wife as late as 1959. Very few people had checking accounts sixty years ago. They bought money orders if they did not pay in person. Most bills were paid in person.

    Just to show how parlous the cash position is at the banks, last week bank cash and equivalents was $1.209 trn. Included were Reserve Demand Deposits of $1.044 trn. The total included vault cash which has recently been around $50 bn. That leaves other cash to use for loans of $115 bn. Much of this number must be relationship invested with other banks and would not be loanable. That means the banks loan daily net cash inputs , if that. In short, they can loan repayments of principle they get in and not much more plus net increased deposits.

    But my only real point here is that the Cash and Equivalents of banks is only technically so. There is no real liquidity in the banking system unless they sell off their Treasuries. Given the need to raise around $100 bn a month at the Treasury, they dare not dump Treasuries to loan to business.

  37. This is so disgusting that I could puke blood. Why bother doing good anymore?

  38. No need to puke blood. The current net operating loss deduction section goes back to 1935. Section 172. Just for flavor, net operating losses of commercial banks had a special net operating loss carry back for losses caused by bad debts of ten years . Section 172 (b)(D). This was in effect for years beginning after 1986 and before 1994. There have long been special situation loss carry back provisions in Sec. 172. Individuals have net operating loss carry-backs too applied at the adjusted gross income level. Those too go back to 1935 as a genesis point.

    There were loss carry forward provisions going back to the 1918 Act as I remember.

    Besides, the big banks got a special basis rule suspension in order to facilitate the big mergers of banks and investment banks last year. This was done by Revenue Ruling and was not even a law change. That was far more important than these carry back changes to the big guys in the financial system.