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E-MailJames Albertus is an Assistant Professor of Finance at Carnegie Mellon University, Brent Glover is an Associate Professor of Finance at Carnegie Mellon University, and Oliver Levine is an Associate Professor of Finance at the Wisconsin School of Business. This post is based on their recent article forthcoming in the Journal of Financial Economics.
Prior to 2018, U.S. multinational corporations faced a repatriation tax on foreign profits they chose to send home to their U.S. parent. As a result, many corporations chose to defer this tax and accumulate overseas profits within their foreign subsidiaries, with the hope of a future tax holiday or reform. That day came in late 2017 with the passage of the Tax Cuts and Jobs Act (TCJA), the signature tax bill of the Trump administration. Among other significant provisions, the new law substantially reduced the repatriation tax rate on these accumulated foreign profits. The change gave corporations immediate access to at least $1.7 trillion in previously considered “trapped cash”.
What did corporate executives do with this newfound liquidity? Proponents of the TCJA suggested that this would spur investment and hiring in the U.S. by providing access to cheap capital. Others argued that the reform was simply a tax break to shareholders who would see increased equity payouts.
Using detailed confidential data from the U.S. Bureau of Economic Analysis, we estimate the response in firms’ real business activity and financial decisions to this sizable liquidity shock. In short, we find no evidence that companies responded to the increased access to cheap capital by increasing investment in the U.S. as measured by capital expenditures, wage expense, R&D, and M&A. Instead, executives increased payouts to shareholders. For every dollar freed by the reform, about 30 cents was paid out to shareholders over the next two years, primarily through share repurchases.
However, despite an increase in shareholder payouts, much of the residual freed cash—about 48 cents on the dollar—was simply retained inside the firm, not used for investment nor payouts. No longer restricted by tax penalties, why didn’t these firms pay out more?
Understanding the Muted Response to a Liquidity Shock
Finance theory suggests that the firms’ response to a liquidity shock depends on whether it is financially constrained. A constrained firm would be expected to increase investment, as its cost of capital is reduced by increased access to cheap internal financing. In contrast, an unconstrained firm’s investment would be unchanged, as its cost of capital has not decreased, and well-behaved management would be inclined to return this excess liquidity to shareholders. The lack of increase in investment, even among the subset of firms estimated to be more constrained, suggests that financial constraints are not a significant concern for these firms.
However, firms chose to only pay out about one-third, and retain one-half, of the new liquidity. If these firms are unconstrained, what explains the high level of cash retention? One possibility is that executives have a personal incentive to retain this cash for the private benefits that it provides. For example, executives can make spending decisions without the oversight that accompanies external sources of financing. We test this possibility using the concentration of institutional ownership as a proxy for the strength of corporate governance. However, we find no differential response in payouts, cash retention, or real investment based on this measure of governance. This is consistent with our other findings that M&A activity does not increase in response to the increased access to cash, an investment channel that is prone to misuse. Together, we do not find evidence that the high cash retention is due to agency conflicts.
We consider two additional possibilities that we test in the data. First, we explore whether firms are using this foreign cash for operational reasons. We do not find this to be the case. Second, we consider whether the response was slow and not fully implemented within two years. After extending the period of study through 2021, we still find a similar response in total payouts. A caveat, however, is that this extended sample coincides with the Covid-19 pandemic, a period in which firms actively sought to increase liquidity.
Interpreting the Findings
Taken as a whole, our results are difficult to reconcile with basic theory. If firms are unconstrained, and well-governed, why is so much of the freed cash retained inside the firm? There are a few possibilities.
While these firms are not currently constrained, they may still wish to retain a high level of cash to protect against cash shortfalls in bad states of the world, i.e. a precautionary savings motive. Gao, Whited, and Zhang (2021) show that firms may hold cash to lower the cost of borrowing, potentially reconciling why firms hold large amounts of cash while simultaneously issuing debt.
It is also possible that executives do not have a tight target for cash holdings. For instance, Graham and Leary (2018) find that much of variation in cash can be explained by cash flow shocks, suggesting that management does not respond sharply to changes in cash ratios. A similar lack of active adjustment has been found with respect to leverage (Welch, 2005). This loose targeting of cash holdings could be evidence that executives are disregarding the negative effect of suboptimal cash management on shareholder value.
However, it is also possible that executives’ muted active adjustment of cash could be an indication that cash holdings policy has only minimal effect on shareholder value. As with other economic trade-offs, optimality implies that marginal costs are equated with marginal benefits. For a relatively unconstrained firm, the marginal benefits of cash are likely small, as the likelihood of a future shortfall is low. At the same time, the marginal costs of holding cash for a well-governed firm may also be quite small. If management is not misappropriating this resource, and the tax costs of holding financial assets inside the firm are similar to outside the firm, the costs of holding cash will be small. Indeed, the TCJA significantly lowered the tax penalty for holding cash inside the firm, a byproduct of lowering the corporate income tax rate relative to personal tax rates. If both the marginal costs and marginal benefits of cash are small, cash holdings decisions become unimportant to shareholder value.
