A Modest Proposal to Reduce the Federal Deficit

September 6, 2010

Since my last foray into the taxation arena, where I examined the (most probably nonexistent) link between tax collections and growth, proved so interesting, even though it was a purely statistical analysis and nothing to do with tax policy as such, I thought I would make a modest proposal in some actual tax policy directions. As I have had occasion to state in the past, I’m not a macroeconomist, but that never stops anyone else from discussing macroeconomic issues, and it won’t stop me. I have two ideas, one “modest,” and one real.

It has been estimated that every dollar cut from the IRS’s enforcement budget winds up costing the government four dollars in revenues. And so it seems to me that if the IRS’s auditing staff were expanded by 10 or 20 or 40 thousand people, or even more, we could simultaneously lower unemployment and cut the deficit. As such, it is a win-win situation–apart from the fact that it would possibly be the least popular thing this administration could do.

However, one idea that I think is more promising is the elimination of the tax deduction for amortization of goodwill. As you know, goodwill is created when a firm pays more than the value of the assets in an acquisition; it is the difference between the purchase price and the asset value. For many firms, particularly serial acquirers, this can add up to a significant amount. Under current tax law, goodwill amortizes over 15 years.

I suppose the purpose originally was to treat intangible assets the same way as tangible assets, which also depreciate over time. However, as I have had occasion to state before, goodwill is not a “real” asset the way intellectual property or trademarks or brand name recognition are real assets. It cannot be licensed, sold, nor its value otherwise tapped, apart from through the tax deduction itself. Many value investors advocate ignoring goodwill, both on the balance sheet and when it is impaired on the income statement. Our reasons for doing so are quite simple: goodwill represents the theoretical excess earnings power arising from acquiring a company rather than just replicating its assets. If that earning power persists, it will be reflected in the calculation of income and return on assets, and if that earnings power drops, it will also be reflected. Therefore, we do not require goodwill or its amortization to tell us what we already know.

The trouble with amortization of goodwill is that it effectively results in taxpayers subsidizing a merger. This paper found a statistically significant increase in goodwill paid for acquisitions after the tax laws changed to allow goodwill amortization.  Whatever amount of goodwill is created by a merger, the taxable income of the merged corporation will be reduced by 1/15th of that amount every year for the next 15 years, with the rest of us taxpayers picking up the tab. The corporate tax rate in the United States is currently 35%, and considering the massive amounts of goodwill bouncing around the system, the total amount of amortization deductions easily reaches into the tens of billions per year.

Of particular concern is when two firms get into a bidding war over an acquisition target, where prices can be bid up to giddy heights far removed from tangible valuation. In contentious auctions, it is often the case that the winner of the auction is actually the one who comes in second, because he or she has convinced a competitor, the actual winner, to pay too much. However, as the price being bid up generally results in an increase in the goodwill portion of the total price paid for the acquisition, the taxpayer is in effect subsidizing fully 35% of the bid increases.

Furthermore, let us consider that mergers and acquisitions have a history that is mixed at best. Damodaran, in his Investment Fables, tells us that researchers examined a set of mergers between 1972 and 1983, with an eye to two questions: 1, Did the return on the amount invested in the acquisition exceed the acquirer’s cost of capital, and 2, Did the acquisitions help the acquirer outperform the competition. 28 of 58 mergers sampled failed both tests, and 6 more failed at least one. Furthermore, many acquisitions are reversed within short time periods; one study places the figure at 44% of the total with a short lead time, and cited that the most common grounds for reversal were that the acquirer overpaid or that the operations of the firms did not mesh. Over longer periods the divestiture rate has approached 50%. We can all understand the virtue in subsidizing success–if mergers are successful a firm’s taxable income will increase, with the result that the deductible amortization  may be offset in part, in whole, or even in excess, assuming that the additional profits could only have been unlocked by the merger itself. But, if mergers have high odds of not producing the anticipated synergy, taxpayers are essentially subsidizing failure.

This is offensive enough in a normal environment, but it is particularly troublesome in the current environment, where firms are accused of piling up assets and either engaging in or preparing for mergers rather than spending that money on internal investment and hiring. Banks fell under considerable criticism for using their TARP money to acquire weaker competitors back in 2008 and 2009.

In summary, the elimination of the amortization of goodwill would remove the incentive for companies to invest their resources in ill-starred and overpriced mergers, and allow them to focus on building better companies, not merely bigger companies. It would also provide significant deficit reduction at a time when the nation is in great need of it.

One Response to “A Modest Proposal to Reduce the Federal Deficit”

  1. Hmmm, a post about goodwill accounting without that didnt generate discussion… Who ‘da thunk it!?

    Anyways, I couldn’t agree more with your analysis. I became interested in the topic after reviewing the company I work for’s balance sheet and learning about goodwill. I see no justification for classifying it as an asset for financial reporting and amortizing it for tax purposes.

    Since it is essentially the net present value of the future earning of the acquired company, it should be booked as an offset to retained earnings that is then zero’d out as those profits are realized.

    As a CPA, this just further reinforces how shameful I find my profession.

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