How Did This One Make the Cut?

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 Homes (PHM) will receive $450 million in refunds. And Hovnanian (HOV), 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?

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About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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