The GAAP Lock-Out Effect and the Investment Behavior of Multinational Firms

This paper looks into the investment behavior of multinational firms with respect to their locked-out foreign earnings. The focus is on multinational firms subject to credit and deferral home-country taxation such as that of the United States. “Locked-out earnings” refers to the earnings of a foreign subsidiary that are reinvested abroad against the firm’s own real income (present value) interest to avoid the repatriation tax and the associated GAAP “penalty” or for any other reason. The paper extends the existing theoretical models beyond the optimal repatriation-versus-retention point to argue that from a real income perspective the primary choice of investment for locked-out earnings is no longer a function of the investment’s profitability, but of the type of the investment (active or passive) and the stage of its maturity as proxies for whether the returns on the investment would be repatriated. One example is that investing locked-out earnings in passive assets generally generates greater present value to the firm than does investing such earnings in the tax- and GAAP-advantaged, even if higher-returning, active assets. This in turn magnifies the conflict between real and book income considerations and can lead firms to act against their own real income interest also when reinvesting locked-out earnings, thereby generating efficiency costs not yet identified, both to the firms and to the economy in general. Identifying such distortions also reveals the misconception in downplaying the social efficiency costs associated with the lock-out effect