This is part 3 in a series. Here are Part 1 and Part 2.
Tax Shields
The organization of the knowledge economy is inclined towards creating great tax advantages. Both start-ups and mature companies enjoy huge advantages that the resource economy does not enjoy. Most investments can be expensed. The companies grow fast enough that they create huge tax losses, even as they create extraordinary value for the owners. Once they become mature global companies, their assets can be transferred almost costlessly to whatever jurisdiction offers the most favorable treatment. Transfer pricing makes it almost impossible for authorities to tell where value was added. Money generated off-shore can stay off-shore tax free indefinitely. In contrast, resource economy companies have easily traceable assets, some of which require particular locations and may be quite literally fixed to that location. Their assets are comparatively easy to tax, whatever form their assets take.
If this is the case, it follows that knowledge economy companies have huge tax shields from their operations. To have these tax shields add value to the business, the CFO of a company needs a business that is low risk, earns the cost of capital after tax, and does not consume much management attention. Investing in marketable securities seems like just the ticket. The gain on securities allows the owners of the company to take advantage of the tax shields that would otherwise go unused.
Here is what we’ve been looking for all along. A reason why cash is better off in the pocket of the company than in the pocket of the owner. In addition, all the other reasons why a firm might hold so much cash are still active and valid. Full use of tax shields would be a driving factor for keeping cash on the balance sheet. The discount rate for tax shields is low and even if only gets used every few years, it adds to the wealth of the shareholders. For a founder, cash on the balance sheet capitalizes an otherwise unused tax shield, provides diversification, defends the core business, and enhances the value of R&D investments by its mere presence.
The question for further study would be when we would expect to see these benefits diminish? Can we empirically test which of these hypotheses are most important in guiding payout policy?
