Market Analysis

Can Korea Tax Its Way to Business Investment?

Korea's plans to goose business spending by taxing the cash on corporate balance sheets probably won't work out so well.

Korean President Park Geun-hye is on a quest to goad big firms into spending more. Photo by Getty Images.

Here's a popular refrain on both sides of the Atlantic: When will corporations stop hoarding cash, start investing, raise wages and make our economies grow faster? US and UK firms have nearly $3 trillion in cash and other liquid assets, and many folks are convinced that if they just started spending this mountain of idle money, we'd all be way better off. On the other side of the world, the IMF is yelling at Japanese firms to "unstash Japan's corporate cash." A similar chorus has rung through Korea for years, and earlier this month, officials announced plans to do something about it (uh-oh): a tax on the biggest firms' cash balances. While they get points for realizing that if you tax something you get less of it, I can't see how this is anything other than a big fat headwind for firms-and it's highly unlikely they splish-splash more cash through Korea's economy.

The whole backlash against corporate cash balances has always confused me and your other friendly MarketMinder editors. One, it ignores fun factoids like all-time-high-and-rising US business investment. And five straight quarters of gangbusters business spending in the UK. And new highs in Korean investment. And record-high real GDP in all three countries. And ... ok maybe not Japan. But you get the point. Two, it ignores all the other factors that influence wages, like supply of and demand for labor. Three, it ignores why firms stash cash in the first place. There is a reason cash balances have soared since 2008, and it isn't greed-firms realized having a big buffer can help insulate them during a downturn. Staying liquid is just good sense.

But a factual analysis of the situation isn't popular in political circles. Especially in Korea, where "economic democratization" was the theme of 2012's presidential campaign. The winner, Park Geun-hye-from the nominally business-friendly Saenuri Party-promised to make Korea's mega-conglomerates (known as chaebol) do more to support the domestic economy. She demurred for her first year and a half in office, but after some indicators slowed (and her popularity ebbed) in the wake of the Sewol ferry disaster, it was time to take action. When her government announced a $40 billion stimulus package in July, they promised to tax corporate cash balances to goad them into investing more, paying more dividends and hiking wages.

A couple weeks ago, we got the details: The largest 1% of Korean firms-about 4,000 companies total-will face a 10% tax on net profits if they don't dish out somewhere between 60% and 80% of net income on domestic investment, dividends and salaries. Based on current earnings and corporate spending data, one Korean research firm estimates the 10 biggest chaebol would owe over $1 billion total in the first year. On the surface, that would seem like a big incentive to spend, spend, spend-if they can't keep the extra dough anyway, why not just spend it as they see fit instead of forking it over to the government?

But as ever, theory isn't real life. Like I said, corporations aren't holding cash for fun. Or out of greed. A lot of it is just plain risk management-Korean firms still remember the pain of the 1997 financial crisis, when several chaebol went under. Companies also have a fiduciary duty to shareholders, so if that cash were sitting there for no reason, we'd see a heck of a lot more shareholders demanding management give them a slice through dividends or buybacks. Or demanding more investment to convert that cash to higher earnings down the road. But many shareholders seem more or less content with the status quo, which is a strong indication they don't think reserves are being mismanaged. Which makes perfect sense when you take a closer look. Many of the chaebol specialize in high-tech manufacturing-a pretty darned cyclical industry. They need flush reserves to carry them through the rough patches when demand for gadgets and cutting-edge appliances plummets.

Compounding matters, it isn't always in shareholders' best interests for companies to concentrate their investment in their home country. Korean chaebol are predominantly exporters, which by definition makes them big foreign investors-when you make a bunch of money offshore in a foreign currency, you tend to just invest more there. Korea exports a ton to the US, so they invest a ton here, too. This is hugely beneficial for Korea's high-tech firms. It allows them to beef up their R&D presence in the US-particularly Silicon Valley-where they benefit from being nearer to the world's biggest concentration of cutting-edge tech firms. When technology's creators, makers and users cluster together, you get a marvelous collision of ideas and innovation. Korean firms with R&D satellites here can ride that wave, manufacture more cutting-edge products in Korea, boost revenues and enjoy a virtuous cycle of growth-benefiting shareholders, employees and the entire Korean economy through capitalist magic. But if Korean firms are penalized for investing abroad instead of at home, they become far less dynamic. It borders on protectionism-always a losing endeavor.

So if the proposed tax becomes reality, it probably won't have the desired effect-firms probably won't hike wages and salaries through the roof to stimulate consumption on the government's behalf. Maybe firms shelter more income offshore and don't report it to Korean authorities-sort of like US firms do to avoid double-taxation on repatriated overseas profits. Maybe, if foreign investment does count toward the quota (still under debate), they just keep doing what they're doing. Or maybe they decide spending 1 trillion won more on labor each year isn't worth 100 billion won in tax savings.

Plus, officials should be careful what they wish for. Firms hire, raise salaries and invest if they believe there is a long-term benefit in doing so. If they boost spending simply to avoid the tax, they could easily become overextended, with a bunch of unprofitable endeavors and employees. They could end up like corporate Japan, where employees still spend hours of time photocopying documents because they have nothing else to do. That's bloat and a drag on the entire economy. And it creates a problem far worse than the imagined problem the balance sheet tax aims to solve. That isn't guaranteed to happen in Korea, and it would be a long, slow ebb, but it's a very long-term possibility nevertheless.

On the bright side, the stimulus package does include some useful measures, like a hefty dividend tax cut. Measures announced earlier this year to spur construction, cut red tape and attract investment still remain on track. So Korea has plenty going for it and remains a dynamic, growing economy. The tax is just one potential negative-and one the rest of the world could learn from.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.