Pfizer and Allergan called off their $150 billion merger this morning. What caused these two companies to call the whole thing off?
The headline reason for not going through with the transaction was that the Treasury Department changed the rules on tax inversions. A tax inversion is a situation where a US-headquartered company, in this case Pfizer, merges with a non-US-headquartered company, in this case Allergan, so that the combined company can locate its headquarters outside the US (in this case, Ireland) and pay a lower corporate tax rate.
According to the New York Times, “Pfizer said that the companies determined that the latest rule changes qualified as an ‘adverse tax law change’ under their merger agreement.” In other words, the two companies weren’t going to gain any tax advantages by combining so why bother going through with it.
This highlights an important question: why do firms merge instead of staying separate? Nobel laureate Ronald Coase proposed an answer in 1937: transaction costs. There are costs to coordinating the actions of firms in markets including contract costs and the like. Similarly, there are costs to taking those same actions and carrying them out within the firm such as hiring additional personnel. All of these are transaction costs. Firms combine when transaction costs are lower in-house, and don’t if transaction costs are lower in the market.
Tax inversions changed the balance between the transaction costs of market coordination and mergers. If you can merge with another company and lower your total tax bill, and everything else can stay the same (worker costs, capital costs, etc.) then you should go ahead and combine the firms. In the case of Pfizer and Allergan, once the tax incentive disappeared, it made more sense to stay separate.
The Obama Administration made the right call. Firms should consider mergers on the basis of transaction costs that are directly related to their businesses, not to tax considerations that artificially tip the balance towards mergers. The latter simply creates business opportunities for tax lawyers, tax accountants, and lobbyists without creating any value for society. My guess is that members of those professions can do more productive things and still earn comfortable livings.