Follow the Money

I wanted to follow up on a few points that I didn’t have space to explore in my New York Times op-ed on the international provisions of Trump’s corporate tax reform. The first is that, well, there isn’t any real doubt that firms borrowed against their offshore cash. These funds weren't really offshore: "Of the 15 companies with the largest cash balances—companies that hold almost $1 trillion in cash—about 95 percent of the total cash was invested in the U.S." And it wasn't that hard for firms to borrow onshore against their legally but not really offshore cash in order to pay dividends, fund buybacks, or, if they wanted, to increase their onshore investment. This is well recognized by those who have focused on the impact of the reform on the corporate debt market (see Alexandra Scaggs' summary of Zoltan Pozsar). A set of big technology companies had large (offshore) assets and significant (onshore) debts, and they are now likely to slowly run down their cash balances and pay down those debts. And I suspect it is a big reason why parts of the balance of payments data look a bit funky this year. This is kind of complicated—when firms had large “cash” balances offshore those cash balances showed up in the U.S. balance of payments data as foreign direct investment (the U.S. parent had assets abroad, and the cash balance was an asset of their 100 percent owned foreign subsidiary so it counted as "FDI"). Yet the portion of FDI abroad that was really "cash" abroad was often invested in U.S. bonds. The net effect then was a rise in U.S. direct investment abroad (typically through reinvested earnings) and a rise in the amount of debt held by the rest of the world (a U.S. subsidiary that is legally located abroad isn’t a U.S. resident for balance of payments purposes). So what’s happened subsequent to the reform, which ended the incentive to hold cash abroad to defer a portion of a firms' tax burden until their was some form of tax holiday? Firms have been bringing some of that cash home (so FDI abroad has been falling) and reducing the bonds held by their offshore subsidiaries. We see this for example in the data for Ireland’s holdings of U.S. treasuries, which have fallen by close to $50 billion since last December. Ireland’s holdings here are also down by about $50 billion. The second is that the tax reform’s low rate for global intangibles left a lot of revenue on the table. The IRS now has a wonderful data set showing the global distribution of the profits of U.S. firms—and the global distribution of the taxes they actually paid. The numbers are from 2016, so before the tax reform. But they give some sense of the magnitude.  U.S. firms earned around $900 billion in the United States ($870b), and paid about 20 percent of that in federal income tax ($175 billion or so). Even before the tax reform, U.S. firms generally weren't paying close to 35 percent of their profit in tax. U.S. firms earned around $225 billion in a set of high tax jurisdictions around the world, and paid about $70 billion in tax—for an effective tax rate of over 30 percent. This includes the high taxes that firms producing in oil states often pay on their earnings, as they pay special income and production taxes and the like. And U.S. firms earned $325 billion in the world's low jurisdictions (I included the $39 billion U.S. firms earned in Puerto Rico here, as Puerto Rico functions as a low tax jurisdiction for the pharmaceuticals industry; I also added in the "stateless" income here). They paid less than $15 billion in tax abroad on those profits, for an effective tax rate of 4 percent or so. The residual U.S. tax they owed was deferred, so there was no cash payment in 2016 (the tax act settled that deferred liability on those profits with a one time 15.5 percent tax on offshore cash balances, net of any tax actually paid abroad). Bottom line: U.S. corporate earnings in the main offshore centers, whether computed using the balance of payments (see my New York Times piece, which has some awesome graphs) or the IRS data, are now about 1.5 percent of U.S. GDP, or about $300 billion a year.  The new law taxes these profits at about 10.5 percent (the new global minimum tax rate on intangibles, or GILTI), or less if a firm has significant tangible assets abroad (the IRS data incidentally has numbers on tangible assets abroad).    The low 10.5 percent rate leaves a lot of revenue on the table. The United States should get most of the difference between the 4 percent pre-reform effective tax rate and the 10.5 percent rate (or it would if the minimum was enforced on a country by country basis). But raising the tax rate on profits offshored to low tax jurisdictions could raise substantial additional revenues. If you assume that offshore profits in tax havens will grow at 5 percent over the next ten years, increasing the tax rate to the 15.5 percent tax rate used to settle firms deferred tax liability under the old law would be estimated to raise something like $200 billion over the standard ten year horizon used to evaluate the impact of tax changes on revenues. OK, a bit less because the GILTI is set to rise to 13.125 percent after 2026, so my estimate is an estimate against a current policy rather than a current law baseline. Moving to a system of global taxation at a 21 percent rate assessed on a country by country basis (the details matter) might raise close to $300 billion over ten years. That simple calculation leaves out the impact of raising the GILTI rate to 13 percent, but it also leaves out the gains from moving to a higher tax rate on intangible exports—and thus removes another tax break built into the new law. Third, there is actually a bit of concrete evidence that firms have been shifting more production offshore as a result of the new tax law, or at least playing transfer pricing games more aggressively to move profits offshore. I have long suspected that tax has played a role in explaining the large (and rising) U.S. trade deficit in pharmaceutical products. And the trade deficit in pharmaceuticals looks to have jumped in 2018. Guess where the bulk of those new imports are coming from?   There could be an innocent explanation here. A big new patent protected drug came on market and it just so happens that the relevant firm had long-standing plans to produce that drug in Ireland.  But it certainly doesn’t seem—based on the trade data showing a $20 billion jump in the pharmaceutical trade deficit in the year after the tax reform—that incentives to produce certain drugs offshore so as to transfer the profit on those drugs to a low tax jurisdiction have gone away. And it's at least possible that Rebecca Kysar’s prediction that the tax law would create incentives to shift tangible assets abroad—and to low tax jurisdictions—is already playing out. More tangible assets (factories) offshore means a lower calculated minimum tax on your offshore intangible income (the patents and the like on a new drug, for example). One last point. Profit shifting isn’t just a function of the U.S. tax law—it is a function of the U.S. tax law and how it interacts with global tax rules and the national tax systems of key corporate tax centers. Firms aren’t interested in shifting profits from the United States to Germany—and they wouldn’t be paying the GILTI (the global minimum) if they actually were paying Ireland’s headline 12.5 percent rate. And, well, I am not sure that much progress is being made globally. A few years ago Ireland promised to phase out the “double Irish”—a tax structure that involved passing profits between two Irish subsidiaries, only one of which was a tax resident of Ireland—by 2020. So there was hope. But, well, it seems like foreign multinationals operating in Ireland have found a new tool—the “green jersey” (which formally uses Ireland’s “Capital Allowances for Intangible Assets “ law). Apple seems to have pioneered this tax structure—as I understand it, Apple moved some of its assets to Jersey, then had its Irish subsidiary buy the rights from its Jersey subsidiary using funds that it nominally borrowed from its Jersey subsidiary. And then it could depreciate the purchase cost against the profits in its Irish subsidiary. It was no longer a tax resident of nowhere (Apple had a unique arrangement, as Ireland viewed Apple Ireland as a tax resident of the United States while the United States viewed it as a tax resident of Ireland and no one collected tax). It was a tax resident of Ireland, but one taxed at a low rate. Other tech companies are apparently following suit. Ireland is happy too; Irish corporate tax revenues are actually booming (they get a bigger cut out of Apple and perhaps others). The best source I have found for all this is Wikipedia. The jargon can be daunting ("CAIA", "BEPS"), but the result is clear enough—a very low effective tax rate (emphasis added).  “…the CAIA BEPS tool in particular, which post-TCJA, delivered a total effective tax rate ("ETR") of 0–3% on profits that can be fully repatriated to the U.S. without incurring any additional U.S. taxation. In July 2018, one of Ireland's leading tax economists forecasted a "boom" in the use of the Irish CAIA BEPS tool, as U.S. multinationals close existing Double Irish BEPS schemes before the 2020 deadline.” So, best I can tell, neither the OECD’s base erosion and profit shifting work nor will the U.S. tax reform end the ability of major U.S. companies to reduce their overall tax burden by aggressively shifting profits offshore (and paying between 0-3 percent on their offshore profits and then being taxed at the GILTI 10.5 percent rate net of any taxes paid abroad and the deduction for tangible assets abroad). The only good news, as I see it, is that the scale of profit shifting is now so big that it almost cannot be ignored—it is distorting the U.S. GDP numbers, not just the Irish numbers.* And in my view, the current tax reform’s failure to change the incentive to profit shift will eventually become so obvious that it will become clear that the reform itself needs to be reformed. * Seamus Coffee has estimated that the depreciation of intangible assets added an insane Euro 40 billion to Ireland’s gross national income in 2018: “Projections from the Department of Finance indicate that this will be more than €40 billion in 2018.” Ireland's (inflated) GDP is just over 300 billion Euros.      

Germany’s economy is slowing by more than can easily be explained by the obvious slowdown in exports (see Gavyn Davies, who, to be fair, believes there were some one-off drags to German growth in h2 2018). Germany ended 2018 with a fiscal surplus of something like 1.75 percent of its GDP. Germany has under-invested in public infrastructure for years. See Alexander Roth and Guntram Wolff of Bruegel: "since the 2000s, Germany has exhibited very low and even negative public fixed net capital formation ratios—below most other European countries." And President Trump has a point when he criticizes Germany's failure to meet its NATO defense spending commitments. Germany’s coalition agreement implies a modest stimulus this year. But Germany has a history of delivering less stimulus than many expect. The IMF has been forecasting Germany’s fiscal surplus would fall for many years now, yet the surplus has kept on rising.* This time may be different, but, well, Germany needs to prove it…and frankly it should throw in a bit of extra stimulus now just to make sure.    The German finance ministry's worries that Germany's scope for stimulus is limited—because it might possibly run a deficit of well under a percent of GDP in 2023—just aren't that convincing. Shahin Vallee has noted that Germany's finance ministry has a recent history of systemically underestimating revenues, by something like half a point a year.** In 2017 and 2018 the argument that Germany needed to stimulate essentially rested on the need to move toward a more balanced global economy, and the value additional German stimulus would provide to its trading partners. Demand growth inside Germany was solid, and the German economy was humming off the combination of okay domestic demand growth and solid external demand. The hope was that a bit of stimulus (or a less restrictive fiscal policy if you prefer, as Germany could provide a positive impulse to demand while still running a budget surplus) would spill over to Germany’s partners through higher German imports. And maybe help to support ongoing wage growth in Germany too. Now, well, Germany itself has clearly slowed, and its economy could use a boost. A sharp deceleration in growth caused in part by a weakening of external demand provides an opportunity for Germany to, more or less seamlessly, bring its own economy into better balance by strengthening the economy's internal motor, and thus naturally starting to replace some of the outsized role external demand has played in keeping Germany's economy humming. And there is basically no downside. The stimulus could be financed without any borrowing—Germany just needs to save less.   If Germany did need to borrow a bit, it could do so at a negative real interest rate. Ten year bunds have a yield of 10 basis points right now; even if the ECB consistently misses its inflation target that would still imply a real rate of negative one. Inflation is currently low.  A stimulus could put Germany’s massive excess savings to work at home, and thus reduce the risks that German savers are now taking abroad. Keeping the labor market relatively tight would help German wages continue to grow (real wage growth hasn't been that strong in 17 and 18, judging from the FT's chart), helping to support demand throughout the euro area—and right now Germany’s European partners could use a bit of a lift. A relatively tight German labor market would also help speed up the integration of the 2015 migration wave. Stronger domestic demand growth would provide a bit of insurance against a disruptive Brexit. What’s not to like? (By the way, the same basic argument applies to several other "twin surplus" countries in Europe, including the Netherlands. Dutch growth also decelerated in the third quarter, and the Dutch don't really need to continue to run sizable fiscal surpluses given their low debt levels.) * The IMF noted in its 2017 Article IV (emphasis added) "Fiscal policy was again neutral in 2016, as the government posted its third consecutive yearly surplus. The general government balance climbed to 0.8 percent of GDP—almost a full percentage point higher than planned—, while the structural balance stood at 0.7 percent." The IMF went on to note "In fact, fiscal plans proved overly conservative through the whole post-crisis period, mostly because tax revenue consistently exceeded official estimates." Yet even after noting this history, the IMF still forecast a fall in Germany's surplus in 2017...a fall which failed to materialize (see the chart above). ** I thought the FT jumped the gun a bit in its claim that the euro area has now turned toward stimulus. The biggest stimulus in the FT's chart appears to come from Italy, and, well, the Commission didn't go along with Italy's fiscal plans. The expansion of over a percentage point of GDP appears to come from an October document (the November numbers were similar), and it corresponds with a headline fiscal deficit of around 2.9 percent of Italy's GDP. The final compromise with Italy authorized a fiscal deficit of about 2 percent of GDP. Germany's coalition agreement makes some overall stimulus for the euro area likely given that France clearly isn't going to consolidate in 2019. But, as I noted in the previous footnote, the German finance ministry has a history of underestimating revenues and that has led the Commission to join the Fund in underestimating the growth in Germany's surplus in the last few years. And, well, the aggregate result of the Commission's projections (with the large fiscal relaxation in Italy that was not approved) was a rise in the headline fiscal deficit for the euro area from 0.6 pp of GDP to 0.8 pp of GDP. And with German borrowing costs still falling, a 0.4 pp primary expansion in Germany implies something like a 0.3 pp change in the headline fiscal balance, so a general government surplus that would still be close to 1.5 pp of German GDP...

China, it now seems, has entered into a real slump. There were plenty of leading indicators. I should have given more weight, for example, to the slowdown in European exports to China over the course of 2018. China's total imports remained pretty strong though until the last couple of months. But they have now turned down. Sharply. In a deep sense, China’s slowdown shouldn’t be a surprise. China tightened last year. Goldman's Asia team had a useful chart in an early January paper showing a sharp consolidation in the “augmented fiscal deficit”—and it looks like China’s efforts to slow the growth of shadow banking and introduce a bit of market discipline into lending have curbed the flow of credit to private firms (see Nathaniel Taplin of the WSJ). And China has a history of tightening too much, and slowing an economy that still structurally relies on credit to generate internal demand (the flip side of high savings) whenever it tries to wean the economy off bank and shadow bank lending. Look at the weakness in Chinese imports in the chart above in late 2014 and most of 2015. That’s the last “tightening” cycle. But the extent of the current slowdown is now increasingly clear in a broad set of data, both data from China and data from China’s trading partners. And that raises the question of how a Chinese slowdown impacts the world. There is a bit of good news here—China (still) isn’t that important a market for the rest of the world’s manufactures. China’s overall imports (of goods) are significant, at around $2 trillion. But about a third are commodities, about a third are parts for re-export (think $800 billion of processing imports vs. exports of around $2.4 trillion), and a bit less than a third are imports of manufactures that China actually uses at home. And that means that China matters far less for global demand for manufactures than say the United States. China’s imports of manufactures for its own use (net of processing imports) are roughly a third of U.S. imports of manufactures. Actually a bit less than a third. The United States doesn’t break down its imports for re-export, but U.S. exports of manufactures are so low—only around 5 percent of U.S. GDP—that imports for re-export can largely be set aside. The imported content of U.S. exports is still—per the OECD—relatively low. Bottom line: when it comes to supplying the rest of the world with demand for their manufactures, the United States is still in a league of its own. China remains in the second division. That doesn’t mean Chinese import demand doesn’t matter at all—$600 billion in imports is real money. When China’s imports were rising quite strongly in late 2017 and early 2018 that provided a bit of help to regions around the world with slow demand growth and weak currencies. I am, of course, thinking of Europe in general, and Germany in particular. Europe’s share of the $150 billion rise in China’s manufactured imports (net of processing) from end 2016 to mid-2018 was something like €30 billion—enough to matter. But on the manufacturing side, China's largest impact on the rest of the world continues to stem from its export machine. China’s exports of manufactures, net of processing, are roughly two and a half times bigger than its imports of manufactures, also net of the processing trade—think $1500 billion vs. $600 billion (for 2018). That’s why the recent stability of China’s currency matters. For now (and of course things could change) China isn’t trying to offset domestic weakness through depreciation and a weaker currency. A 10 percent fall in China’s imports is a much smaller shock to global demand than a depreciation that reallocates global demand toward China and raises China’s exports by 10 percent. While a Chinese depreciation would be a negative to shock to the world, China’s apparent willingness to use fiscal tools to restart its economy should be helpful to the world, at least directionally.* It is an inadvertent benefit, perhaps, from the trade truce, and Trump’s apparent willingness to cut a deal, almost any deal, to restart soybean exports and avoid a new round of tariff escalation. Looking only at manufacturing trade of course is too narrow: China is now a very important net source of demand for commodities. It increasingly has the kind of impact on the oil market it once had on the market for industrial metals. China accounted for a quarter of the growth in global oil demand last year. And the United States is increasingly more important as a source of marginal supply for oil—a reversal of its traditional role. The Permian is giving Saudi Arabia's best oil field a run for its money.** Current energy pricing reflects the confluence of expectations of strong U.S. supply growth (in the face of significant reductions in Venezuelan and Iranian exports) as pipelines connect West Texas to the Gulf of Mexico—and weaker demand growth out of China. A fall in Chinese auto demand has a big impact on Chinese domestic output (most Chinese cars are made in China, with largely Chinese parts, thanks to China’s tariff wall), a measurable impact on the profits of some foreign firms with successful Chinese JVs, a modest impact on German exports and, at the margin, a measurable impact on global growth in oil demand. China matters for the entire world, no doubt. But its impact on the world isn’t totally symmetric.   * UBS recently argued that the net fiscal stimulus would be between 1.5 and 2 percent of GDP in 2019—with roughly 1.5 percentage points of GDP in central tax cuts offset in part by central government spending cuts of around 1 percentage point of GDP, and a roughly 1.5 percentage points of GDP fiscal loosening at the local level to support increased infrastructure investment. I of course would prefer a somewhat different kind of fiscal stimulus, one less focused on pro-business tax cuts and one more focused on raising low levels of social benefits and reducing the relatively large social contributions paid by some workers. ** I left services—a poorly measured category often heavily influenced by trade in tax that gets inordinate attention because of the widespread perception that it is the United States’ comparative advantage—for a footnote. But that’s more or less right for China. Its imports of tourism services (vacations) are significant (around $300 billion in 2018), though poorly measured. But they certainly matter for some individual countries that have been at the center of the tourism trade, most notably Thailand. China's imports of other services are still trivial. And China isn’t (yet) a big services exporter. The impact of a slowdown in China on global demand for non-travel related services can largely be ignored. Many articles highlighting the great potential services offer for the United States blur the line between actual trade in services and the ability of a foreign firm to provide services in China if it establishes in China (an important distinction in my view; U.S. firms setting up shop in China to provide services inside don't support many jobs back in the United States).