Follow the Money

A deep dive into the details of China's balance of payments over the last few quarters of data. During the dollar's depreciation in 2017 and the first quarter of 2018, it looks like China was adding to its official assets once again—though the growth largely came from the state banks.

The impact of the U.S. tax reform on the U.S. trade balance was a hot item of debate last December. There was an argument that reducing the headline tax rate—and creating an even lower tax for the export of intangibles—would reduce the incentive for firms to book profits abroad in offshore tax centers. Booking those profits at home would raise U.S. services exports—while the service “exports” of countries like Ireland and Luxembourg (really re-exports of intellectual property created in the U.S) would fall. This would have no overall effect on the balance of payments. The rise in the recorded exports of intellectual property from the U.S. would be offset by a fall in the offshore income of U.S. firms. For example, Google (U.S.) would show a bigger profit as offshore sales would be booked as exports of IP held in the U.S. (a service export) while Google (Bermuda) would show a smaller profit —and that would translate both into a smaller trade deficit and a smaller surplus on foreign direct investment income.*  But shifting paper profits around would bring down the measured trade deficit—a potential win for Trump. It is obviously too soon to assess the full impact of the tax reform. But it isn’t too soon to start looking for some clues. The q1 balance of payments data doesn’t suggest that firms have lost their appetite for booking profits abroad, or their appetite for booking the bulk of their offshore profits in low tax jurisdictions. This shouldn’t be a surprise—the lowest rate in the new U.S. tax code is the new global minimum rate on intangibles. What changed?  As expected, firms stopped “reinvesting” their earnings abroad (“reinvestment” allowed the firms to defer paying corporate tax under the old tax code and wait for a repatriation holiday to free up their "trapped" profits abroad) and raised their dividend payments back to headquarters. No surprise there: the reform ended the incentive to legally hold profits offshore so as to defer tax, as there is no incremental U.S. tax on funds repatriated to headquarters. To be clear, the “reinvestment” abroad was a matter of accounting. The profits weren’t actually held abroad. Apple (Ireland) couldn’t put its funds in Apple’s main bank account, or lend directly to Apple (U.S.). But it could put money on deposit in a U.S. bank, buy U.S. Treasury bonds and buy the bonds issued by other companies. Now though there is no need to maintain the fiction that the funds are offshore. Over $300 billion was notionally sent back to the U.S. in q1 alone (an annualized pace of $1.2 trillion). That is literally off the charts… Still, the stock of accumulated funds legally held abroad in order to defer payment of U.S. tax was huge, and even the massive dividend payments in q1 have only made a small dent in the accumulated stock. Around $3 trillion has been reinvested abroad since the infamous Homeland Investment Act of 2004  (The number from the balance of payments matches reasonably well with other estimates).  The details of the balance of payments suggest the bulk of that was “reinvested” in tax havens and thus almost certainly wasn’t invested in physical assets.** Of course, tax structures take time to set up and time to unwind. The data from the first quarter may not be indicative of how the balance of payments will evolve as firms and their accountants digest all the implications of the new law. As interesting, if not more so, are the first reports of the tax rates that profit-shifting firms will pay under the new tax law. And, well, those reports don’t suggest that the firms have any real incentive to shift either their intellectual property or actual manufacturing back to the U.S. For example, a large pharmaceutical firm that has placed its intellectual property in Bermuda and seems to produce primarily in Puerto Rico (a part of the U.S., but outside the U.S. for tax purposes) and Ireland estimates that it will now pay a tax rate of 9%. That’s a lot lower than the tax rate it would pay if it located its intellectual property and physical production in the U.S. It is also lower than the global minimum tax rate of 10.5% on intangibles. The tax structure is pretty direct—put your IP in a really low tax jurisdiction, and sweep all the profits there, so that they don’t stay in the fairly low tax jurisdictions where manufacturing takes place, let alone the location of most sales.   Michael Erman and Tom Bergin of Reuters report: “analysts and academics say corporate filings often show that drug companies frequently reduce their taxes by parking patents in a low-tax haven…and then have their affiliates - which manufacture or market the drug - pay the tax haven subsidiary royalty fees for the right to use the patent. This arrangement sees a drug sold into a target market, like the United States, at a high price, with the U.S. distribution arm getting a sales margin as low as 5 percent. Sometimes the U.S. distribution profit is not enough to cover group costs incurred in the United States.” And Richard Waters of the Financial Times has indicated that the bulk of the big technology firms aren’t going to unwind their tax structures either. Not a surprise really—“ tax reform” was not designed to raise revenues, but rather to cut corporate America’s tax bill. Including, it seems, the taxes of companies that were engaged in aggressive forms of tax shifting (e.g. showing operating losses in the U.S. operations even though the firm was globally very profitable). So there aren’t likely to be big changes in the locations where paper profits are booked.  Nor will there be a sudden fall in the U.S. trade deficit. */ U.S. firms earn more abroad than foreign firms report to earn in the U.S., even though the stock of foreign direct investment in both directions, measured at market value, is roughly equal. **/ These previously tax deferred offshore profits were subject to a one-time tax as the U.S. transitioned to a new system for taxing offshore income last December:  the accumulated stock of tax deferrred offshore profits was taxed at 15.5% if the profits were held in cash, and 8% if firms really has invested in tangible assets abroad—and firms have to pay this to settle their deferred liability no matter whether they legally repatriate the profits or not.