Fiscal Policy

Korea has no shortage of fiscal space.  It should use it.

The pharmaceutical industry's tax strategies appear to have a large impact on the trade data. There isn't any other obvious explanation for why the (goods) deficit in pharmaceuticals exceeds the surplus in civil aircraft..

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...

   

Sales tax revenues have recovered. Fiscal year 2019, which started in July, should be a good year thanks to Federal disaster aid. The real question though is what happens when Federal aid starts to fall.

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.  

Germany seems to have ruled out all the mechanisms for eurozone fiscal expansion that the IMF liked…