This One Weird Tax Trick Could Shrink the Trade Deficit
December 18 2017 - 5:59AM
Dow Jones News
By Greg Ip
Besides tax reform, one of President Donald Trump's most
cherished goals is reducing the gaping U.S. trade deficit.
In a little-appreciated way, the tax bill expected to pass
Congress this week may do just that. This wouldn't come by making
businesses and workers more productive or changing other countries'
trade practices, but by curbing the incentive for multinational
companies to artificially shift profits abroad.
Independent research suggests this could reduce the trade
deficit by half, or roughly $250 billion a year, and deliver a
one-shot 1% or greater boost to annual gross domestic product. This
would be an accounting effect rather than a change in actual
business or worker income. (It would also be independent of any
increased work or investment from lower tax rates.) Nonetheless,
some analysts think the positive optics might curb some of Mr.
Trump's protectionist instincts, which are heavily driven by the
trade deficit.
Because the current U.S. corporate tax rate, at 35%, is higher
than almost every other developed country's, it encourages
multinational corporations to minimize U.S.-based income. For
example, a U.S. company may design a smartphone in California,
spend $250 assembling it in China, then sell it for $750 in a third
country. The $500 difference represents the output of American
designers, marketing executives and engineers and should be treated
as an American export. To minimize U.S. tax, though, the company
may lease or sell its intellectual property to an Irish subsidiary
for a nominal amount, and the Irish subsidiary sells the phone for
$750. Its resulting profit is taxed at Ireland's 12.5% rate, or
lower.
This sort of "transfer pricing" by U.S. multinationals
understates U.S. output by $280 billion a year, according to a
study by Fatih Guvenen of the University of Minnesota and three
co-authors. This effect has grown; they estimate treating U.S.
exports as foreign-based income depressed official estimates of
annual productivity growth by 0.25 percentage point between 2004
and 2008.
The high U.S. tax rate also encourages foreign multinationals to
hold down their U.S. profits (and thus taxes) by inflating the cost
of goods, interest and overhead they charge their U.S. affiliates.
For a sample of 98 foreign-owned tech companies alone, Mr. Guvenen
and his co-authors estimate that understated their profits by $21
billion in 2012.
The tax plan is meant to curb transfer pricing through a lower,
21% corporate rate, an effective minimum tax on intellectual
property income earned in low-tax countries, a minimum tax on
foreign companies that artificially reduce their U.S. tax, and
preferential tax treatment of exports of U.S. intellectual property
products (a provision that may violate World Trade Organization
rules).
Kevin Hassett, chairman of Mr. Trump's Council of Economic
Advisers, estimates this could boost GDP by $142 billion a year, or
0.7%. Analysts at Deutsche Bank are even more optimistic. They
estimate the deficit could be reduced by $150 billion to $270
billion a year, with a corresponding one-off boost to GDP of as
much as 1.4%. They think this effect could materialize in as little
as year, judging by a similar tax change in Britain in 2009.
This increase in measured GDP wouldn't, however, represent an
actual increase in Americans' incomes. The salaries of engineers,
scientists and designers at American technology and pharmaceutical
companies wouldn't change. Rather, the companies that employ them
would simply book revenue in the U.S. that they previously booked
at their foreign units.
How the tax plan affects the trade deficit through other means
is unclear. A lower corporate tax rate makes U.S. production more
appealing relative to some countries, but that is countered by the
incentive to book profits abroad since, under the tax bill, they
will no longer be taxed when they are brought home. And economists
warn that tax cuts that increase budget deficits, as would this
one, often boost the trade deficit by spurring consumer and
business demand for imports.
Deutsche Bank analysts Robin Winkler, George Saravelos and
Oliver Harvey predict even an accounting-driven decline in the
trade deficit "could reduce the pressure on [Trump] to resort to
outright protectionist measures." On the other hand, Mr. Trump's
complaints are mostly about bilateral trade deficits, especially
with Mexico, China, Canada and South Korea, whereas transfer
pricing mostly affects dealings with low-tax jurisdictions such as
Ireland, the Netherlands, and Bermuda.
And one final caveat: The decline in the trade deficit will be
matched by a commensurate loss of income from foreign assets,
highlighting the drain from years of U.S. foreign borrowing.
Write to Greg Ip at greg.ip@wsj.com
(END) Dow Jones Newswires
December 18, 2017 05:44 ET (10:44 GMT)
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