Is the Prospect of a Trade Deficit Reduction an Accounting Illusion?

December 21, 2017 2:00 PM
Photo Credit: 
REUTERS/Carlos Barria

Will the new US tax overhaul passed by Congress reverse a longstanding incentive that causes multinational corporations to shift profits away from their US operations into affiliates in low-tax jurisdictions? A story in the Wall Street Journal by Greg Ip raises the possibility that such a shift might shrink the trade deficit by more than $250 billion and boost US GDP by more than 1 percent. But it is not clear whether the new legislation will change profit shifting so dramatically. Even if it does, the accounting changes will have no effect on broader measures of national income and the trade deficit—and no economic effects on firms or workers.

The basis of the story is a research paper circulated by the National Bureau of Economic Research earlier this year. The paper finds that US multinational corporations report profits in low-tax jurisdictions that far exceed the revenues and production activities based in those jurisdictions. There are a variety of techniques to shift profits; one of the most important is to have a foreign subsidiary buy patent rights from its US parent (often using money lent to the subsidiary at a low interest rate from the parent), which enables the subsidiary to book the royalties earned on the patents. The paper estimates such profit shifting is worth $280 billion per year. Moreover, the paper does not examine profit shifting by foreign multinationals operating in the United States, which have the same tax-driven incentive to shift profits into low-tax jurisdictions.

Tax rates in jurisdictions to which profit is being shifted are typically much lower than 21 percent, so it is not clear that much will change.

The new US tax law reduces the top corporate tax rate from 35 percent to 21 percent. Among major economies, the United States would move from having one of the higher corporate tax rates to one of the lower rates. Tax rates in jurisdictions to which profit is being shifted are typically much lower than 21 percent, however, so it is not clear that much will change. There are other elements of the tax legislation aimed at profit shifting, but their likely effects are not clear. Brad Setser is skeptical and a group of tax experts worries that the net effect may be to increase tax avoidance and profit shifting.

In the absence of profit shifting, US corporations would report higher exports (such as royalty services) and lower imports (such as overpriced supplies from foreign affiliates), and the US goods and services trade deficit would be smaller. But reported income on foreign investments also would be smaller. The current account balance, which adds up goods, services, and investment income and is often highlighted as the broadest measure of the US trade balance, would be unchanged. The current account deficit in 2016 was $452 billion or 2.4 percent of US GDP (data from International Monetary Fund World Economic Outlook).

Similarly, gross domestic product (GDP), which measures production inside US borders, is understated by profit shifting. Gross national product (GNP), which measures income of US residents wherever it is earned, is not affected by profit shifting.

Profit shifting does help to explain one perennial puzzle of the US international accounts: the fact that reported net income on international investments is positive despite US liabilities that exceed US assets. In the absence of profit shifting, returns on US foreign assets would be lower and returns on foreign assets in the United States would be higher, implying that there is a burden of net debt owed by the United States to the rest of the world after all.