This One Weird Tax Trick Could Shrink the Trade Deficit

By FeaturesDow Jones Newswires

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.

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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)