Now that Democrats have taken the House, it seems likely that the Tax Cuts and Jobs Act will turn out to have been the only major piece of legislation enacted under Donald Trump. There might conceivably be an infrastructure bill, but don’t get your hopes up: Trump’s people seem dead set against straightforward public spending, i.e., just building the damn infrastructure, and Democrats probably won’t agree to privatization disguised as public investment.
Now, the TCJA played almost no role in the midterms: Republicans dropped it as a selling point, focusing on fear of brown people instead, while Democrats hammered health care. But now that the election is past, it seems like a good idea to revisit the bill and its effects. What I want to focus on in this piece is the effects on the balance of payments.
Why the balance of payments? Because the theory of the case – the not-necessarily-stupid rationale for the corporate tax cuts at the heart of the bill – depended crucially on claims about what tax cuts would do to international movements of capital. So one important piece of any attempt to assess the results so far involves looking at the balance of payments changes since the lower tax rate went into effect.
And looking at those changes in the balance of payments also offers a good way to debunk some of the fallacies that all too often creep in when we discuss these issues. So let’s dive in, beginning with a recap of how the TCJA’s supporters claimed it would work.
What tax cuts were supposed to do
A tax cut for corporations looks, on its face, like a big giveaway to stockholders, mainly bypassing ordinary families: of stocks held by Americans, 84 percent are held by the wealthiest 10 percent; 35 percent of U.S. stocks are held by foreigners.
The claim by tax cut advocates was, however, that the tax cut would be passed through to workers, because we live in an integrated global capital market. There were multiple reasons not to believe this argument in practice, but it’s still worth working through its implications.
I illustrated this argument with a simple diagram (simple for economists – I told you this was wonkish), reproduced as Figure 1. The figure shows the marginal product of capital – the increment to GDP from an additional unit of capital – as a function of the capital stock. If we provisionally (and wrongly) assume perfect competition, this marginal product will also be the rate of return on investment. Meanwhile, GDP is the area under the curve MPK up to the level of the current capital stock.
What tax-cut advocates argued was that the rate of return in the U.S., net of taxes, is set by global forces. Suppose that there is a global rate of return r*; then the U.S. will have to offer r*/(1-t), where t is the corporate tax rate.
Now imagine cutting t; the figure shows a complete elimination of corporate taxes, but the logic is the same for simply reducing the rate. This should lead to inflows of capital from abroad, increasing the capital stock, which both raises GDP and reduces the rate of return. In the end the after-tax return on capital should be back where it started, with all of the tax cut passed through to wages instead.
The crucial point, however, is that for this to happen you have to have a large increase in the physical stock of capital – it’s not an immaculate financial transaction. This in turn means that those inflows of capital have to enable a massive wave of real investment in plant and equipment. That doesn’t necessarily mean directly importing machinery; it could mean importing consumer goods or exporting less stuff of our own, either way freeing up resources for producing capital goods here at home. But the logic of the pro-tax cut case depends on the cut facilitating a period of large trade deficits. (I don’t think anyone told Trump about this.)
This is not, however, the way most reporting on the issue has framed it. Instead, reports have mostly focused on corporations moving funds home from their overseas subsidiaries, and asked what they are doing with that money. That’s not exactly wrong, but “moving money home” doesn’t mean what people think it means, and is very loosely connected to the important economic issue here.
On “moving money home”
U.S. corporations have large assets overseas. Some of these assets reflect past investments made for fundamental business reasons – e.g., auto plants built to serve foreign markets. But a lot of those overseas assets reflect tax avoidance strategies.
Here’s how that works: a U.S. company manipulates transactions with an overseas subsidiary in a low-tax jurisdiction like Ireland so as to make profits, wherever they’re actually earned, appear on the books of the subsidiary rather than the home company. For example, the company may pay inflated prices for components it buys from the subsidiary, or assign the subsidiary patents and licenses on which it pays large royalties. These shifted profits then show up in the data as investments abroad, even though they may not correspond to anything real, as is clearly the case for much foreign investment in Ireland.
International tax avoidance is, by the way, a big deal. Gabriel Zucman and his colleagues have shown that we’re talking about trillions of dollars of assets and many billions in lost tax revenue.
Now, when the U.S. reduces its corporate tax rate, this reduces the incentive to engage in such schemes: corporations don’t have to go to Ireland to avoid taxes, they can do it right here in the U.S.A. So you would expect the tax cut to lead to repatriation of assets, and that’s indeed what happened. The Bureau of Economic Analysis, which produces our balance of payments statistics, had a very helpful box on the effects of the TCJA in its latest report on international transactions that included a striking chart on the impact on multinational corporations (Figure 2). Following the tax law’s enactment, U.S. firms had their subsidiaries pay the home company huge dividends; the counterpart of these dividends, on paper, was a sharp drop in investment overseas.
But what did these big numbers correspond to in reality? Quite possibly nothing.
Imagine a U.S. company whose overseas subsidiary has $1 billion in a London bank account. Following the enactment of the tax cut, it decides to transfer that $1 billion back to the parent company – but the parent keeps the money where it is. In that case the balance of payments statistics show a big drop in net direct investment abroad, because the parent firm is reducing its apparent stake in the subsidiary. But the reality is that the company still owns that same $1 billion in London – it has just shifted from owning it indirectly via the subsidiary to holding it directly. It’s just accounting, with no real-world effect.
Of course, the company could choose not to keep that $1 billion in a London bank; it might do something else with it, such as buy shares back from its stockholders. But what happens to the money then? The shareholders might themselves buy assets overseas; even if they buy stock here, whoever sells them the stock might invest the proceeds abroad.
In other words, looking at corporate financial maneuvering after the tax cut doesn’t really tell us anything about whether the cut is, in fact, attracting global capital into the United States. To make that assessment, we need to look at net sales of assets to foreigners by the U.S. as a whole – or, equivalently, at our net sales of goods and services, because the balance of payments always balances: the trade balance is by definition the inverse of the net capital inflow.
What actually happened to capital inflows?
If we’re trying to assess the possible effects of the TCJA on the U.S. ability to invest, we need to know how much, if at all, it promoted true inflows of capital – resources made available to the United States that let us invest more than we ourselves are saving. These inflows can be measured two different ways. One is to look directly at the international financial account: asset transactions with foreigners, where selling assets is an inflow and buying assets an outflow. The other is to look indirectly at the difference between sales and purchases of goods and services, because the trade balance broadly defined (including investment income) – aka the balance on current account – is the flip side of capital inflows.
In principle these two methods should give the same result. In practice there is sometimes a significant “statistical discrepancy,” probably because some financial transactions don’t end up being properly reported. This is less of an issue for goods and services, although some of the same strategies used for tax avoidance can distort this balance too. Anyway, I’ve prepared a little chart showing quarterly measures of capital inflow since 2016, by both methods (Figure 3.)
There are big statistical discrepancies in a few quarters. As I like to say, in the fourth quarter of 2017 America was a big exporter of errors and omissions. But overall the data tell a consistent story about what has happened to capital inflows since the tax cut went into effect, which is … nothing much. That elaborate financial dance between corporations and their subsidiaries seems, in fact, to be an accounting maneuver with little real-world relevance. The international consequences of the tax cut appear to be minimal.
And that’s a big deal, because promoting capital inflows was at the heart of the halfway reasonable argument for the tax cut. So far, that argument appears to be not totally stupid, but also, as it happens, quite wrong.
The big giveaway
On its face, a corporate tax cut looks like a big giveaway to stockholders. Proponents of the TCJA claimed that this was misleading, because large capital inflows would ensure that the cut went to workers instead. But there’s no sign of those big inflows, so what looks like a big giveaway to stockholders is, in fact, a big giveaway to stockholders.
And about 35 percent of that giveaway is to foreigners, so the tax cut makes America as a whole poorer.
Can we see this in the data? Unfortunately, I don’t think it’s possible to extract this signal from the noise. If corporations returned all of the tax cut to stockholders via increased dividends, you might be able to see it in increased payments of investment income to foreigners. But much of it was used for stock buybacks, which won’t show up in the same way.
True, stock buybacks should raise the price of the stocks remaining, and you could try to allocate 35 percent of this capital gain to foreigners. When Trump boasts about rising stocks, or laments declines that he blames on Democrats, remember: higher stock prices actually make America poorer, because they don’t add anything to our real wealth while increasing foreign claims on the nation as a whole.
But stocks fluctuate so much, for so many reasons (or no reason at all), that I don’t think it’s productive to try and guess how much of that fluctuation is due to the tax cut. Better to focus on the fundamentals: corporate taxes have been cut by around $100 billion a year, so that’s around $35 billion going to foreigners.
OK, that concludes my wonkiness here. The moral of this story is that the tax cut seems to have produced some biggish financial activity on the part of corporations, but it’s all basically accounting maneuvers signifying nothing. A balance of payments perspective, like other perspectives, points to a tax cut that, surprise, cut taxes on corporations, but had few real consequences for the economy.
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Paul Krugman has been an Opinion columnist since 2000 and is also a Distinguished Professor at the City University of New York Graduate Center. He won the 2008 Nobel Memorial Prize in Economic Sciences for his work on international trade and economic geography. @PaulKrugman
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