Co-authored by Sonu Varghese
President Trump and Congress passed a massive tax reform package in December 2017, which was the most far-reaching of its kind in recent history, especially with respect to corporate taxation. The new law slashed corporate tax rates from 35% to 21%, and made significant changes to the way international profits of US firms are taxed, all in a bid to have companies repatriate overseas profits and jumpstart investment spending in the US. This would boost productivity, which has been lackluster over the past decade and half, and eventually feed into higher wage growth – sending the trajectory of US economic growth higher.
One obvious question since then is whether multinational companies have in fact changed their behavior around funneling profits through tax havens. One quarter (which is all we recently got data for) is not long enough to gauge the full impact of the new tax law on international taxation but it does provide some clues as to what may be happening.
We first take a step back and look at how multinationals shifted profits around and the impact of this. We then review measures that were included in tax reform to prevent these, and finally look at what’s happened so far in 2018.
Profit shifting has exacerbated the trade deficit
Multinational companies have found creative strategies to reduce their US tax liabilities over the last couple of decades, and this has had a significant impact on the US trade balance. The following graphic illustrates how US and foreign multinationals have reduced their tax liabilities over the years.
For example, a technology parent company creates a foreign subsidiary in a tax haven country like Ireland. The subsidiary subsequently purchases, at very low cost, intellectual property from the parent. This allows the subsidiary to collect the firm’s global profits, which were exempted from US taxes until they were repatriated. The overseas profits are reinvested abroad, though most companies have invested most of their cash in the US bond market (as we have written about previously).
In some cases, companies also offshore production of high value products to their tax haven subsidiary, which are subsequently imported back to the US (like active ingredients in pharmaceuticals or concentrate for soft drinks).
On the other hand, foreign multinationals, or US firms that have relocated to a tax haven (through an “inversion”), have their US subsidiaries import valued components at high cost. Or they load up their US subsidiary with tax deductible debt (borrowed from the foreign parent). So foreign multinationals end up reporting a very low income on their US investments, thereby lowering their US tax liability.
Now, as a result of all this profit shifting (or transfer pricing), US exports are artificially suppressed, while imports are raised. So the trade deficit (exports minus imports) goes up, simply because companies are looking to reduce their US tax liabilities.
However, this does not affect the current account balance, which is the sum of the trade deficit and net income on direct investment (income paid on US investments abroad minus income paid on foreign investments in the US). Thanks to profit shifting, US companies see higher income from their foreign investments while foreign multinationals report lower income from their US investments. So the net income from direct investments is artificially boosted even as the trade balance worsens.
Tax reform tried to change the incentive for profit shifting
The tax reform package that Congress and President Trump passed in December 2017 included incentives, and mechanisms, to end the profit shifting. These included:
- A lower tax rate – The corporate tax rate was lowered from 35% to 21%, to incentivize corporations to book profits in the US.
- Repatriation – Sets a one-time mandatory tax of 8 percent on illiquid assets and 15.5 percent on cash and cash equivalents for corporate profits currently held overseas. However, the companies can pay these taxes in installments over eight years.
- Base-erosion and anti-abuse tax (BEAT) – This works like an alternative minimum tax for corporations. If a company generates more than $500 million annual revenue in the US, and its American subsidiaries pay more than a specified level of tax-deductible payments to the overseas parent, those subsidiaries must now pay a minimum tax on their US profits after adding back in certain deductions. So, foreign multinationals cannot reduce their US tax liabilities by loading their US subsidiaries with tax deductible debt.
- Territoriality – The previous system taxed US multinationals on a worldwide basis, and so they owed taxes on profits generated in the US and outside. However, taxes on foreign profits were deferred until these were repatriated to the US. The new system ends this worldwide system of taxation and exempts US corporations from US taxes on most foreign profits.
- Essentially, what this does is eliminate the tax on future dividends repatriated from overseas, i.e. profits generated outside the US. This obviously creates an incentive for profit shifting to areas where the tax rate is lower than the new 21 percent rate and that is where the next two provisions come in.
- Global intangible low-taxed income (GILTI) – Under this provision, US parents of foreign subsidiaries have to pay 10.5 percent on profits in excess of a 10 percent return on tangible investments offshore. The idea is to prevent profit shifting by companies that derive profits from US developed intangible investments (like intellectual property) and have minimal tangible investments (like factories) offshore – for example, Apple, Microsoft and Google.
- The next provision is a mirror image of GILTI.
- Foreign derived intangible income (FDII) – This provides a lower rate on domestic income derived from exports (that exceeds a 10 percent return). The goal is to encourage exporting from the US, instead of shifting intellectual property to a tax haven and exporting from there.
However, the FDII tax rate is 13.125 percent, which is higher than the GILTI rate, and so the incentive to shift has not gone away. Also, under GILTI, overseas income below the 10 percent threshold is not subject to any US taxes, whereas under FDII, income below the 10 percent hurdle is subject to the full corporate tax rate of 21 percent.
What tax reform has achieved to date
As companies shifted their profits overseas, much of their earnings were ‘reinvested’ abroad due to the 35 percent charge they would incur to repatriate it. Lowering the corporate tax rate to 21 percent and charging a one-time tax on overseas cash potentially created an incentive to move assets (at least in the short run) back to the United States.
This goal of tax reform, at least if the first quarter is the start of a trend, was achieved.
In the first three months of 2018, reinvested earnings turned negative, which implies that the earnings in the latest quarter were not reinvested abroad (in fact it went the opposite way). In addition, dividends and withdrawals, which captures the overseas profits that flow back into the United States, surged to $305 billion. As the chart shows, the higher dividend payment relative to reinvested earnings is a sign of repatriation of some overseas profits.
However, despite this, there is still a massive amount of formerly reinvested earnings that remain abroad. Measured on a cumulative basis, reinvested earnings totaled $3.8 trillion from the first quarter of 2000 to the fourth quarter of 2017. After repatriation, the large sum of earnings abroad only fell to $3.6 trillion by the first quarter of 2018, i.e. a less than 10 percent drop. Clearly, companies still have a lot of assets held overseas.
Moreover, if provisions included in the tax reform package really disincentivized profit shifting, we would see the trade balance (exports minus imports) start to improve – since US exports would no longer be artificially suppressed and imports artificially raised. At the same time, net income on direct investment should shrink – since US corporations would earn less on their overseas investments while foreign firms would book higher profits in the US.
However, first quarter data suggests that this has not happened yet. In fact, the trade balance has worsened in 2018 (i.e. larger trade deficit) and net income has not changed significantly either. At the same, this is only one quarter worth of data and it remains to be seen whether the trend in flows will continue, and whether the stock of reinvested earnings will be drawn down.
Also, US corporate tax revenue has also collapsed this fiscal year, falling by 25 percent between October 2017 and May 2018 compared to the same period in the previous fiscal year. A big part of this is by design, since the corporate tax rate was slashed from 35% to 21%, but it also suggests that multinational corporations have a long way to go in repatriating their overseas stash and paying taxes on them. As we noted above, these firms have eight years over which to repatriate their overseas cash, with no interest. So they clearly are in no hurry. This is unlike the tax amnesty provided by Congress in 2004, when corporations brought home about one-third of the total cash held overseas. Corporate tax revenue increased by more than 45 percent in the 2005 fiscal year.
What happens to the repatriated assets?
As we pointed out in a prior piece, the overseas earnings for US corporations were mostly reinvested in the US bond market – treasuries and corporate bonds – instead of physical assets (like factories) outside the US. So in a sense, this cash was already made available for investment in the US, in that multinational corporations lent their overseas profits to the US government and other US corporations. In another recent piece, we discussed how multinational technology firms (who account for the bulk of overseas held cash) have started to liquidate their portfolio of marketable securities, i.e. bonds.
The big question is what happens to the cash that was brought back?
There are several choices that companies could make. They could expand their business and make capital investments, thereby boosting productivity over the long term and wages for employees. This was the hoped-for route when tax reform was passed, with the new tax system laying the foundation for higher long term economic growth.
The other option for corporations is to use the repatriated cash to fund share buybacks, dividends and debt repayments, all of which are essentially a form of returning the cash to shareholders. In other words, they would rather return the money to shareholders since they cannot find profitable investment opportunities themselves, due to insufficient demand. They could also continue to keep the bulk of their cash invested in the bond market, in which case they would be funding the US government and other corporations.
So far the evidence suggests that corporations are returning the bulk of their cash to shareholders via the buyback route. Corporations have been engaging in significant share buybacks throughout the current bull market cycle, with S&P 500 buybacks averaging roughly $550 billion annually. However, S&P 500 buybacks jumped to an annualized level of $756 in the first quarter of 2018, which beats the previous record of $688 billion in the third quarter of 2007.
One quarter does not make a trend and so we will continue to watch the data to see if the trend in cash repatriation continues apace, and whether most of this goes toward capital investments or returned to shareholders. The current account data, including the trade balance and net income on direct investments, should also tell us if anything changes with respect to profit shifting.
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