Herbert Poenisch: Is the US Tax Reform Another Beggar-My-Neighbor Policy?

2017-12-25 IMI

Herbert Poenisch, Member of IMI International Committee, Former Senior Economist of BIS Brics Role in Global Finance The US House of Representatives and the Senate passed the tax reform bill recently. It has three pillars: first is the reduction of the main tax rate on profits of C-corporations from 35% to 20%. The second change is the replacement of the current system of depreciation allowances for new equipment with immediate 100% expensing. Third, the recovery period for most non-residential business structures is to be shortened from 39 to 25 years[i]. In addition it would move to a territorial tax system to encourage US companies to return their offshore profits and earnings home. Under the territorial tax system, offshore profits in the form of dividends are tax-free to encourage the repatriation of capital back to the home country[ii]. While these measures might be beneficial for the USA[iii], other countries, notably China will experience a negative backlash. Mme Lagarde of the IMF called this ‘overly aggressive tax competition among countries is a form of beggar-my-neighbor policy which hurts everybody’[iv]. The main concern in China is the impact on Chinese investors who might relocate to the USA to benefit from lower tax rates than currently up to 40% in China. It is not only Chinese companies who are affected, but first and foremost US companies which now have a real incentive to repatriate their offshore profits and earnings. This may lessen the availability of US corporate capital to invest overseas, which China still needs[v]. Different from the impact on corporations, this article will focus on the macroeconomic implications, first in the USA and the world economy. The US tax reforms will have an impact on aggregate demand and supply, on inflation, on debt and capital flows. Countries facing a backlash from the US tax reform should voice their concerns in international organizations, such as the IMF and the WTO. US authorities should respect international agreements and consult and coordinate policies to prevent a relapse into beggar-my-neighbor state of affairs.

The present US macroeconomic scenario

The US administration is trying to solve a macroeconomic problem, ie inadequate domestic growth with a redistribution of income from labour income to capital income while incurring increasing fiscal deficits. This is not the first time in recent history that this medicine has been prescribed, first in the Kennedy tax cuts of 1964 and then the Reagan tax cuts of 1981. However, the national savings rate was 10.1% then and is 1.8% now. Economies short in savings cannot go on deficit spending binges without borrowing surplus savings from abroad, such as from China. While China was willing to invest in US treasuries in the 1980s, the world has changed and China, leading other current account surplus countries, will not be willing to finance US excess demand for an uncertain future. Secondly, the US current account was in slight surplus during the 1964 and 1981 tax cuts. Presently, the current account deficit of 2.6% of GDP is likely to increase sharply due to fiscal deficits in a low savings environment. Thirdly, the budget deficit was 0.2% in 1965 compared with 2.5% in 2017[vi]. Assuming that the tax cuts will not be compensated by expenditure cuts in other areas, the government debt is expected to add USD 1.5trillion over the next ten years, increasing from 77% to close to 100% of GDP[vii]. In addition, the tapering of US interest rates will mean a higher debt service burden, adding some USD50 billion annually.

Financial impact of tax reforms

The mantra of the supply siders is that the tax cuts will be self-financing, because they will spur economic growth, causing revenues to surge and thus correct the financial imbalances of the first round. This is where the tale goes from facts to fiction[viii]. There is a clash of two ways to stimulate the economy, the supply siders who like to see the corporate sector as major transmission mechanism of stimuli and demand siders, Keynesians and Marxists who blame the demand deficit as main culprit for lack of growth. This again is linked to the rising profit rate, with a low multiplier effect as compared to a rising wage rate with a high multiplier effect. Inequality of income and wealth is seen as one of the determinants of unsustainable growth[ix]. Assuming that the fiscal stimulus will preserve or even raise the present meager US real growth of 2%, which is expected to taper off in the next years[x], the financial implications for the US and the world will be formidable. First of all, the budget deficit will have to be financed[xi]. There will be a surge in the issue of treasury securities from USD15tr to USD 16.5 tr, an increase of 10%, which in an environment of rising interest rates will have to be sold below par[xii]. Who will be ready to buy these additional debt instruments? The US banks, institutional investors and corporates will be busy investing in the real sector. However, even they will be weighing the real earnings prospects against higher returns from treasury securities. Corporations ever since the 1980s have turned into financial intermediaries rather than facing the real economy risks. The US current account balances might be improved as dividends and earning from abroad might flow back to the USA. The additional growth in the US might increase the demand for inputs, such as intermediary goods, but also more exports are envisaged, leading to a better current account balance in the best case. This will lift the national savings rate and reduce the need for import of surplus savings from abroad. Secondly, on the financial account, however, capital will continue to flow into the USA driven by the following factors. US based banks , the US stock and bond markets will attract funds from abroad thanks to the improved growth environment as well as higher expect returns. Foreign investors, first and foremost China and Japan, who presently own 45% of US government securities will be tempted to invest in these securities offering increasingly attractive returns. This will lead to capital outflows from emerging markets and downward pressure on their exchange rates. Some foreign investors, such as China and Russia are in process of diversifying their forex portfolio away from US government securities into FDI and other projects linked to the Belt and Road Initiative. Chinese corporations may even undertake to channel some FDI into the USA to take advantage of the lower tax environment. In addition to the Belt and Road investments this will lead to further capital outflows from China and a downward pressure on the RMB. It might also hamper the RMB internationalization strategy as these investments will be nominated mostly in USD.

Possible global and Chinese reactions

The world has arrived at this juncture once before, when Japan adopted various fiscal stimuli to boost growth and to avoid the deflationary trap. At that time Germany condemned the Japanese programme as a species of beggar-my-neighbor policy[xiii]. This time round it was the Europeans again who issued a warning to the Trump administration over its planned tax reform, saying it would ‘be at odds’ with free-trade international rules because it risked being discriminatory towards foreign companies. They claim that some of the bill’s measures would ‘contravene’ the rules of the WTO’s principles as well as double taxation resolutions. Some measures ‘may risk having a major distortive impact on international trade’[xiv]. China will be well advised to play a similar role as Germany and EU, make its voice heard in the G20 and prepare its reaction against this fiscal ‘beggar-my-neighbor policy’. As there is no international body, such as the IMF which addresses exchange rate distortions, or the WTO which mediates in trade disputes, there is no arbitration mechanism for fiscal competition. This has plagued the EU countries where different fiscal regimes have distorted competition among member states, such as Ireland offering the lowest corporate tax rate. Even more so in the world at large it is left to individual countries to defend themselves against fiscal competition, in this case from the USA. In particular, the US administration argues that its tax reform is targeted at domestic players, but it has a huge impact on the outside world as it triggers various capital flows. Economies after all are mutually interconnected. As the USA administration has ignored the basic pillars of global economic policy since World War 2, ie international agreements, consultation and coordination, other countries need to make their voices heard, such as the EU in a protest to the US administration or just pursue its own policies. China might adopt counter fiscal measures and/or reinforce its capital controls. Restricting capital outflows through enterprises can be targeted first. Priority should be given to outward investments linked to the Belt and Road initiative. If Chinese companies increase their FDI in the USA some capital controls could be enforced. Secondly banks, Chinese based banks have been part of the export surpluses scenario as their cross-border USD assets exceed their USD liabilities. It will be impossible to stop them lending to the US interbank market or even to US non-bank corporations. The PBOC, SAFE, CIC could divest from investing foreign exchange reserve in US debt securities to USD denominated securities issued by non-US governments, or even start buying local currency instruments issued by BRICS countries[xv]. Finally, individuals are still barred from investing massive amounts overseas due to the prevailing foreign exchange controls. There is still hope for international mediation. In the IMF Press Briefing on 14 December, the IMF spokesman Murray replied to a question on this issue that the Article IV consultations with the US, which will be conducted during the first few weeks of 2018 will address the US tax reforms and the results will be published in July 2018[xvi]. China should play its role within the G20, reminding the world of the adverse effects of aggressive fiscal measures in one country on the rest without consultation and coordination. After all, the G20 claims to be the new government, however without a permanent secretariat. [i] Barro, Robert J (2017): How US Corporate Tax Reform Will Boost Growth. In: Project syndicate 13 December www.project-syndicate.org [ii] Tang, Frank and Zhang, Maggie (2017): US reform bill puts pressure on China to tweak its tax code to avert fund flight, lure investment. In SCMP, 6 December www.scmp.com [iii] Furman, Jason and Summers Lawrence H (2017): Response to Robert Barro’s Tax Reform Advocacy. In: Project syndicate, 13 December www.project-syndicate.org [iv] Lagarde, Christine (2017): Speech in the UAE, 22 February www.imf.org/speeches [v] South China Morning Post editorial (2017): Trump tax reform a challenge for China. 9 December www.scmp.com [vi] Office of Management and Budget (2016): Historical tables of the US Government, February www.whitehouse.gov/omb/budget [vii] Feldstein, Martin (2017): Cutting US Corporate Tax is Worth the Costs. In: Project-syndicate 27 November www.project-syndicate.org [viii] Roach, Stephen S (2017): America’s supply side scam, In: Project syndicate 24 November www.project-syndicate.org [ix] Even the IMF turned its attention to the income and wealth inequality affecting growth. Inequality and unsustainable growth: two sides of the same coin. In: IMF Staff Discussion notes (2011) www.imf.org/publications [x] See IMF and IBRD forecasts autumn 2017. [xi] The market reaction to Japan’s recent fiscal stimulus packet was a drop in bond prices and a hike in yields. Oh, Sunny (2017): Japan stimulus send shivers through its bond market. Marketwatch, 28 September www.marketwatch.com [xii] The Japanese experience with the JGB rising yield are a case in point. [xiii] Brittan, Samuel (2013): The folly of beggar-my-neighbor policy. IN: Financial Times 1 February www.ft.com [xiv] Chassany, Anne-Sylvaine (2017): EU finance ministers warn US administration over tax bill. In: Financial Times, 11 December www.ft.com [xv] Poenisch, Herbert (2017): Building not replacing. BRICS role in global finance. IN: OMFIF October www.omfif.org [xvi] IMF Press Briefing 14 December 2017 www.imf.org/press

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Herbert Poenisch: Is the US Tax Reform Another Beggar-My-Neighbor Policy?

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