Corporate tax and the trade balance

Episode Summary

Executive Summary: The episode examines how U.S. corporate tax reform changed multinationals’ incentives, ending deferral and moving from a global to a territorial system while adding new minimum taxes on intangible income and anti-abuse rules for foreign firms. Brad Setzer argues these rules may only partly curb profit shifting and could even encourage some offshore tangible investment, with limited effects on the overall current account but meaningful shifts in its composition.

Main Topics: Old U.S. worldwide tax system and profit shifting (Priority: 5/5): Before reform, U.S. firms could defer tax on foreign earnings if profits stayed offshore, encouraging them to park intellectual property and earnings in low-tax jurisdictions and accumulate large retained profits abroad. How tax distortions appeared in macro data (Priority: 5/5): The conversation explains how profit shifting showed up in the balance of payments as inflated income surpluses, large holdings of Treasuries in places like Ireland, and a trade deficit that looked larger because some offshore profits were economically tied to U.S. activity. Mechanics of transfer pricing and intangible income shifting (Priority: 4/5): The discussion details common structures such as cost-sharing agreements, offshore subsidiaries, and the relocation of IP rights, using examples from Apple, Microsoft, pharmaceuticals, and Starbucks-style licensing. What changed in the 2017 U.S. tax reform (Priority: 5/5): The law cut the corporate rate, ended deferral, and moved to a territorial system while introducing a global minimum tax on intangible income and special rules meant to reduce tax-motivated offshore booking. Potential unintended incentives under the new rules (Priority: 4/5): Setzer warns the new framework could still favor offshore subsidiaries and may even push some firms to move tangible assets abroad, especially in pharmaceuticals, in order to lower their taxable intangible base. Effects on foreign multinationals and BEAT (Priority: 4/5): The BEAT regime targets foreign-owned U.S. subsidiaries that used debt, interest deductions, and related-party payments to minimize U.S. tax, reducing opportunities for base erosion. Implications for trade balance, current account, and GDP (Priority: 5/5): The speakers debate whether reform will materially change measured trade or current account figures. Setzer expects mostly compositional shifts rather than large aggregate changes, while Ireland’s GDP and tax-center data may be especially distorted.

Key Arguments: Old U.S. tax rules encouraged U.S. multinationals to keep profits offshore because deferred tax liabilities made repatriation expensive. Those offshore profits were often already invested in U.S. financial assets, so the apparent foreign-ness of the money was partly accounting rather than economic. Profit shifting inflated the U.S. income surplus from foreign direct investment and made the trade deficit look larger than underlying activity alone would suggest. The growth of low-tax profit booking accelerated after 2000 as IP became easier to transfer and firms copied successful tax structures used by peers. The new system reduces the headline rate and removes deferral, but the remaining global minimum on intangibles is low enough that firms may still find offshore structures attractive. The intangible-income minimum tax may unintentionally reward shifting tangible assets abroad, especially in sectors with mobile production such as pharmaceuticals. BEAT and interest-deduction constraints are designed to stop foreign multinationals from stripping profits out of their U.S. subsidiaries. The most likely macro effect is not a big change in the overall current account, but a reclassification of income flows between trade, services exports, and investment income. A more efficient policy, in Setzer’s view, would have preserved global taxation but lowered the rate and ended deferral while fully crediting foreign tax paid.

Data Points: U.S. corporate tax rate before reform: 35% - Referenced as the old headline rate before the 2017 tax law cut it to 21%. U.S. corporate tax rate after reform: 21% - The new statutory corporate rate under the reform. Global minimum tax on intangible income: 10.5% - Set as half of the 21% rate, intended to tax certain offshore intangible profits. Deduction for foreign taxes paid under intangible-income regime: 80% - The tax base allows a partial deduction for taxes actually paid abroad. Imputed return on tangible assets abroad: About 10% - Used to separate tangible income from excess intangible income for minimum-tax purposes. Special low rate on export of intangibles: Just above 13% - A provision intended to encourage retention of IP in the U.S. through export-based treatment. U.S. external debt: About 50% of U.S. GDP - Used to explain why interest payments might be expected to dominate the income balance. Retained offshore earnings: Over $2 trillion - The accumulation of deferred foreign earnings held abroad by U.S. firms under the old system. Foreign profits in low-tax jurisdictions (Europe multinationals example): Around $200 billion - Estimate of reinvested earnings in low-tax jurisdictions. Foreign profits in low-tax jurisdictions including all earnings: Close to $300 billion - Broader estimate cited for European multinationals’ low-tax jurisdiction earnings. Estimated size relative to U.S. GDP: 1% to 1.5% of U.S. GDP - Consensus estimate for the scale of income booked in low-tax jurisdictions. Time period of major rise in profit shifting: 2000 to 2010 - The period when reported profits in low-tax jurisdictions rose sharply.

Pivotal Quotes: "there was this really large build-up of treasuries held in Ireland" — Brad Setzer: Explaining how tax-deferred offshore profits showed up in financial data. "the trade deficit looks a lot bigger than it really is because of this profit shifting" — Brad Setzer: Summarizing how tax-motivated income booking distorts the measured trade balance. "I would favor a system of global taxation, retaining a system of global taxation, lowering the rate and ending deferment" — Brad Setzer: His preferred policy alternative to the new territorial system.

Implications: Listeners should expect the tax reform to reshape how profits are booked more than how real production changes. The biggest effects may be on multinational behavior, data interpretation, and tax competition rather than a large immediate shift in U.S. growth or the current account.