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Tax reform is now boosting measured GDP

Summary:
The Financial Times reports that the recent corporate tax reform is beginning to encourage companies to bring intellectual capital back to the US: Google has overhauled its global tax structure and consolidated all of its intellectual property holdings back to the US, signalling the winding down of a tax loophole estimated to have saved American companies hundreds of billions of dollars. The internet search company said on Tuesday the move was designed to simplify its corporate tax arrangements and was in line with OECD efforts to limit international tax avoidance, as well as recent changes to US and Irish laws. Google’s actions came ahead of the close of the so-called “double Irish” tax loophole, which has been used by US companies to channel international profits through

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The Financial Times reports that the recent corporate tax reform is beginning to encourage companies to bring intellectual capital back to the US:

Google has overhauled its global tax structure and consolidated all of its intellectual property holdings back to the US, signalling the winding down of a tax loophole estimated to have saved American companies hundreds of billions of dollars.

The internet search company said on Tuesday the move was designed to simplify its corporate tax arrangements and was in line with OECD efforts to limit international tax avoidance, as well as recent changes to US and Irish laws.

Google’s actions came ahead of the close of the so-called “double Irish” tax loophole, which has been used by US companies to channel international profits through Ireland and on to tax havens like Bermuda — putting them outside the US tax net. That led American companies to amass more than $1tn offshore as of the end of 2017, when President Donald Trump’s tax reform changed the treatment of overseas profits.

This action does not impact the actual GDP of the US, as even profits supposedly “held overseas” are in fact owned by US multinationals. It’s an accounting gimmick to avoid taxes, which has no implications for variables such as national income, productivity, exports, etc. But these tax shifting activities do impact measured levels of national income, productivity, exports, etc.

A paper by Fatih Guvenen, Raymond J. Mataloni Jr. Dylan J. Rassier and Kim J. Ruhl provides an example:

Consider the iPhone, which is developed and designed in California but assembled by an unrelated company in China, with components manufactured in various (mostly Asian) countries. Taking some hypothetical ballpark figures, suppose the bill of materials and labor costs of assembly amount to $250 per iPhone and the average selling price is $750, for a gross profit of $500 per phone. For simplicity, assume that there are no further costs of retailing and that all iPhones are sold to customers outside of the United States. 

Two important questions arise from this simple scenario: First, defining GDP as total domestic value added, how much should each iPhone contribute to U.S. GDP? Second, given the profit-shifting practices described above, how much of each iPhone’s gross profit is actually included in U.S. GDP? 

To answer the first question, note that the $250 paid to contract manufacturers and suppliers in Asia is not part of U.S. GDP, whereas how much of the $500 gross profit should be attributed to U.S. GDP depends on where that value is created. If consumers are willing to pay a $500 premium over the production cost for an iPhone, it is because they value the design, software, brand name, and customer service embedded in the product. If we assume these intangibles were developed by managers, engineers, and designers at Apple headquarters in California (Apple, U.S.), then the entire $500 should be included in U.S. GDP. In the national accounts, the $500 would be a net export under charges for the use of intellectual property in expenditure-based GDP, matched by an increase in Apple’s earnings in income-based GDP.

They suggest that much of this output is actually attributed to tax havens such as Ireland:

Suppose that Apple generates intangible assets in the United States and legally transfers them to a foreign affiliate (e.g., one in Ireland). Payments for the use of intellectual property will accrue in Ireland rather than in the United States, which means that the returns to Apple U.S.’s intangible assets are attributed to an Apple affiliate outside the United States and not included in U.S. GDP.

Productivity in the US, especially in high tech industries, is higher than the reported figures. Until the recent tax reform, this problem had been getting worse over time. They report that the practice of US multinationals parking money in tax havens tends to inflate reported GDP in countries like Ireland and Netherlands by 9% to 13%. In the US, the reduction in measured GDP is closer to 1%.

So far, the effects of the recent tax reform on measured US GDP are relatively small. But if the Google decision is copied by lots of other companies, it has the potential to raise reported GDP, productivity, and exports in the US, without affecting actual GDP, productivity and exports.

This process could disrupt a NGDP targeting regime. Fortunately, the impact would be too small and too gradual to lead to a significant business cycle. More likely the unwinding of overseas IP investments would add a few tenths of a percent per year to reported GDP in the US, at most.

As far as Ireland is concerned, if they ever abandon the euro I strongly suggest they target domestic labor income, not GDP.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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