American corporations pay much less in tax than they used to. Figures from the National Income and Product Accounts imply the effective levy on profits has halved since the 1960s:
You could therefore be forgiven for thinking that “corporate tax reform” would be about increasing the government’s take, rather than reducing it.
If that were the agenda, reformers should start by cracking down on corporate tax havens. In particular, they should focus on the distortions caused by a peculiar rule letting American companies defer tax on profits earned abroad as long as those profits are reinvested there. This rule has inspired many large companies to “reinvest” much of their foreign earnings, but mostly into vehicles that hold dollar-denominated fixed income. These decisions are driven by tax, rather than the needs of the underlying business.
Since 1982, when the data begin, American businesses have spent about $5.1 trillion accumulating direct investments abroad:
About $2 trillion of this growth has come from reinvesting profits “earned” in seven small countries known for helping multinationals avoid tax: Bermuda, the UK Caribbean islands, Ireland, Luxembourg, the Netherlands, Singapore, and Switzerland. Another $1.7 trillion can be attributed to profits earned elsewhere, such as Canada and the UK, and reinvested in those countries. Finally, a little less than $1.5 trillion was spent by American investors using their own money. (The Bureau of Economic Analysis calls this “equity outflows other than reinvestment of earnings”.)
The net effect is that just over half of America’s foreign direct investment assets are now held in these seven corporate tax havens, up from a fifth as recently as the mid-1990s:
Focusing just on flows of money from America abroad through mergers, acquisitions, and greenfield investment produces a radically different picture.
Since 1982, the seven corporate tax havens have received less than a quarter of the money spent on traditional direct investment coming from America. Most of that occurred in the years immediately before the financial crisis. Take out Luxembourg — balance of payments data imply it is a conduit for tax cheats to invest in the US and other developed markets — and only 17 per cent of outbound direct investment has gone to corporate tax havens since the early 1980s.
For comparison, 29 per cent of America’s outbound direct investment since 1982 went to the UK alone. (Some of that may have been tax-related given the Channel Islands, but in general the FDI data don’t imply the UK is used as a corporate tax haven.) Add Australia, Canada, France, Germany, and you can explain about half of America’s direct investment outflows. Most of the rest can be explained by the larger European countries, the big economies of Latin America, India, Japan, and Opec. (Weirdly, total outbound direct investment into China has been negative since 1982, and about equal to zero if you combine China with Hong Kong and Taiwan.)
The chart below compares total outbound direct investment into the seven tax havens, the major economies of Argentina, Australia, Brazil, Canada, France, Germany, India, Italy, Japan, Mexico, OPEC, Spain, and the UK, and the rest of the world:
These real investment patterns broadly fit the nature of America’s trade relationships. However, they don’t remotely match the official figures on the places that are most profitable. Supposedly, direct investments in the seven corporate tax havens consistently yield about 3 percentage points more than investments in other parts of the world.
In 2016, for example, America’s direct investments outside the tax havens generated an effective yield of 6 per cent, while the assets in the seven corporate tax havens had an implied yield of 9 per cent:
That’s weird! Why would real money not flow to where it earns higher returns?
One plausible explanation is that haven-based subsidiaries of American companies overcharge their corporate parents for access to patents and other intangible inputs. By reducing exports and increasing imports, this would exaggerate the size of America’s trade deficit. Meanwhile the shift of earnings offshore would overstate the apparent profitability of investments in places such Ireland and Luxembourg. (Brad Setser has more on this subject, see the related links.)
This would help explain why, despite their allegedly superior profitability, relatively little outbound direct investment goes from America to places such as the Cayman Islands and Ireland. Essentially none of the direct investment assets owned in those two countries by Americans were acquired through traditional outflows. That makes sense because substantial real investment just isn’t necessary to generate the profits reported in those places. The seemingly large stock of direct investment assets in those tiny countries is simply due to the need to “reinvest” profits “earned” there to avoid paying tax.
Thus we now live in a world where the majority of America’s FDI income is “earned” from seven corporate tax havens. In 2016, the latest year for which we have data, American direct investments abroad generated $410 billion in income. Of that, $254 billion — about two-thirds — came from the havens. That’s up from just 25 per cent as recently as the mid-1990s:
These profits are largely “earned” in these places for tax reasons, not because that’s where the value is actually created. If tax weren’t the main motivator, profits ought to be repatriated to American shareholders through dividends and buybacks. But, with the notable exception of the 2005 tax holiday, almost none of the money earned in the tax havens is ever sent home.
Since the crisis, 74 per cent of profits earned in the havens has been “reinvested” rather than repatriated. In Ireland, the most egregious case, only 8 per cent of profits have been repatriated to America. For comparison, about half of the profits earned outside the tax havens have been repatriated since 2009.
(The relatively low repatriation rate is arguably due to the fact that most countries have lower corporate rates than the US even if they aren’t tax havens. When the UK cut its corporate tax rate, for example, reinvestment of FDI income more or less stopped as repatriation soared. One amusing consequence was an apparent decline in the growth rate of Britain’s foreign direct investment assets.)
American shareholders would have received an additional $514 billion since 2009 if income earned in the seven havens had been repatriated at the same rate as income earned in the rest of the world — or roughly $334 billion after paying America’s 35 per cent corporate profit tax rate. (Ignoring for now the tax credits meant to prevent double taxation.)
There is more to tell in this story using the industry-level FDI data, but we’ll save that for another post.
Some clarifications on US corporate tax policy — FT Alphaville
Offshore Profits and U.S. Exports — Brad Setser
Dark Matter, soon to be revealed? — Brad Setser
Why Doesn’t Apple Export More Services (Wonky) — Brad Setser
The case against Luxembourg — FT Alphaville
The costs of offshore tax avoidance, part 1 — FT Alphaville