Relevant and even prescient commentary on news, politics and the economy.

Employment Growth: the Adjusted Household Survey

Menzie Chinn provides a link to an interesting analysis from the Bureau of Labor Statistics in his post entitled Properties of Some Labor Market Indicators. Dr. Chinn’s post is an interesting read in itself but take a peek at chart 1 of the BLS paper, which compares the payroll survey and the “adjusted household survey”. Over the past decade, the growth in each has been roughly similar. But also note that the growth in the payroll survey from 1998 to early 2001 exceeded the growth in the adjusted household survey.

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Output Volatility: GDP v. GNP

While macroeconomists spend a lot of effort trying to understand the volatility of output, we spend less time worrying about whether output should be measured by real GDP or real GNP. As we discussed here, the difference between GNP and GDP (known as net income from abroad) is quite modest for the U.S. If we look at quarterly data from 1970 to today, average real GDP growth has been 0.769% per quarter (annualized, this amounts to less than 3.1% per year), while average real GNP growth has been 0.767%. In other words, not much difference since net income from abroad was only 0.7% at the beginning of this period with the ratio being half of that for the end of the period. The standard deviation of real GNP growth was 0.852% over this period as compared to 0.847% for real GDP growth. In fact, the only significant differences between the two series seems to be the last quarter of 2001 when real GNP growth exceeded real GDP growth by 0.6% and the first quarter of 2002 when real GDP growth exceeded real GNP growth by 0.5%.

As I was preparing this post on Ireland’s economic growth, I recalled a paper from Colm McCarthy entitled Volatility in Irish Quarterly Macroeconomic Data, which notes:

The quarter-to-quarter volatility in real macroeconomic aggregates, including gross output (GDP) and gross income (GNP), is very pronounced for the Irish data, more so than for other OECD countries.

The principal source of volatility in Irish real GDP lies in the recorded figures for industrial output.

Within the industrial output category, which is the aggregate of manufacturing and construction, the excess volatility can be traced to a small number of manufacturing sub-sectors.

These sub-sectors are known to be dominated by exporting multinationals, whose shares in recorded output greatly exceed their shares in employment or in the generation of domestic demand. Recent patterns of growth in these manufacturing sub-sectors show very sharp rises in output, exports and Gross Value Added (GVA), unaccompanied by commensurate movements in employment or payroll.

As I read his introduction, I was wondering if much of the GDP volatility might be due to variations in the degree of transfer pricing manipulation. McCarthy’s conclusion certainly raises the issue of transfer pricing:

The Irish economy has a high GDP/GNP ratio as well as large short-run variations in value-added components other than wages. This paper finds that the Irish quarterly macro data are being seriously distorted by the unusual structure of Irish Manufacturing. This relates to the, no doubt perfectly legitimate, activities of some multinational sectors. These sectors have output valuations dominated by profits rather than wages, and fluctuations in output composition or in transfer pricing or both are clearly at the source of the quarter-to-quarter volatility in overall activity as measured. Care is warranted in interpreting the seasonally adjusted data anyway, since the seasonal factors are based on a period of unprecedented change in the Irish economy. The ESA-95 national accounting rules do not cope easily with a large multinational sector and transfer pricing, and we suggest that the CSO might consider some method of smoothing the Net Factor Payments numbers, and perhaps some other components, on a quarterly basis.

Figure 1 of his paper shows how unusually high Ireland’s GDP/GNP ratio is, while figure 2 points out that this ratio has increased over the last couple of generations. Figure 2, however, only points out that Ireland’s real GNP growth has been less than its real GDP growth. McCarthy also notes that Ireland’s real GNP growth is almost as volatile as its real GDP growth.

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CBPP on the Budget and Tax Cuts

As the GOP argues that Congress is cutting spending to reduce the deficit, Robert Greenstein, Joel Friedman, and Aviva Aron-Dine present evidence that demonstrate: (1) their actions will actually increase the deficit and (2) their actions are just another example of reverse Robin Hood-ism:

Sometime early next year, the House of Representatives is expected to vote on the budget reconciliation legislation that the Senate passed on December 21 and the House passed in a slightly different version on December 19. That legislation would make significant cuts in a number of programs serving low- and moderate-income families and individuals, including Medicaid, child support enforcement, and student loans.

Supporters of the legislation defend the cuts as “tough choices” that need to be made because of large and growing budget deficits. These claims are undercut by the fact that, in the last six weeks, the House has passed four tax-cut bills that together cost more than twice what the budget reconciliation bill saves. The claims are further undermined by Congress’s unwillingness to rethink any previously enacted tax cuts as part of its supposed reevaluation of priorities in light of deficits.

In particular, Congress has chosen to allow two tax cuts that exclusively benefit high-income households – primarily millionaires – to begin taking effect on January 1, 2006. By 2010, these tax cuts will eliminate two current provisions of the tax code that limit the value of the personal exemptions and itemized deductions that people at high income levels can take.

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Corporate Taxation, Transfer Pricing, Growth, and Efficiency

Kash treats us to a recent analysis of corporate taxation from the CBO with page 9 addressing transfer pricing:

Internal transfer pricing provides another means for shifting profits out of high-tax countries. Multinational corporations engage in a substantial amount of international trade between affiliated companies located in different countries. A multinational firm may try to shift profits out of high-tax countries by setting their internal prices artificially high or low for goods or services that are traded between its business affiliates in different countries. For example, the firm may shift income out of a high-tax country when an affiliate in that country is paid too little for its export sales to affiliates in low-tax countries. It may also shift income when an affiliate in a high tax country pays too much for imports purchased from affiliates in low-tax countries. In such instances, the cross-country tax differentials may also influence where businesses choose to invest but in a more complicated way than by simply moving their production operations to low-tax countries. Instead, tax planning may require that businesses structure their activities in ways that make it easier to shift income. Such planning may result in economically inefficient behavior by the company, both in terms of how it must structure its operations and finances to shift the income and in terms of the direct costs that it must pay to acquire planning expertise and either avoid or resolve controversies with tax authorities.

The incentives to shift profits between two countries depend for the most part on the differences between statutory tax rates. That contrasts with the incentives for the location of capital used in production, which depend on the ways in which a wider range of tax provisions work together to determine the taxes imposed on new investment. When a company shifts profits from a high-tax to a low-tax country, the company pays tax on those profits at the lower statutory rate. The company’s tax saving equals the amount of profits shifted times the difference between the statutory tax rates in the two countries. In that way, the shifting of income may also redistribute tax revenue between the two countries, as the company pays tax to the low-tax country – at a lower rate- instead of paying it to the high-tax country. As a result, only part of the revenue lost by the high-tax country represents a reduction in the taxes paid by the company. The rest is revenue gained by the low-tax country.

Footnote 29 is of special interest:

The United States and other member countries of the Organization for Economic Cooperation and Development impose limits on the ability of companies to manipulate such internal transfer pricing, generally on the basis of the arm’s-length principle. Under that approach, the “correct” price is the price at which companies or people would be willing to trade if those traders were not economically related. In many cases, determining the correct arm’s length price – especially when the item traded is unique, such as a patent or a trademark- is difficult. As a result, taxpayers and tax authorities often disagree about the correct price.

There are two points contained in this brief statement. One relates to the issue of intangible valuation, which we discussed here. While we noted that representatives of multinationals often game this issue, tax authorities also play advocacy games at times. The OECD introduces transfer pricing thusly:

A large share of world trade consists of transfer of goods, intangibles and services within multinational enterprises. To determine tax liability in each jurisdiction, the right price (arm’s length price) has to be applied, the OECD has issued guidelines on this principle to avoid double taxation.

One summary of the OECD Transfer Pricing Guidelines notes:

These guidelines maintain the arm’s length principle of treating related enterprises within a multinational group and affirm traditional transaction methods as the preferred way of implementing the principle. These controversial issues are not just of interest to tax experts. National tax administrations, taxpayers and business people alike, all have a share in avoiding conflicting tax rules which might seriously hamper the development of world trade.

Simply put – the central goal of the OECD to promote growth and free trade with adherence to arm’s length pricing for intercompany transactions seen as a central element of achieving this goal. The concern that national tax authorities such as the IRS or Revenue Canada might try to advocate positions contrary to this goal is shared by not only the OECD but also by Kash and Alfons J. Weichenrieder as co-authors of Tax Competition And Transfer Pricing Disputes:

Transfer pricing regulations, which are designed to limit multinationals’ profit shifting activities, have been tightened in recent years in the US. These new regulations have been enacted to increase the tax revenue collected from multinationals, in response to domestic political concerns that foreign companies are not contributing adequate tax revenues. This paper examines the implications of such a struggle by governments to collect tax revenues from multinational firms. It is shown that such behavior will lead to a non-cooperative equilibrium characterized by the double taxation of corporate profits, and consequently by a depressed level of international trade. Conversely, cooperation between governments could potentially increase both tax revenues and trade.

Interestingly, a December 8, 2005 Memorandum of Understanding between the IRS and Revenue Canada “to resolve disagreements in respect of the underlying facts and circumstances in [double tax] cases”, which followed a June 3, 2005 Memorandum of Understanding that vowed to strive for reciprocity and consistency in resolving double tax cases. The two tax authorities have been quarreling with each other on a host of transfer pricing issues, but finally agreed to a process where these double tax disputes would be resolved using the arm’s length standard based on the actual facts in each case. I guess one might applaud these agreements except for the fact that both Canadian and U.S. law codified the arm’s length standard, which is an economics principle that must look at the actual facts in any particular case, many years ago. So the cynic in me asks what do these Memorandum of Understandings do other than say that the tax authorities will follow their own laws? Duh!

But you might ask don’t the tax authorities have economists working for them as do the representatives of national tax authorities. While they do, I would ask you to review some of the insightful (if not jaded) comments from AB reader OldVet as to how the attorneys for the IRS seem to get in the way of effective transfer pricing enforcement while those pretending to be economists for the representatives of the taxpayer play the economists at the tax authorities for fools with “analyzes” so disingenuous that I suspect the National Review would refuse to put their writings up as being credible. Note, however, that the point that Kash and Alfons J. Weichenrieder make is that tax authorities often ask their economists to also act like overpriced whores. At the end of the day, honest multinationals have to pay more to avoid double taxation, while those who engage in transfer pricing manipulation to evade U.S. taxation somehow escape effective scrutiny. I wish it were as simple as the line in Shakespeare’s Henry VI: “The first thing we do, let’s kill all the lawyers”. Yet, these lawyers are trained to be advocates. Economists are not trained to be paid whores, but alas we see so many behaving that way.

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Ireland’s Corporate Taxation

PGL’s insightful post about corporate taxation and Ireland’s economic growth reminded me of something I read recently from the CBO. In November they published a very interesting report entitled “Corporate Income Tax Rates: International Comparisons.”

A few weeks ago I noted the surprising fact that Ireland actually taxes capital income at a much higher rate than the US does. Well, the above-mentioned CBO report contained another tidbit that was surprising to me: while Ireland has a statutory marginal tax rate far lower than that of the US (12.5% in Ireland versus 39.3% in the US), the difference in effective tax rates is much smaller. The reason is that the US has very liberal depreciation schedules, which significantly reduces the taxes that US corporations must pay. The result is that the effective tax rate that US corporations pay on the income from their investments in machinery and equipment is actually only around 22%, versus about 10% for Ireland. That’s certainly a substantial difference, but far smaller than it seemed at first glance.

Even more surprising, however, was table 2-1 from the CBO report that showed that, somewhat counterintuitively, Ireland actually collects a much larger slice of national income in corporate income taxes than the US does, despite their tax rate being lower. The US collects only about 1.8% of GDP in corporate income taxes, while Ireland collects about 3.7% of GDP in corporate income taxes. This extremely large share of national income being paid as taxes by corporations in Ireland is astonishing, particularly given Ireland’s very low statutory tax rate.

Much of the explanation for this, I’m sure, is exactly the phenomenon that PGL described wherein US (and other) multinational corporations effectively transfer some of their profits to Ireland to take advantage of its lower corporate income tax rate. The Irish government thus effectively collects tax money from multinational corporations on income that was actually earned by those corporations in other countries, and which would otherwise generate tax revenues for other governments.

So Ireland enjoys a decided benefit from its low corporate income tax rates. But note that this benefit is a very different one from the typical supply-side argument in favor of low taxes, which is that low taxes promote growth by promoting capital investment and thus generating economic growth. There certainly was a lot of capital investment in Ireland during the 1990s. But much of the gains to Ireland from its low tax rates were simply due to profit transference from the US to Ireland by US multinational corporations. As I’ve argued before, the link between economic growth and tax rates has yet to be established.


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The Irish Economic Miracle and Tax Policy

A couple of weeks ago Kash challenged a claim that Ireland’s growth was due to low taxation of capital income:

Ireland has indeed been the fastest growing economy in the OECD (that’s the club of the world’s richest countries). But it has HIGH taxes on capital, not low ones.

Since I’m Irish, I have been intending to post something on the economic miracle. While Kash was upset with James Glassman, the right-wings supposed expert on Ireland’s economy seems to be Benjamin Powell who penned Economic Freedom and Growth: the Case of the Celtic Tiger:

Most theories of economic growth can be dismissed as an explanation for the rapid growth of the Irish economy. The thesis of this paper is that no one particular policy is responsible for Ireland’s dramatic economic growth. Rather, a general tendency of many policies to increase economic freedom has caused Ireland’s economy to grow rapidly.

In a way, Kash might be happy to seem Powell rejecting a single theory of economic growth, but as I read Powell’s paper, he attributes Ireland’s growth to only two alleged causes – a reduction in tax rates and some bizarre rightwing index known as economic freedom. As one reads his paper, notice that Ireland’s income tax rates are still high and its tax system is still progressive. It is true that Ireland has a low corporate tax rate – a theme that we will return to. Also notice how Powell rejects Keynesian factors and convergence theory (see Brendan Walsh and Patrick Honohan), and the following measurement issue as possible factors for the rapid increase in Irish income:

One alternative explanation is that there has not been a “Celtic tiger.” As The Economist (1997:21) reported, “Is it too good to be true? Yes a few critics say: it was all done with smoke mirrors and money from Brussels.” One argument is that Ireland’s GDP is much higher than GNP because of the amount of profits that foreign-owned companies send back to their owners overseas. The high GDP numbers, therefore, do not necessarily translate into wealth for the Irish citizens. Yet, The Economist also notes that “Ireland’s GNP has been growing nearly as quickly as its GDP.” The dramatic economic growth in the 1990s is not only evident from the increases in both GDP and GNP but also in other statistics.

But Ireland’s GDP does exceed its GNP by about 20% as noted here, here, and here:

Gross domestic product (GDP) is the total value of all goods and services produced in an economy in a given time period. Gross National Product (GNP) is the total value of all goods and services produced in an economy in a given time period which accrues to the residents of a country. The difference is made up of net factor flows, which in reality includes net profit repatriation by multinationals and interest on the foreign component of the national debt. In Ireland’s case, GDP is significantly larger than GNP because of the large US multinational presence here.

I emphasized the RTE-Business definition partly because the link provides growth rates for GDP and GNP, which indicate that GNP growth was less than GDP. Using data from table 12 of the Budgetary and Economics StatisticsApril 2005, I have graphed the GDP/GNP ratio from 1990 to 2004. It does seem the GDP growth has exceeded GNP growth for much of the past 15 years. For more discussion, see this post.

But I’ll concede the point that real GNP has also be growing quickly over the last several years as does Antoin E. Murphy who also notes the difference between GDP and GNP growth as he discusses the role of transfer pricing manipulation plays in exaggerating Ireland’s reported GDP and the fact that it was employment increases as much as increases in output per worker that led to the growth in output per capita.

Pierre Fortin also attributes the increase in output per capita to an increase in the employment to population ratio:

Over the past decade, Ireland’s real domestic product per head has doubled, and its national unemployment rate has declined from 16 percent to less than 5 percent. This has made the Irish Republic one of the ten richest countries in the world. This economic is the joint outcome of a long-term productivity boom dating back to the 1950s and 1960s, and a sudden short-term output and employment boom that has seen Ireland’s job performance recover, since 1993, all the ground lost during the previous twenty years. It turns out that, for several decades, Ireland has been remarkably supportive of long-term productivity growth through its openness to free international trade and investment, its business-friendly industrial and tax policies, and its free secondary and low-cost higher education. The short-term aggregate demand push experienced since 1993 has been fuelled by the solid economic recovery in Europe and the United States, continued improvement in Ireland’s international cost competitiveness, streamlined public finances, and low (net-of-inflation) interest rates. The aggregate supply response to this expansion in demand has included a sharp increase in women’s labour force participation rate, a large flow of new and return immigrants, and massive foreign direct investment, particularly from U.S. multinational corporations. In combination, these developments in labour and capital markets have kept the boom going with no increase in inflation until late 1999. The extended noninflationary response also owes much to Irish fiscal discipline, consensus-based wage moderation, and participation in the Single European Market and the European Monetary Union.

In other words, one can have an aggregate demand stimulus without reckless fiscal policy – just as George W. Bush has proven the converse. Robert Rubin would be proud even if Benjamin Powell has yet to grasp what the Keynes really meant in the General Theory.

Returning to Powell’s thesis that lower tax rates and increasing economic freedom were the primary cause of the Irish economic boom, the Irish Congress of Trade Unions argues:

Of late, a myth has grown up around the birth and, indeed, the conception of the Celtic Tiger. A growing number of influential commentators and politicians have taken to asserting that tax cuts were the key stimulus for the period of remarkable economic growth Ireland enjoyed between 1994-2001. Indeed, they repeat this assertion as if it were a matter of established economic fact – an irrefutable economic law – rather than the political contention it actually is. To date this claim, dressed up as established fact, has gone largely unchallenged. Yet, an examination of the evidence reveals it has little basis in reality. In fact, the evidence reveals that reductions in taxation followed the economic expansion – tax cuts did not spawn the Celtic Tiger. The promotion of the myth that low taxes created the Irish economic ‘miracle’ is part of a wider, conservative political agenda which, in essence, seeks to limit the role of the state and maintain
the benefits reaped by a small minority, during the Celtic Tiger years.

I do not wish to dismiss the role that the low corporate tax rate played in attracting investment from the technology leaders during the U.S. productivity boom of the late 1990’s. Brendan Walsh provides an interesting discussion of how Ireland’s position in the European Union and its income tax incentives to U.S. multinationals made Ireland an attractive place for foreign direct investment. U.S. tax planners also realized that the Republic of Ireland was expecting them to create employment opportunities as the price of favorable tax rates.

One should also recognize – as did Antoin E. Murphy that much of this attraction was the ability of these multinationals to source their U.S. created income as if it were Irish GDP ala transfer pricing manipulation. For example, a recent article in the Sunday Times by Tom McEnaney notes that Microsoft Ireland had received 7.5 billion euros in gross profits during its latest fiscal year renewing a discussion as to whether Microsoft “uses Ireland to shelter profits”. Microsoft’s worldwide gross profits were over $33 billion. Mr. McEnaney also notes that Microsoft’s effective tax rate for the year was 26%. Whether Microsoft is involved with the type of transfer pricing manipulation we discussed here is not clear.

Mark Cassidy provides more discussion and evidence on the role of foreign direct investment of certain U.S. multinationals in the Irish economic miracle.

The Irish economic miracle was in part an employment boom as it had laid the foundation for a productivity boom many years earlier. This employment boom piggybacked the U.S. technology boom with U.S. multinationals realizing that Ireland not only was a gateway into the European Union that could avoid customs duties but also a means for reducing its effective tax rate by using transfer pricing manipulation to shift U.S. income into tax-advantaged Ireland. The really odd thing about the tax cut jihadists in the U.S. is that they are now complaining that the IRS might actually enforce section 482 of the U.S. tax code. Their hypocrisy is apparent when they claim – as many have been recently doing – that enforcing section 482 will lead to an outsourcing of jobs to low-tax jurisdictions. The Irish know that the lack of enforcement of section 482 has been part of their success in attracting jobs from U.S. multinationals.

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Menzie Chinn on the Post-recession Employment Record

Dr. Chinn begins his post by quoting the President’s year-end list of accomplishments:

The Economy Is Growing And Creating Jobs. Since May 2003, the economy has added nearly 4.5 million new jobs. The unemployment rate is down to 5 percent – lower than the average for the 1970s, 1980s, and 1990s. Last quarter, the economy grew at 4.1 percent and has been growing steadily for more than two years.

He then provides some illuminating graphs to suggest that the employment record is not as great as advertised. For discussions of real wages, see James Hamilton.

Update: For those of you who decided to read the comments under Menzie’s post, you’ll see the old Household Survey canard again from “Kane” (signed Tim). Yes, the reported figure has risen by about 5 million since George W. Bush took office but let’s remember why they put the footnote that reads: “Data affected by changes in population controls in January 2000, January 2003, January 2004, and January 2005”. Let’s also remember that the employment to population ratio exceeded 64% in 2000 and is less than 63% now.

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Can Congress Deny Birthright Citizenship?

Stephen Dinan of the Washington Times argues that it can and it should:

“There is a general agreement about the fact that citizenship in this country should not be bestowed on people who are the children of folks who come into this country illegally,” said Rep. Tom Tancredo, Colorado Republican, who is participating in the “unity dinners,” the group of Republicans trying to find consensus on immigration. Birthright citizenship, or what critics call “anchor babies,” means that any child born on U.S. soil is granted citizenship, with exceptions for foreign diplomats. That attracts illegal aliens, who have children in the United States; those children later can sponsor their parents for legal immigration. Most lawmakers had avoided the issue, fearing that change would require a constitutional amendment – the 14th Amendment reads in part: “All persons born or naturalized in the United States, and subject to the jurisdiction thereof, are citizens of the United States.” But several Republicans said recent studies suggest otherwise.

Even if Congress could end run the 14th Amendment, I consider this proposal offensive. Dinan makes two claims without citing any support for either. What is his evidence for the premise that birthright citizenship attracts immigration (I refuse to use the term “illegal aliens” in this regard)? And it is interesting that he suggests “recent studies” suggest that Congress can pass a law that is clearly at odds with the 14th Amendment – and yet Dinan fails to identify a single one of these alleged studies.

The coverage of this issue from Jim Puzzanghera is more convincing in its counterargument on the legal issue:

According to the Constitution’s 14th Amendment, ratified in 1868 to give former slaves U.S. citizenship, “all persons born or naturalized in the United States and subject to the jurisdiction thereof, are citizens of the United States.” Tancredo said citizens of other countries are not subject to U.S. jurisdiction, and he added that drafters of the 14th Amendment did not intend it to apply to children of illegal immigrants. But in a case in 1898, the Supreme Court ruled that a Chinese immigrant born in San Francisco was legally a U.S. citizen, even though federal law at the time denied citizenship to people from China. The court said birth in the United States constituted “a sufficient and complete right to citizenship.” Rep. Zoe Lofgren, D-Calif., who serves on the House immigration subcommittee, said it would take a constitutional amendment to deny birthright citizenship.

The unambiguous words of our Constitution and the ruling from the Supreme Court – what part of either does Mr. Dinan fail to understand?

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Multinationals and National Income Accounting

One of the joys of blogging is that one occasionally gets interesting emails from AB readers such as this one:

When a US based manufacturer (Caterpillar jumps to mind) makes products in Brazil and sells them in Europe, would that count as an export? What about a Toyota Camry manufactured in Ohio? Is that an import?

The first example is similar to something that the folks at Street Authority had in mind:

GNP: Gross National Product measures the total amount of goods and services that a country’s citizens produce regardless of where they produce them. As a result, GNP includes such items as corporate profits that multinational firms earn in overseas markets. For example, if an American firm operates a plant in Brazil, then the profits that the firm earns would contribute to U.S. GNP.
GDP: By contrast, GDP measures the total amount of goods and services that are produced within a country’s geographic borders. Therefore, for GDP purposes, an American company with a plant in Brazil will actually contribute to Brazilian GDP.

The value-added produced when the Brazilian subsidiary of Caterpillar can be thought of being composed of Brazilian wages and the profits for the U.S. shareholders of Caterpillar. Both are counted as Brazilian GDP with this transaction being seen as a Brazilian export to Europe. The profits generated, however, represent U.S. net income from abroad and would be part of our GNP and not Brazil’s GNP.

In the second example, let’s imagine that Toyota’s U.S. subsidiary sells the Camry to some U.S. retail distributor for $20,000 with the cost of components being $15,000 and value-added created in the Ohio plant being recorded as $5000. All of that value-added is counted as U.S. GDP with this being a U.S. produced car, which is purchased by a U.S. consumer. Of course, we could ask where those components were produced. Of the $5000 in value-added, let’s assume that $4000 is wages with $1000 being the profits for Toyota’s shareholders. In our example, Japanese net foreign income from abroad is $1000, which is deducted from U.S. GNP.

The following graph shows the ratio of U.S. GDP to U.S. GNP over the past 35 years. Note that GNP has slightly exceeded GDP as the U.S. has consistently had positive net foreign income from abroad. The rise in the GDP/GNP ratio in the early 1980’s likely reflects the fact that our current account deficits virtually wiped out the net creditor position of the U.S. with the U.S. now in a position of having negative net foreign assets. So why hasn’t the GDP/GNP ratio surprised unity – since one would expect the U.S. to have negative net foreign income from abroad?

I guess the accounting answer is that the profits from U.S. investments abroad are higher than the profits from foreign investments in the U.S. Of course, the allocation of accounting profits for a multinational enterprise depends on its intercompany pricing policies. While the IRS strives to enforce arm’s length pricing, one can identify situations where foreign parent corporations source very little profits in their U.S. subsidiaries, while U.S. parent corporations can source substantial portions of their profits in foreign low-tax jurisdictions.

I can think of two excellent examples of where transfer pricing manipulation distorts the calculation of GDP. One comes from Russia and the types of transfer pricing issues that are part of the Yukos Oil scandal as discussed by the World Bank with the Introduction noting:

Part II addresses a puzzle in Russia’s national accounts. According to official data, the oil and gas sector in Russia comprises less than 9 percent of GDP, while exports from this sector alone amount to 20 percent of GDP. At the same time, the production of services exceeds the production of goods by a wide margin, while the official share of non-market services is very small. Other data also raise questions – for example, the trade sector in the official accounts is huge and profitable, with about one third of GDP and half of all profits generated by trade. We argue that these puzzling observations can be explained by transfer pricing. Many large Russian companies use trading companies to market their output. Using transfer pricing, a firms’ production subsidiary sells output cheaply to the same firm’s trading subsidiary, which then sells it to customers at market prices. Hence, most of the value added accrues to the trading company. Tax can be avoided if the trading subsidiary is able to pay a lower effective tax rate than the production subsidiary would have without the “transfer” of value added. Since Russia’s national accounts are not adjusted for these schemes, transfer pricing has the effect of greatly exaggerating value-added in the service sectors, especially in trade, and underestimating it in industry, especially industries that make heavy use of transfer pricing, such as oil and gas. Correcting the trade margins, using international comparisons, results in oil and gas almost tripling in size, industry again becoming the largest sector, and market services losing some of their weight in GDP. The results are published in part II of this report, including a conversion table that compares the shares of various sectors in GDP before and after the recalculation.

But I’m only warming up for a longer post on the Irish economic miracle – so my second example of transfer pricing manipulation and GDP accounting must wait until later this week.

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