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Hassett’s Evidence on Transfer Pricing and the U.S. Trade Deficit

Hassett’s Evidence on Transfer Pricing and the U.S. Trade Deficit

In my last post, I questioned Kevin Hassett’s claim that transfer pricing manipulation was responsible for half of our trade deficit and asked what was the paper he referenced. We have the text of his speech:

There is another important factor to consider when thinking about how these changes will affect the economy. A recent NBER working paper (Guvenen, Mataloni, Raisser and Ruhl 2017) argues that profit shifting by large multinational firms causes part of their economic activity to be attributed to their foreign affiliates, leading to an understatement of U.S. GDP. Moreover, this profit-shifting activity has increased significantly since the mid-1990s, resulting in an understatement of measured U.S. aggregate productivity growth. The authors correct for this mismeasurement by “reweighting” the amount of consolidated firm profit that should be attributed to the U.S. under a method of formulary apportionment. Under this method, the total worldwide earnings of a multinational firm are attributed to locations based upon apportionment factors that aim to capture the true location of economic activity. The authors use equally weighted labor compensation and sales to unaffiliated parties as proxies for economic activity. Applying the formulary adjustment to all U.S. multinational firms and aggregating to the national level, the authors calculate that in 2012, about $280 billion would be reattributed to the U.S. Given that the trade deficit was equal to about $540 billion, this reattribution would have reduced the trade deficit by over half in 2012.

Formulary apportionment can take on many forms. One form is to allocate taxable profits by sales but this approach would likely lead to a different allocation of income than a true arm’s length approach especially for a nation that imported a lot of sourced produced abroad. Wasn’t this realization central to that debate over the Destination Based Cash Flow Tax idea? This NBER paper, however, does something else as noted by this summary:

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Puerto Rico, Transfer Pricing, and Kevin Hassett

Puerto Rico, Transfer Pricing, and Kevin Hassett

Scott Greenberg provided a nice summary of what section 936 was and how its expiration had contributed to Puerto Rico’s economic and fiscal difficulties:

beginning in 1976, section 936 of the tax code granted U.S. corporations a tax exemption from income originating from U.S. territories. In addition to section 936, the Puerto Rican corporate tax code gave significant incentives for U.S. corporations to locate subsidiaries on the island. Puerto Rican tax law allowed a subsidiary more the 80% owned by a foreign entity to deduct 100% of the dividends paid to its parent. As such, subsidiaries in Puerto Rico had no corporate income tax liability as long as their profits are distributed as dividends. When section 936 was in effect, U.S. corporations benefited greatly from locating subsidiaries in Puerto Rico. Income generated by these subsidiaries could be paid to U.S. parents as dividends, which were not subject to U.S. corporate income tax under section 936, and were deductible from Puerto Rico’s corporate income tax. Because of these generous tax incentives for business, Puerto Rico grew rapidly throughout the 20th century and developed a substantial manufacturing sector, though it remained relatively poor compared to the U.S. mainland. However, because section 936 made foreign investment in Puerto Rico artificially attractive – creating, in effect, an economic bubble – it left the island vulnerable to a crash if the tax provisions were ever to be repealed.

The story is that starting in 2006, the IRS would treat the Puerto Rican affiliates of life science companies as contract manufacturers which would greatly reduce the transfer pricing manipulation made legal under section 936. Greenberg notes:

2006 also marked the beginning of a deep recession for Puerto Rico, which has lasted until today. Puerto Rico’s high corporate taxes on domestic corporations along with low taxes on U.S. subsidiaries had skewed the Puerto Rican economy toward foreign investment from the U.S. When section 936 was repealed in 2006, foreign investment began to flee. Without a strong domestic corporate presence to fill the void, the economy began to contract, along with tax revenues.

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Does Kevin Hassett Understand Transfer Pricing?

Does Kevin Hassett Understand Transfer Pricing?

Howard Gleckman does:

It is true that bringing US corporate rates in line with our trading partners may reduce incentives for improper transfer pricing. But there is a flaw in Hassett’s argument: While these practices are aimed at reducing tax lability, they do not represent real economic activity. And limiting income shifting won’t significantly increase domestic employment.

He was noting this presentation:

Kevin Hassett, chair of President Trump’s Council of Economic Advisers, argued today that the corporate tax cuts in the Sept. 27 Republican Unified Framework would boost overall economic growth. How? In large part because its corporate tax rate reductions would encourage firms to shift jobs from overseas to the US. But the claim is unsupported by the evidence. In a speech at the Tax Policy Center today, Hassett said that the GOP plan would not only increase domestic employment but also raise worker wages by an average of $7,000. That is quite a promise, but after unpacking his argument, it seems improbable at best. His claim: Making statutory US corporate tax rates competitive with the rest of the developed world would encourage firms to stop inappropriate transfer pricing, corporate inversions, and other income-shifting practices. Half of the US trade deficit, he said, results from transfer pricing.

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