Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. This is an extended version of a column that appeared at Project Syndicate on January 15th.
President Trump and the Republicans succeeded last month in passing their big tax cut. It may not have many of the desirable attributes of true tax reform (equity, efficiency, bi-partisanship, revenue-neutrality, or cyclical timing); but it is major legislation, as promised. What about that other major Trump promise, to cut the US trade deficit? The tax cut is virtually certain to raise the budget deficit and in turn to raise – not lower – the current account deficit. Call it the Return of the Infamous Twin Deficits. As when Ronald Reagan cut taxes in 1981-83 or when George W. Bush cut taxes in 2001 and 2003.
There are different measures of the balance of payments, each appropriate for different purposes. The narrowest measure includes only merchandise trade. President Trump likes to focus on bilateral merchandise balances, which are probably the least informative of all the measures in use. We should be interested in a broader measure, such as the overall balance on goods and services. His old-fashioned focus on net exports of cars between particular pairs of countries has been rendered obsolete by the modern multi-national production process in which inputs move back and forth across borders, among national contributors to the chain of value-added that leads to a final product. Furthermore, exports and imports of, say, the services of auto designers are as important in the process as the physical trade in auto parts.
For now, let’s focus on the current account balance, a definition that is slightly broader still than the balance in goods and services. It is an important measure because it shows whether the US is spending beyond its means and therefore going into debt to the rest of the world. The current account balance adds in such other transactions as net investment earnings from abroad, emigrants’ remittances, and foreign aid. The international balance of payments statisticians a few years ago started calling such flows “primary income” and “secondary income” (apparently out of fear that people might otherwise understand what were the transactions involved).
Regardless which model, tax cut causes current account deficit
Today’s column on the negative effect of a tax cut on the current account balance, is “wonkier” than makes for optimal readership. It will briefly run through what four different textbook models have to say about the question. That is the bad news. The good news is that they all give the same answer. The reader only has to be convinced by any one of them. You can skip the others.
Argument number 1: A tax cut boosts income and spending. It is true that the particular tax cut recently passed by Congress heavily concentrated in the corporate tax system rather than the personal income tax system. But Republicans like to point out that corporations are people too. Or, to be more, corporations are owned by people and run by people. Most of the corporate windfall will be passed through to shareholders in the form of dividends and share buy-backs, and given to managers as higher pay. The recipients of the higher income will spend some of that. (To the extent that the firms distribute the tax savings to their workers, as Republicans say they expect, the propensity to spend will be even higher.) Either way, some of this spending will fall on foreign goods. Imports go up. Trade balance goes down.
That first argument was the simple Keynesian model. That model is less relevant when the economy is in the area of full employment, as the US is now, and constrained by capacity.
Argument number 2: If national output is constrained by capacity, then the increase in spending goes entirely into the current account deficit, rather than only partly. Furthermore when output is constrained the increased demand tends to lead to inflation. The higher prices for US products are another reason why domestic consumers will decide to buy more imports and foreign consumers will buy less US exports.
Argument number 3: What about the burst of investment that is supposed to result from the Republican tax reform and that is supposed to raise productivity eventually? We must distinguish between short-run effects and longer-run considerations. In the short run, higher investment is another form of spending: again imports rise and the trade deficit widens. (Think of imports of capital goods like machine tools.) In the longer run, the White House is counting on the corporate tax cut to attract corporate investment from abroad to the United States. The resulting net capital inflow will be that much bigger if the Fed responds to the increased demand for goods by raising interest rates, as it is expected to continue doing. The effect of a net capital inflow? It is a current account deficit virtually by definition. (Remember: the current account deficit is the rate at which the country is borrowing from the rest of the world.) According to the so-called intertemporal approach to the current account, a policy change that people believe augurs higher productivity in the future causes a deficit today.
Argument number 4: Don’t forget the exchange rate. The dollar floats in the foreign exchange market. An appreciation of the dollar would be the likely result of the higher interest rates and would be a concomitant of the net capital inflow. The effect of the stronger dollar, in turn, would be a loss of international price competitiveness and another reason for the trade balance to worsen.
So whichever approach one uses, it is hard to escape the conclusion that the tax cut will work to widen the trade and current account deficits, the opposite of what Trump has promised.
Does this mean that Trump skeptics can sit back and confidently wait for him to be proven wrong? There is one fly in that particular ointment.
Statistical errors from tax-motivated transfer pricing
As we have seen, the effect of the tax cut is virtually certain to work to widen the true current account deficit as well as the reported current account deficit. But it is just possible that the change in tax law will narrow the reported trade deficit in the first year, due to an annoying measurement problem, even as it in fact widens the true trade deficit. The annoying problem is a measurement error that for years has made the trade deficit appear worse than it really is, and that might now go away, resulting in an illusory improvement. The problem concerns “transfer pricing” on the part of multinational corporations.
Transfer prices are the prices that a corporation uses for accounting purposes, when valuing trade across national borders in inputs among its subsidiaries. Consider an American pharmaceutical company that establishes a plant in Ireland. The Irish affiliate imports some inputs consisting mainly of the intellectual property represented by the drug patent, assembles the product in Ireland, and exports it back to the US. The value of the drug patent is in reality the biggest contribution to the value added chain. But because Ireland’s corporate income tax is lower than America’s, the company has a big incentive to pretend that the value of the patent is low, so that most of the profits will show up in low-tax Ireland rather than showing up at the US corporate headquarters where the R&D was done. This sort of profit-shifting — or “creative accounting” to apply a less kind phrase — has long been widespread. It has made the US trade balance look worse than it really is. At the same time it has made US primary income look better than it really is — that multinational investment income that is boosted by the exaggerated profits which the firm is supposedly earning in Ireland. [That is, assuming that the American owner at least reports the profits as having been earned somewhere, before reinvesting them abroad, which may not always have happened in the past.]
George Saravelos and colleagues at Deutsche Bank argue that if this measurement error is eliminated, it could give a one-time boost to the reported trade balance (particularly in the form of reported service exports) as large as $250 billion, which by itself would cut the trade deficit in half. But again, this would improve the reported trade balance, not the true one. And the current account balance would not improve at all, neither the reported one nor the true one, because the apparent improvement in service exports would be offset by an apparent worsening of profits earned abroad.
The current account balance would instead deteriorate for all the reasons stated above: Tax cut causes budget deficit causes current account deficit. The twin deficits are back yet again.
This post written by Jeffrey Frankel.