Suddenly, America's Trade Deficit Isn't So Awful

Tax avoidance depresses corporate earnings from exports. Some of that will end with the bill Republicans just passed.

An American product, sold there, profit booked elsewhere.

Photographer: Qilai Shen/Bloomberg

It’s possible that more than half of the U.S.'s trade deficit is a mirage -- an artifact of corporate shenanigans designed to avoid taxes.

Official statistics say that the U.S. trade deficit is about 3 percent of gross domestic product -- smaller than in the 2000s, but still historically large:

A Hole That's Not as Deep as It Looks

U.S. trade deficit as a percent of gross domestic product

Source: Federal Reserve Bank of St. Louis

But a recent Goldman Sachs note about tax reform makes the startling claim that the real trade deficit is much smaller -- less than 1.5 percent. That note contained the following chart:

If this chart is right, the trade deficit has shrunk by more than half since the early 2000s, and is now considerably smaller than it was in the 1980s. There's even the possibility that this is a low estimate -- drawing on a recent paper by economists Fatih Guvenen, Raymond Mataloni Jr., Dylan Rassier and Kim Ruhl, the Goldman Sachs team speculates that the true trade deficit could be as little as 25 percent of the reported number -- i.e., less than 1 percent of GDP.

The overstatement is the result of corporate profit-shifting. The U.S. corporate tax is paid based on where a company records its earnings. Consider a hypothetical company called NoahCorp, based in the U.S. but with an affiliate in low-tax Ireland. If NoahCorp Ireland makes a profit, NoahCorp USA doesn’t have to pay taxes until the money gets repatriated to the U.S. In the meantime, that money can be used to make overseas investments, or held offshore until the U.S. grants a tax holiday.

Here’s an example adapted from Guvenen et al.’s paper. Suppose that NoahCorp produces the NoahPhone, using research, design and branding done in the U.S., then sells it to people in Japan. Normally, the revenue from that sale would be counted in U.S. exports. But in order to avoid paying corporate tax on the profits from the sale, NoahCorp sells its patents and brands to NoahCorp Ireland for a pittance. It then declares that the profit from the Japanese phone sale actually goes to the Ireland subsidiary, not the U.S. parent company. The parent then doesn’t have to pay U.S. corporate tax. And the phone sale doesn’t get counted in U.S. exports.

Of course, at some point, NoahCorp shareholders in the U.S. will want the money from the sale. At that time, NoahCorp Ireland will transfer the money to NoahCorp USA, where it now gets taxed. But now the money is counted as investment income rather than export income, so it doesn’t subtract from the trade deficit.

The result of all this profit-shifting is that the U.S. trade deficit seems wider than it really is, while U.S. income on foreign investments gets overstated. It looks like the U.S. is really bad at selling things overseas, but very good at choosing its foreign investments. For many years, pundits believed that wise U.S. investing was partially making up for uncompetitive manufacturing -- now, it turns out that both of those stories might be different aspects of the same illusion.

What does this mean for U.S. policy? First of all, it means the corporate tax cut just passed by Congress could dramatically shrink the reported trade deficit, while not actually changing real economic activity. The bill cuts the U.S. corporate tax rate from 35 percent to 21 percent, changing the U.S. from a high-tax country to a moderately taxed nation. A lower tax rate will tend to reduce the incentive for multinationals to engage in the kind of avoidance schemes described above. This effect will be partially canceled out by another feature of the tax reform -- the shift from a worldwide corporate tax system to a territorial one, which increases the incentive to use tax havens. But if the effect of lower rates dominates, reported foreign investment income will shrink, and reported exports will rise, as companies report more profit to their U.S. branches and less to their foreign subsidiaries.

Nothing real will be changing, of course. The same phones will still be sold, and the same intellectual property will be created. But it will look like a huge win for the Donald Trump administration, which pledged to cut trade deficits.

A more substantive result concerns the changes in the global economy that took place during the 2008 financial crisis and the Great Recession. In the mid-2000s, as the U.S. trade deficit ballooned, many economists and commentators alleged that global imbalances were getting out of hand and were setting the country up for disaster. In net terms, U.S. consumers were borrowing from foreign countries in order to consume imports.

Many predicted a devastating correction -- and at first it seemed like the financial crisis and the Great Recession fulfilled that prophecy. But the U.S. trade deficit remained stubbornly high. This confounded those who had thought the imbalances were unsustainable. It also seemed to foretell another crisis, since it implied another big adjustment was inevitable.

But the findings of the Goldman Sachs team, and of Guvenen et al., show that the imbalances smoothly adjusted -- and happened on schedule. It was just covered up by massive tax avoidance. And that probably means that another big global rebalancing, with an attendant financial crisis, isn’t looming.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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