Banana Republic and Auerbach’s Destination-Based Cash Flow Tax

I’m hoping Santa brings me a new winter coat but if he is comparison shopping between Old Navy and Banana Republic, note they are both owned by the GAP. Bruce Blonigen is right when he challenges this old canard:

Do large mergers benefit or harm consumers? Over the years, corporations and economists have argued that mergers benefit consumers by increasing efficiency, reducing production costs, and, in turn, lowering prices.

But the real reason I thought about shopping for apparel comes from CNBC:

It's a border-adjustment tax for goods that are imported. About 95 percent of clothing and shoes sold in the U.S. are manufactured overseas, which means imports make up a vast majority of many U.S. retailers' merchandise ... A retailer like the Gap buys a sweater from its overseas manufacturer for $80. Gap has an additional $15 in other expenses associated with that sweater (like transporting it). Gap sells the sweater to a shopper for $100. So tax is calculated by taking that $100 in revenue, subtracting the $80 cost of the good, subtracting the $15 other costs, leaving $5 in profit. If Gap pays a typical 35 percent tax rate on the $5 profit, its tax bill for that sweater is $1.75.

Hey, a $100 coat would be nice but I’ll question this example in a bit. The topic is the tax proposal from Alan Auerbach that I’ve been critiquing:

I think the real issue here is that this proposal smooshes together two very different ideas sort of like how shimmer was a floor wax and a dessert topping. Auerbach has been pushing a tax on economic profits instead of accounting profits for a long time. But typically profits taxes are sourced based not residence based. Now it is true that developing nations don’t like the idea of paying royalties to developed nations so they have favored residence based approaches but the OECD has favored sourced based approach to taxing income. Then again, a company like Apple neither declares its foreign based income in the US or in China but in places like Bermuda…we would repeal the corporate profits tax for multinationals but then give them a payroll subsidy. Whether this violates current WTO rules, it certainly is a distortion facing sourcing production in Detroit over Windsor. Maybe Trump might like this idea but this is precisely because he wants to use tax policy to shift production away from foreign sources and back to places like Michigan.

CNBC focus on the trade distortion. While Auerbach fires back with the notion that a dollar appreciation exactly offsets any trade distortion, CNBC’s discussion assumes a fixed exchange rate. The economists at Goldman Sachs take an intermediate view:

The “idealized version” is that standard proposition of the Mundell-Fleming model that trade protection under floating exchange rates would have no net effect on net exports. Of course the transfer pricing implications are a bonus for highly profitable US based multinationals who want to do massive income shifting and declare it all “perfectly legal”. This is a horrific idea which should not become law.

Let’s return to this transfer pricing in a bit but permit me to critique the CNBC example by noting what one would learn by looking at the financials for the GAP. Their operating profits are actually 15% of sales – not 5% - and their recorded operating expenses are 25% of sales not 15%. Cost of goods sold are only 60% of sales and that includes occupancy expenses, which are defined as:

Occupancy costs refer to expenditure required to occupy and maintain the physical space a business inhabits

Let’s assume that these represent 10% of sales. The cost to the GAP of that $100 coat I hope Santa gets me is only $50 – not $80. As Brad Setser thinks about the transfer pricing aspects of what may become Trump’s new tax and trade policy, he seems to be hoping Santa brings him a new iPhone:

The iPhone, famously, is designed in California and is assembled in China out of parts manufactured (mostly) in Asia .. No one questions that the iPhone is designed in the United States. And a lot of the software that makes an iPhone an iPhone is also created in the United States. And the export of intellectual property rights—the U.S. design and engineering embedded in a “designed in California” iPhone sold in Asia or Europe—should in theory enter into the balance of payments as a services export. I would think it should show up in the line item for the export of “charges for the use of intellectual property, computer software” though in practice it may enter as a payment for research and development services

Brad notes, however, that much of Apple’s profits end up offshore:

Apple here is really a metaphor. It is the most high profile case, but it is—judging from the size of reinvested earnings in the balance of payments and the cash balances various firms have built up abroad—far from unique. Certainly the profits that U.S. firms report in low-tax jurisdictions—Ireland, the Netherlands, Luxembourg, the Caribbean, Singapore—are now large relative to U.S. exports of software and research and development services.

Check out Brad’s comment section and they get into this Auerbach tax. I was wondering how much of GAP’s income is sourced offshore as apparel multinationals are notorious for such income shifting. It turns out, however, that GAP sources very little income offshore. So OK Santa – buy my coat there. Happy Holidays everyone!