Scoring DBCFT: That Bottle of French Wine You Bought for Your Sweetie Yesterday

Brad Setser gets the transfer pricing issues surrounding Alan Auerbach’s Destination Based Cash Flow Tax (DBCFT):

Small aside on the border adjustment: a border adjustment eliminates the incentive to game the system by shifting profits offshore, but it does so by exempting profits on exports from any onshore tax. It basically abandons the notion of trying to tax the intellectual property (IP) rents on export income, or the economic rents from the export of natural resources for that matter. And it could create incentives for other kinds of gaming. I am convinced that the current system is heavily gamed in ways that hurt U.S. exports of IP and high-margin products (the active ingredient in pharmaceuticals for example), but the proposed border-adjustment gets rid of some of the games by in effect not taxing certain kinds of hard-to-tax income.

I have seen some rough guesses of the alleged net revenue gains from DBCFT based on the simple minded notion that our imports exceed our exports. But if Greg Mankiw is right about this being eliminating the corporate profits tax in favor of VAT, then these rough guesses may be all wrong. I will try to explain using four examples two of which we shall discuss today. A 1989 discussion from the GAO explained how both a tax-credit VAT and a subtraction VAT works:

Both the subtraction and tax-credit methods of calculating a value added tax are based on the premise that value added is equal to a firm’s sales minus purchases. The methods differ in what information is used to calculate the tax. The subtraction method calculates the tax once during the reporting period on the total business activity of the firm. It is simply the total value of sales minus the total value of purchases multiplied by the tax rate. In contrast, the tax-credit method is calculated on the basis of individual transactions, i.e. on each sale and purchase. The individual calculations are then aggregated into the total taxes on sales and the total taxes on purchases. The difference is the tax liability of the firm.

We will deal with subtraction VAT later this week but our current examples are based on imports from Europe which relies on tax credit methods. Rick Steves provides the relevant tax rates for European nations. Let’s imagine you bought a $10 bottle of French wine on the way home to celebrate Valentine’s Day with your wife. The multinational that sold you this bottle spent $7 in France making the wine and $2 in the U.S. on distribution costs. The intercompany price between the French parent and the U.S. affiliate was set a $7.50 by a bilateral Advance Pricing Agreement (APA) where the multinational did care want to game anything as French income tax rates are almost as high as the current U.S. profits tax rate. The French parent ended up paying $0.10 on French VAT since its value-added of $0.50 was taxes at a 20% rate. Auerbach would have us have the same VAT but then abandon the profits tax. So at this transfer price we would also get $0.10 in VAT after the tax credit and the labor subsidy are factored in but lose out on the $0.175 in income taxes. Auerbach et al. admit:

Taxing business income in the place of destination also has the considerable advantage that the DBCFT is also robust against avoidance through inter-company transactions. Common means of tax avoidance – including the use of intercompany debt, locating intangible property in low-tax jurisdictions and mispricing inter-company transactions - would not be successful in reducing tax liabilities under a DBCFT. Here however the distinction between universal and unilateral adoption is important. With adoption by only a subset of countries, those not adopting are likely to find their profit shifting problems to be intensified: companies operating in high tax countries, for instance, which may seek to artificially over-price their imports, will face no countervailing tax when sourcing them by exporting from related companies in DBCFT countries.

As Brad notes – gaming the system will continue as our multinational will be tempted to lower the transfer price to $7 a bottle wiping out French profits. This change if allowed would increase U.S. VAT by lowering French VAT. Of course the French tax authorities would strongly object. Auerbach might advise the French to follow our lead by eliminating their corporate profits tax and relying exclusively using VAT. I don’t exactly see that happening but let’s talk about your lovely wife who was the real big spender buying you a $100 Swiss watch, which cost the Swiss parent $70 to make and its U.S. affiliate $20 to distribute. The current transfer price is set at $75, which makes this example a lot like that cheap bottle of wine you bought her. Since Switzerland has both low income taxes and a low VAT, I leave it to your brilliant wife to explain to you the details.

Al Ullman and the Destination Based Cash Flow Tax

TaxAnalysts reminds us of Congressman Al Ullman:

When Ullman won his first race for the House in 1960, he was regarded as a solid liberal -- which only made his victory more surprising, because his district was historically conservative. Once in Congress, Ullman solidified his left-leaning credentials, earning a 100 percent rating from Americans for Democratic Action (ADA) in 1961.

By 1974, his ADA rating fell to just over 50%. What changed?

Ullman's education at Ways and Means apparently included a course on consumption taxes, because he came to believe deeply in their relative efficiency. He put ideas into action by introducing the Tax Restructuring Act of 1979. The bill, introduced in late October, featured $130 billion in cuts to existing taxes, offset by $130 billion in new revenue from a federal VAT. The sluggish economy of the late 1970s needed a shot in the arm, and tax cuts were just what the doctor ordered, Ullman argued. Specifically, he suggested: (1) a $52 billion cut in Social Security payroll taxes, with rates dropping from 6.65 percent to 4.5 percent for both workers and employers; (2) a $50 billion cut in personal income taxes, with credits for the poor and elderly and various investment incentives; and (3) $28 billion cut in corporate income taxes, with the top rate dropping from 46 percent to 36 percent, as well as "substantial depreciation reform."

How did Greg Mankiw described the Destination Based Cash Flow Tax?

Consider the following tax reform: (1).Impose a retail sales tax on consumer goods and services, both domestic and imported. (2) Use some of the proceeds from the tax to repeal the corporate income tax. (3) Use the rest of the proceeds from the tax to significantly cut the payroll tax.

Was Ullman ahead of his time? I learned about this when I asked someone who knows this history about a 1994 proposal from certain Republicans to have a subtraction VAT much like the Japanese VAT. The Europeans have a tax-credit VAT. GAO explains the details. As I noted earlier, Alan Auerbach has admitted his proposal to end U.S. corporate profits taxes and have us rely entirely on VAT will increase transfer pricing manipulation not lower it:

A lot of folks thought DBCFT would end tax arbitrage but not if the U.S. adopts it alone. It just seems all the work for clever accountants and lawyers will be occurring offshore. Auerbach et al. do make a point that if all nations abandon the taxation of profits and raise retail sales taxes to offset the revenue loss, then transfer pricing becomes irrelevant.

Of course VAT differs in its detailed implementation from a retail sales tax. If all nations went on the European system, Auerbach’s dream of ending transfer pricing manipulation might have a chance. But if the U.S. follows Japan with a subtraction VAT, transfer pricing still matters.

The Distributional Consequences of the Carbon Tax from the Climate Leadership Council

Martin Feldstein, Ted Halstead, and Greg Mankiw (FHM) are singing the praises of a proposed carbon tax:

First, the federal government would impose a gradually increasing tax on carbon dioxide emissions. It might begin at $40 per ton and increase steadily. This tax would send a powerful signal to businesses and consumers to reduce their carbon footprints. Second, the proceeds would be returned to the American people on an equal basis via quarterly dividend checks. With a carbon tax of $40 per ton, a family of four would receive about $2,000 in the first year. As the tax rate rose over time to further reduce emissions, so would the dividend payments … According to a recent Treasury Department study the bottom 70 percent of Americans would come out ahead under a carbon dividends plan. Some 223 million Americans stand to benefit.

The study by John Horowitz, Julie-Anne Cronin, Hannah Hawkins, Laura Konda, and Alex Yuskavage is interesting in many ways including:

To examine the effects of a sample carbon tax, OTA estimated the 10-year revenue effects of a carbon tax that started at $49 per metric ton of carbon dioxide equivalent (mt CO2-e) in 2019 and increased to $70 in 2028. We estimate that such a tax would generate net revenues of $194 billion in the first year of the tax and $2,221 billion over the 10-year window from 2019 through 2028. This revenue could finance significant reductions in other taxes. In 2019, this carbon tax revenue would represent approximately 50 percent of projected corporate income tax payments or 20 percent of the OASDI portion of the payroll tax. If the revenue were rebated to individuals it would amount to $583 per person in the U.S.

The authors are looking at a large carbon tax than FHM are proposing, which is why their estimate of the effect of a per person rebate is larger than $500. Table 4 on page 20 provides an estimate the percentage increase in the pricing of various forms of energy. Most interesting is table 6 on page 26 entitled “The Distribution of $49/mt Carbon Tax and Revenue Recycling as it explores the distributional effects of several options including “no revenue recycling”. While FHM advocate complete revenue recycling, some might advocate using the extra revenue to increase certain forms of government spending such as green technology, infrastructure, and even transfer payments such as medical care and Social Security. The reductions in after-tax income from this progressive agenda would tend to hit those with higher incomes more. The authors also estimate the effects of a revenue neutral carbon tax where either payroll taxes or corporate profits taxes are reduced. If the latter is what the politicians end up doing, it follows that the well to do benefit on net while the rest of us pay more.

The Death of Dodd-Frank?

I’m not sure why my Facebook page highlighted this:

Dismissing a half century of successful free market policies is perhaps the worst thing Donald Trump has done to the Republican party. The President’s ignorant beliefs in zero-sum trade policy and massive infrastructure spending repudiates decades of conservative ideology and undermines the American economy. Luckily, while the rest of the Trump administration is marching head on in a radically anti-free market direction, at least one segment hasn’t fallen in line yet. The reliably conservative Vice President Mike Pence has hired one of the libertarian Cato Institute’s top directors as his Chief Economist. Mark Calabria was the Director of Financial Regulation at the Cato Institute until being tapped by the Vice President for this role.

The link is to what clearly is a very rightwing group. Calabria used to work for Senator Richard Shelby and Phil Gramm. He received his degree from George Mason. So what does Calabria think of Dodd-Frank?? Repeal Dodd-Frank? So what’s his reasoning?

After the bank bailouts of 2008, the public was promised “never again.” Unfortunately the same congressional architects of that bailout, Sen. Chris Dodd and Rep. Barney Frank, enacted legislation giving regulators the permanent option of bailouts, as eshrined in the Dodd-Frank Act.

Calabria links to an earlier discussion:

For instance most economists recognize today that many of the New Deal policies implemented in the 1930s slowed the recovery and added to unemployment. Although harder to quantify, an important reason to avoid financial crises is to avoid the policy mistakes that sometimes follow in their aftermath. Accordingly I hope we all share the goal of minimizing both the severity and frequency of financial crises. This is not something we ever want to repeat again ... Key ingredients of this crisis were: exceptionally loose monetary policy ... There is perhaps no issue that drove the passage of the Dodd-Frank Act more than the public perception that certain large institutions enjoyed the backing of the federal government. A situation commonly called “too big to fail” (TBTF). Not by coincidence the first two titles of Dodd-Frank are aimed at addressing the too-big-to-fail status of our largest financial institutions. Here I raise a number of concerns and observations that merit meeting the claim of ending TBTF with considerable skepticism. One reason that debates over TBTF are often so heated is that there is no actual explicit subsidy provided on-budget for such purpose … Section 204, for instance, is quite clear that the Federal Deposit Insurance Corporation (FDIC) can purchase any debt obligation at par (or even above) of a failing institution. If rescuing a creditor at par is not the very definition of TBTF, I’m not sure what is.

Read the entire discussion for yourself as I will concede that I have quoted some of his most right wing comments. But let’s be clear that Dodd-Frank is about a lot more than what to do if a bank declares bankruptcy. I want to return to his most recent discussion as it relates to the issue what we should do to lessen the chances of financial institutions failing in the first place:

It is time for Congress to deliver on the “no bailout” promise. And Rep. Jeb Hensarling has a plan to do just that in his Financial Choice Act. Core to the Choice Act is a move to improve financial stability by increasing bank capital, while reducing reliance on the same regulators who missed the last crisis. While I would have chosen a different level of capital, the Choice Act gets at the fundamental flaw in our financial system: Government guarantees push banks to reduce capital that, unfortunately, leads to excessive leverage and widespread insolvencies whenever asset values (such as houses) decline. Massive leverage still characterizes our banking system, despite the “reforms” in Dodd-Frank. Even ardent supporters of Dodd-Frank, such as economist Larry Summers, have recently concluded it has not made banks safer.

I agree that higher capital requirements would be an improvement but the Goldman Sachs crowd surrounding President Trump are clamoring for lower capital requirements. Maybe Pence and his new chief economist can bring some sanity to this debate. But Dodd-Frank is still about a lot more than capital requirements. Oh wait, Calabria has more to say:

No contributor to the housing boom and bust has been as ignored by Congress as much as the Fed, and its reckless monetary policies in the mid-2000s. Years of negative real rates drove a boom in our property markets. Stanford economist John Taylor has written extensively and persuasively on this topic, yet it remained ignored by Congress. Such reforms are too late to unwind the Fed’s current distortionary policies, but they may moderate future booms and busts.

The interest rates have “remained too low for too long” canard again? Oh gee – Pence’s chief economist is not only a libertarian – he’s a gold bug.

The Passing Of Raymond Smullyan

Raymond Smullyan died on February 6, 2017 at age 97, a brilliant mathematical logician, philosopher, magician, musician, and several other disciplines. I should provide a link or two or three or more, but if you are interested, just google him.  There is a really huge amount there.  One of  his more amusing yet deep books bore the title, "What is the Name of this Book?"

It is many years since I have seen him, but I knew him personally, and he impressed the living daylights out of me, not merely for his intellect, but also his great and deep wit.  He always had everyone around him laughing, and in a world that has always been full of horrors, there is a great virtue in that.

He was one of those who recognized that my late old man had proven the seriously clear and useful version of Godel's Incompleteness Theorem (actually two theorems), the version that makes it clear that consistency implies incompleteness, assuming one is dealing with a sufficiently rigorous logical system.  Thus he argued they should be called the Godel-Rosser theorems, as they are called by many in Europe.  The key to the "Rosser Trick" is the "Rosser Sentence" that "For every proof of this statement there is a shorter proof of its contradiction."  Yeah, that really kills it.  I mean,  What is the Name of this Book anyway?

As a strictly personal and youthful remembrance, I can report that when I was about 8, give or take a year, he pulled a dime out of my ear that I did not know was there. But then, that is the sort of thing magicians do.

RIP,  Ray.

Barkley Rosser (Jr.)

Intel’s Domestic Investment

Brian Caulfield of Forbes announces some good news:

Intel Chief Paul Otellini said Tuesday that the chip maker will spend $7 billion over the next two years to upgrade its U.S. manufacturing facilities. He made the announcement in Washington, D.C., a surprising place for a chip maker to talk about something as nuts-and-bolts as building a new “fab,” or fabrication facility. Over the past eight years, Intel has built six new fabs, and upgraded another. Since 2002 it has invested $50 billion in capital and R&D in the United States. This is the first time an Intel chief executive has rolled out construction plans anywhere east of the Mississippi River. Even so, this is hardly a political, feel-good exercise. Intel needs its fabs–and in some ways, it doesn’t have much choice but to keep marching along to the relentless beat of technology ... For all the dollars involved in the upgraded fabs, there will be few “new” jobs. Instead, Intel executives say the investment will preserve about 7,000 skilled jobs in Oregon, Arizona, and New Mexico, where Intel will begin making the new processors first. Intel generates 75% of its sales outside the United States, but conducts about 75% of its semiconductor manufacturing inside the Unites States, the company said.

Hat tip to Josh Marshall who gets into the politics:

It's worth noting that the original announcement for the Arizona plant in 2011 was done during a visit by President Obama to an Intel plant in Oregon. So Intel's desire to add some presidential flavor to factory announcements is nothing new. But it again puts on display of corporate America's evolving and bifurcated relationship with President Trump: consumer brands conspicuously keeping their distance or actively criticizing the President while manufacturing brands openly work with him to give him credit for hiring decisions which likely have little or nothing to do with him. Intel is of course in some sense also a consumer brand. But since its products are almost always packaged within a piece of hardware produced by another brand - Apple, Lenovo, Dell, etc. - its consumer exposure is much less.

Given all the discussion of the Destination Based Cash Flow Tax, let’s note a few other statistics from their reported financials for 2015. Their total sales were over $55 billion with 75% being overseas even as most of its production was in the U.S. Intel’s pretax income was $14.2 billion with 62% of its sourced in the U.S. under the current corporate profits tax. I would imagine that Intel would receive a yuuuge tax break if the Destination Based Cash Flow Tax is enacted.

The Scale Of Trump's Yemen Botch

It is  becoming clear that the scale of the botch by Donald Trump in Yemen in his first effort at a foreign military action is much greater than .first reported, as reported by Juan Cole.   Right from the start we heard that people in the military were complaining about poor vetting of intel and how there was more military resistance than expected, with one American dying and three getting injured.  There was the embarrassment of a bunch of civilians getting killed, with the latest estimate of those now as high possibly as 30. On top of this we had the absurdity of the whole thing being decided mostly over a dinner with Steve Bannon and Jared Kushner the main parties to it, although supposedly SecDef Mattis signed off on it, followed by the bizarre business of Trump not even going to the Situation Room for this his first military outing.  Maybe he thought that since there were so many pictures of Obama there, and even with Hillary, that this is not something he wanted to do.

Of course there was pushback from the Trumpisti over this, claiming that the whole thing had been planned by Obama, who had just not  quite had enough time (or maybe even guts) to finally sign off on it, and furthermore that some bad leaders of the target group, Al Qaeda in the Arabian Peninsula (AQAP), were killed.  The latter may be true, although as Juan Cole reports, the main target of the raid, AQAP leader Qassim al-Rimini, was not killed and has since put out an audio publicly mocking Trump.

But now Cole further reports (as have others) that Obama had apparently not decided to do the raid. It was long planned, but it was not just a matter of waiting for more intel.  They thought it was not a wise effort, and indeed it has not turned out well.

On top of that, now the Yemeni government led by Mansour Hadi that the US and Saudi Arabia support has just forbidden the US from engaging in any further ground military assaults.  Oh.  Cole suggests that aside from the matter of civilian casualties, there is the matter of Trump's insulting Muslim immigration ban, which Cole reports has the leaders of this US-backed Yemeni government "disgusted."  Oh.

Before just signing off on this as an unsurprising botch by our horrendous new president, I thought it might be worth looking more  closely at the Yemen situation and also the policies of Obama and earlier presidents in connection with it. This ties to what I consider to be the worst thing that Obama did during his presidency, the drone wars.  Data on this is not all that available, but thebureauinvestigates has some estimates for whatever the are worth.  In 2016 Yemen was second after Afghanistan for being on the receiving end of such drone strikes.  There were far more in Afghanistan at 1071 to 38 in Yemen, 16 in Somalia, and only 3 in Pakistan, although back in 2009 Pakistan was the top recipient, with 2010 the top year for such strikes overall.  When it comes to estimated civilian casualties, Afghanistan was up to 65-100 for 2016 and Somalia had 3-5, but there were estimated to be zero in both Yemen and Pakistan, although over the whole period since 2009 there may have been up to 100 in Yemen total.

So there we have Obama's seriously morally questionable drone war policy causing an estimated zero civilian dead during 2016, but within two weeks of becoming president, Trump manages to have as many as up to 30 civilians killed in an operation reportedly more generally botched.  No wonder the Yemeni government we are supposedly supporting does not want us around on the ground at all.

Let me add just a bit of historical background and discussion of the current situation in this troubled nation.  The Yemenis claim to be the "true Arabs," and Ptolemy called the place "Arabia Felix," meaning "Arabia the Happy."  Home to the ancient Sabaean Kingdom that presumably produced the Queen of Sheba, it was and still is the wettest and most fertile part of the Arabian peninsula, which made it well off in the ancient world, along with being a major producer and exporter of spices. Now it has the lowest real per capita income in the Arab world, under $4000 per year and even behind pretty pathetic Sudan and Mauretania.

There are two important things that seem to have held true about Yemen over time as it slid from the best off Arab nation to the worst off economically.  One is that it has long been very divided with local groups controlling their own territories, even as the place was supposedly ruled by a long string of outsiders up through the Ottomans in the early 20th century.  The other has been that those outsiders wanted to control it  because of its location at the southern end of  the Red Sea, making it a crucial location for controlling trade between the Indian Ocean and the Mediterranean.  While the Ottomans officially ruled it from the 1500s onward (it had a brief period of independent and unified rule in the 1300s), they never controlled its highlands, and the British from 1850 on controlled the crucial  seaport of Aden near the southern tip. The split between a northwestern part controlled (sort of) by the Ottomans and a southeastern part controlled by the British is pretty much where we are at now with the official capital of Sana'a in the north controlled by rebel Zaydi Shia Houthis, and Aden and the southeast mostly controlled by the official government of Mansour Hadi, backed by the US and Saudi Arabia, with Iran semi-supporting the Sana'a based regime.

The northern highlands have long been the home of the Zaydi (Zaidi) Shia, who converted in the 800s.  This is the most moderate branch of Shi'ism, the closest of them to Sunnism, 8-Imam Shi'ism in contrast to Iranian 12-Iman Shi'ism.  No outsiders have been able to control them, although many have tried, including the Saudis early in the 20th century, who managed to carve off part of their territory, Asir province, home of most of the 19 Saudis who participated in the 9/11 attack on the US.

After the British pulled out in the early 1970s, their former Aden protectorate became a Marxist regime.  The area was traditionally Sunni of the Shafi orientation. However, the two Yemens unified in 1990 under the leadership of  Ali Abdullah Saleh, who had led the northern Sana'a-based nation since 1978. He was tossed out in 2012 with the support of the US as a result of Arab Spring uprisings the previous year.  But then the  Houthi tribe of Zaydi Shia revolted and took control of Sana'a, with the official government of Hadi retreating to Aden.  Then the Saudis and the Iranians got involved, with the Saudis doing lots of  destructive bombing with support from the US.  Juan Cole claims that the claims of Iranian support for the Houthis by the Saudis and US are exaggerated, although one of  Sean Spicer's more flagrantly false remarks was to turn a Houthi attack on a Saudi ship into an Iranian attack on a US naval vessel, sheesh. Oh, and to top this off, Saleh is back apparently helping out the Houthi regime in Sana'a, if not quite in charge.

Then, of course, on top of all that mess we have al Qaeda, with it long argued and agreed that the Yemeni branch of it was and has been the most powerful one outside of  the Afghan-Pakistani home base, and maybe more so now than there.  In late 2000, while Bill Clinton was still president, they successfully attacked the USS Cole.  In January, 2001, the Yemen government of Saleh launched a campaign against them.  In 2009 they officially joined with the weaker Saudi branch to become AQAP as they continue to be.  They long ago managed to gain control of territory in the eastern part of Yemen, which they supposedly still control.  Both the Saleh and Hadi governments accepted US intervention there in the form of  the drone strikes, even as later the Hadi government would get bogged down in its fight with the Houthi rebellion, which was far from where AQAP operates.

So, big surprise, this is a horrendously complicated and tragic situation, one that obviously took a lot of attention from Obama while he was president, who  apparently had managed to get the civilian deaths in the drone war against AQAP down to zero even as civilian deaths in the Houthi-Hadi war have grown, with the US involved through the Saudis on the Hadi side.  But now Trump has really botched it, so much so that the Hadi regime says we are not to  mess there, and this is an outfit that has planned direct attacks on the US.  For all of what Trump claims he wants to do, this really is a massively serious botch, far bigger than was initially reported.  Will he and his team learn anything from this?  I  do not know, but this one will not be easily fixed anytime soon.

Barkley Rosser

Day later addendum:  Juan Cole has now posted more from the Bureau of Investigative Journalism, who sent people into the attacked village of Yakla five days after the attack.  The number of dead civilians appears to be 25, including 9 children under the age of 13 and 8 women, one of them heavily pregnant.

Auerbach’s Admission on the Transfer Pricing Aspects of His Tax Idea

Brad Setser is doing serious thinking about the transfer pricing aspects of the Destination Based Cash Flow Tax (DBCFT). I will read it but first he has distracted me with a link to an interesting paper by Auerbach et al. which includes this important admission:

Taxing business income in the place of destination also has the considerable advantage that the DBCFT is also robust against avoidance through inter-company transactions. Common means of tax avoidance – including the use of intercompany debt, locating intangible property in low-tax jurisdictions and mispricing inter-company transactions - would not be successful in reducing tax liabilities under a DBCFT. Here however the distinction between universal and unilateral adoption is important. With adoption by only a subset of countries, those not adopting are likely to find their profit shifting problems to be intensified: companies operating in high tax countries, for instance, which may seek to artificially over-price their imports, will face no countervailing tax when sourcing them by exporting from related companies in DBCFT countries.

This is the point of my Trump Toaster Oven tale and what Lawrence Summers said:

Fourth, the combination of a sharply lower rate, new opportunities for tax arbitrage and the fact that any revenue gains from bringing overseas cash home are one-shot means the Federal revenue base would erode. The result would be cuts in entitlement payments to consumers who spend heavily, tax hikes on individuals and reductions in government spending. Over time, this will slow growth and burden the middle class.

A lot of folks thought DBCFT would end tax arbitrage but not if the U.S. adopts it alone. It just seems all the work for clever accountants and lawyers will be occurring offshore. Auerbach et al. do make a point that if all nations abandon the taxation of profits and raise retail sales taxes to offset the revenue loss, then transfer pricing becomes irrelevant. But let’s be a bit careful as some sales taxes such as the Medical Device Excise Tax is not retail based but set at the manufacturer’s price – an issue we dealt with here. The Auerbach et al. claim is actually well known. But will all nations choose to shift the tax burden from profits to consumption? I’m not sure but maybe the proponents of a worldwide abandonment of profits taxes replaced by higher sales taxes need a slogan:

Corporations of the World Unite!

Steven Pearlstein Accuses U.S. of Violating WTO Rules with Respect to Pharma R&D

Pearlstein takes a look at Team Trump’s stance on pharmaceutical pricing. Dean Baker takes issue with this statement:

Because ours is the only country that does not negotiate prices with drug companies, using a national formulary, Americans pay roughly twice what patients in other countries do for the most widely used drugs still under patent. What that means, in effect, is that Americans pay for the 20 percent of drug industry revenue that is invested in researching new drugs, giving the rest of the world a free ride. In exchange for this largesse, a disproportionate share of the high-paying research jobs are located in the United States. Drug companies also used to pay a disproportionate share of corporate taxes to the U.S. Treasury until they became as innovative in tax avoidance as they are in product development.

Dean counters:

Pearlstein is asserting that the United States is making its citizens pay more than people elsewhere for their drugs, in effect as a bribe, to get drug companies to locate research jobs in the United States. This is a clear violation of WTO rules and would be quite a news story if Pearlstein has any evidence to back up this assertion. As a practical matter, we would expect drug companies to locate their research facilities where the cost of the research is lowest. The cost of research is not affected one iota by what a country's citizens pay for drugs. Most likely the reason most research is located in the United States is the enormous subsidies that the government provides through the National Institutes of Health (NIH). It is not a coincidence that a huge number of biotech companies are located in the Maryland suburbs of Washington, right next to the NIH campus.

While this may be true for basic research as phase I and phase II clinical trials, phase III clinical trials need to be conducted in the region or nation where the ultimate drug will be marketed and sold. Let’s take Gilead Science’s latest treatments for hepatitis C virus infection – Havroni and Solvadi – as an example. Gilead sold over $19 billion of these products in 2015 at very high profit margins. U.S. sales of these products were $12.5 billion in 2015. The initial research through phase II trials were not done by Gilead but rather by Pharmasset, Inc. So how Gilead acquire these rights?

Gilead Sciences to Acquire Pharmasset, Inc. for $11 Billion ... Pharmasset currently has three clinical-stage product candidates for the treatment of chronic hepatitis C virus (HCV) advancing in trials in various populations. ... Under the terms of the merger agreement, a wholly-owned subsidiary of Gilead will promptly commence a tender offer to acquire all of the outstanding shares of Pharmasset's common stock at a price of $137 per share in cash.

I suspect this subsidiary was Gilead Ireland Research UC. So this Irish affiliate (think Double Irish Dutch Sandwich) paid for the phase II rights. We can only guess who funded the phase III trials. But it seems a lot of the profits are sourced offshore. We can only speculate what Gilead thinks about the Destination Based Cash Flow Tax. As to the claim that we do not negotiate on prices, this passage from Gilead’s 10-K filing is interesting:

In July 2014, we received a letter from the U.S. Senate Committee on Finance (Senate Committee) requesting information and supporting documentation from us related to Sovaldi and the pricing of Sovaldi in the United States. The letter raised concerns about our approach to pricing Sovaldi, its affordability and its impact on federal government spending and public health. In December 2015, the Senate Committee released the results of the investigation, which alleged that we engaged in a revenue-driven pricing strategy in setting Sovaldi's price. Gilead disagrees with many of the conclusions in the report. In January 2016, we received a letter from the Massachusetts Attorney General that their office is considering whether our pricing of Sovaldi and Harvoni may constitute an unfair trade practice in violation of Massachusetts law. In February 2016, the Massachusetts Attorney General’s office served us with a Civil Investigative Demand requesting that we produce documents related to our HCV products.

A Confused Explanation of the Effect on the Taxation of Foreign Income Under the Auerbach Tax

This Destination-Based Cash Flow Tax debate has generated a lot of discussion – some of it helpful and some of it quite confused. Tim Fernholz is making a noble attempt but he stumbles on something others seem to get confused about:

Some of that money appears to be a result of companies shifting earnings overseas by moving their intellectual property (IP) abroad. And some firms whose income is entirely predicated on easily movable IP, like drug makers, have simply moved their headquarters to tax havens in order to escape US tax obligations entirely.

Permit me to interrupt. Inversions only get rid of the repatriation tax. The real issue here is the tendency for companies like Amgen to migrate their U.S. created intangible assets offshore. But this is not where I fear Tim has gone astray:

The next feature of the plan to think about is the destination-based aspect of it. Republicans propose to end the longstanding, uniquely American idea of taxing worldwide income.

Sorry but I need to interrupt again. Other nations are on territorial systems (no repatriation tax) but tax corporate profits on a sourced-based system. Please continue Tim:

If you consider for a minute about what kind of incentives this might create, one of the obvious ideas for an American firm would be to move production and intellectual property overseas, to a low-tax or low-labor cost country, while continuing to sell products in the US. Just as companies today try to shift income overseas because it is effectively untaxed there, they would similarly do so if their foreign income was untaxed by law. To battle this incentive, we finally reach the border adjustment part of the proposal. The adjustment would, at its simplest, make it so that foreign purchases by companies would not be deductible, to balance the lack of taxes on exports—that is, the tax only targets domestic consumption.

Yes Amgen, Apple, and Google source a lot of income abroad under the current system which should receive a section 482 challenge from the IRS. This House proposal would not increase their U.S. taxes at all – it would simply mean that the IRS would no longer be able to challenge such aggressive transfer pricing. So why call this “to battle this incentive”? It is like throwing up the white flag of surrender. This is the point I was trying to make earlier.

What, you think our country is so innocent?

 Today:

O'Reilly: But he's a killer though. Putin's a killer."

Trump: There are a lot of killers. We've got a lot of killers. What, you think our country is so innocent?

One year ago: Donald Trump defends Vladimir Putin over Alexander Litvinenko murder:

Have they found him [Putin] guilty? I don't think they've found him guilty. If he did it, fine but I don't know that he did it. 

You know, people are saying they think it was him, it might have been him, it could have been him. But in all fairness to Putin - and I'm not saying this because he says 'Trump is brilliant and leading everybody' - the fact is that he hasn't been convicted of anything. Some people say he absolutely didn't do it. 

First of all, he says he didn't do it. Many people say it wasn't him. So who knows who did it?"

General Strike and Recall

Alex Gourevitch has written a thoughtful and well-informed essay about the general strike, Whose Strike? The essay begins with an essential cautionary tale -- an overview of the violent history of strike repression in the U.S. 

This historical background is important. For one thing, it may help to dispel the misleading cries about the intrusion of a presumably un-American "fascism." Violent repression of labor activism is as American as cherry pie. But Gourevitch's point is not that a general strike is too risky to consider. It is that because it is so risky, it cannot be taken lightly: 

In the past, workers stayed out on those strikes, even fighting the state, in part because of dense, historically developed, cultures of solidarity; established traditions of militancy; organized, if not always recognized, unions; and long connections with left-wing organizers. These days, the appetite for fighting the state is next to nil, there is no tested public sympathy for labor actions, and there are no clear organizations standing ready to lead. 

If you’re going to ask people not just to risk losing their jobs but potentially face the armed apparatus of the state, there had better be preparation, leadership, and some evident readiness for mass labor actions. 

Not to mention, there had better be a recognizable goal. But what is the point of the proposed general strike? To say down with Trump? What, so we can have Pence? 

Or is the point just a generalized ‘No’? A massive expression of discontent? None of the significant costs of a general strike are worth it if it’s just a grand gesture of refusal.

As to what should be that recognizable goal. I have a few suggestions: 1. abolition of the wages system and 2. direct democracy. Those two phrases are shorthand. They refer to a complex analysis, not to whatever image or association is evoked by the words in the phrase. Abolishing the wages system and direct democracy are processes, not proclamations.

Trump And The Fed

It may be way too soon to say anything sensible about what Trump thinks about the Fed or will do  about it, but as the first person to have publicly called for appointing Janet Yellen as Chair (back in 2009), I figure I am more situated to stick my neck out to say something, especially when it looks like what is coming is a big contradictory mess.

For the moment the Fed seems to be laying low, having made almost no change in policy or projections as reported by the diligent Tim Duywww.economistsview.typepad.com/economistsview/2017/02/fed-watch-fomc-employment-report-warsh.html [trying to link to economistsview.typepad.com/economistsview/2017/02/fed-watch-fomc-employment-report-warsh.html , but not succeeding].  They remain open to maybe tightening after March if the employment report improves notably, but otherwise seem to be on a "steady as you goes" path for the moment, doing almost nothing.  This on top of a letter from Congressman McHenry demanding they stop cooperating with any international banking entities until Trump  makes appropriate appointments.  And Tim adds a comment on a recent column by former Fed gov Kevin Warsh, who indulged in criticizing the Fed by demanding that it follow policies it is already following.  In this latest post Duy suggests that perhaps Warsh is running for Fed Chair, which means one has to appear to criticize Fed policy, even if one is not really.  Which raises the question of what Trump will do.

Let us start with something that hardly anybody has noticed, but is just taken for granted: that Trump almost certainly will not reappoint Janet Yellen as Chair.  This just seems to follow from his general attitude that all incumbents are no good, and especially anybody appointed by Obama, except for FBI Director Comey.  Why she is no good is not immediately obvious, and in fact several times over the last two years he praised  her "low interest rate policies" noting that as an old real estate developer he has always been a fan of such policies.  However, in June of this past year when the Fed did not raise the fed funds target rate, he denounced her personally and the Fed more generally for not doing so, charging that their failure to do so was part of a plot to goose the economy in an effort to help elect Hillary Clinton. Given that rhetoric it seems unlikely that he would reappoint her, although it could still come to pass that if when her term comes up next year markets seem to like her as well as GOP commentators, he could change his mind.

Let me note how this expected non-reappointment is a violation of  existing norms regarding the Fed, that it mostly been above obvious partisan politics. The sign of this is that the last three Fed Chairs were each reappointed by an incoming president of a different party when that president came into office.  Thus, Republican Ronald Reagan reappointed Dem Fed Chair Paul Volcker.  Dem  Bill Clinton reappointed GOP Alan Greenspan, and Dem Barack Obama reappointed GOP Ben Bernanke.  But it is all but taken for granted that there is no way Trump will appoint Dem Yellen, and it seems that few observers are batting an eyelash over this, although as near as I can tell she has done a pretty good job and deserves reappointment.

Which brings us to the hard fact that as of now Trump's attitude towards what kind of person he might appoint to the Fed as either just an ordinary governor (and there are two current vacancies) or as Chair to replace Yellen is highly unclear.  On the one hand he has made noises about supporting hard money gold bugs, who presumably would push for higher interest rates soon.  OTOH, we have already seen that "as a real estate developer" he has long liked low interest rates, and we now have a situation where he has been bashing various foreign countries for supposedly holding their  currencies at overly low values relative to the dollar, with the dollar having risen since his election thanks to rising interest rates that happened immediately on his election in the markets, not pushed by the Fed, due to the expectation that he will  be increasing the budget deficit.  All this simply points to that he does not remotely have a coherent view yet of what his broader economic policy is or will be, much less what his preferred monetary policy.  If he increases budget deficits while appointing monetary hawks to the Fed, he may well end up with a Reaganesque mid-80s boom of the dollar to be associated with an unpleasant further hollowing out of our manufacturing sector that he has supposedly been elected to help out.

It is unclear if he is cognizant of the contradictions inherent in his current set of supposed economic policy positions, much less what he will do if and or when he becomes aware that he is facing such contradictions.

Barkley Rosser

Sawdust Caesar

The expression "sawdust Caesar" occurs in this clip from a 1945 newsreel on the execution of Benito Mussolini:

I hadn't heard that description of il Duce before. It comes from a 1935 book by George Seldes, Sawdust Caesar: The Untold History of Mussolini and Fascism. The book was completed in 1931 but publishers in England and then in France backed out of commitments. Many passages could be extracted verbatim from Sawdust Caesar to describe contemporary events. Here is a particularly apt example:

The Auerbach Tax and Automobile Multinationals

Bloomberg reports:

A proposed tax on imports that President Donald Trump is said to be warming to could upend the competitive landscape for carmakers, boosting Ford Motor Co. while hindering manufacturers that rely more on overseas factories including Toyota Motor Corp. House Republican leaders have proposed a so-called border-adjusted tax, which would place a levy on vehicles imported into the U.S. and fully exempt those exported. Though Trump initially deemed the idea too complicated, White House Press Secretary Sean Spicer last week said it was under consideration and could help pay for a wall along the Mexico border. The overhaul to the U.S. tax system could hand an advantage to Ford, Honda Motor Co. and General Motors Co., which rely the least on imported vehicles among major automakers. The shake-up would also undermine Toyota

Is Bloomberg assuming a fixed yen/$ exchange rate so these border adjustments boost exports and discourage imports? Greg Mankiw and Paul Krugman take a very different view. Greg breaks down this Destination Based Cash Flow tax as a three-fer:

Impose a retail sales tax on consumer goods and services, both domestic and imported; Use some of the proceeds from the tax to repeal the corporate income tax.; and Use the rest of the proceeds from the tax to significantly cut the payroll tax.

Greg is assuming the rise in sales taxes is greater than the cut in income taxes, which is not clear. But let’s hear from Paul:

Greg and I disagree on whether replacing profits taxes with sales taxes is a good idea, but agree that all of this has nothing to do with trade and international competition – because it doesn’t. I suspect, however, that Greg is being naïve here in assuming that we’re just seeing confusion because border tax adjustment sounds as if it must involve competitive games. There’s some of that, for sure, but one reason the competitiveness thing won’t go away is that it’s an essential part of the political pitch. “Let’s eliminate taxes on profits and tax consumers instead” is a hard sell, even if you want to claim that the incidence isn’t what it looks like. Claiming that it’s about eliminating a dire competitive disadvantage plays much better, even though it’s all wrong.

Alan Auerbach – the proponent of this idea – joined with Douglas Holtz-Eakin to state why this competitiveness argument is all wrong: These two (AHE) wrote:

Unlike tariffs on imports or subsidies for exports, border adjustments are not trade policy. Instead, they are paired and equal adjustments that create a level tax playing field for domestic and overseas competition; Border adjustments do not distort trade, as exchange rates should react immediately to offset the initial impact of these adjustments. As a corollary, border adjustments do not distort the pattern of domestic sales and purchases

So if this is not going to advantage Ford and GM to the disadvantage of Toyota, could something else be driving Ford’s support and the opposition from companies like Toyota. I have been looking more at the transfer pricing angle objecting to this claim from AHE:

Border adjustments eliminate the incentive to manipulate transfer prices in order to shift profits to lower-tax jurisdictions

A lot of people read this and think transfer pricing manipulation goes away. But this is clearly wrong if our trading partners have positive corporate tax rates that are sourced based. Even AHE admits this later:

Thus, the multinational would have no incentive to use transfer prices to shift profits away from the United States, even if the tax rate in the foreign country is very low. Indeed, it would benefit by shifting profits to the United States, to reduce the taxes it pays in the low-tax country.

Lawrence Summers adds:

Businesses that invest heavily, hire extensively and export a large part of their product will have negative taxable income on a chronic basis .. Fourth, the combination of a sharply lower rate, new opportunities for tax arbitrage and the fact that any revenue gains from bringing overseas cash home are one-shot means the Federal revenue base would erode. The result would be cuts in entitlement payments to consumers who spend heavily, tax hikes on individuals and reductions in government spending. Over time, this will slow growth and burden the middle class.

He is correct about the “new opportunities for tax arbitrage" which is what I referring to with my Trump Toaster Oven example where I noted:

While currently Tiffany might want to raise the intercompany price – she knows the IRS could object. Of course Auerbach’s DBCFT would change her incentives as she might want to lower this price to only $80 to eliminate the Canadian income tax – assuming the Canadian Revenue Agency does not object.

Of course the Canadian Revenue Agency would strongly object. Toyota is a lot like our example. The Auerbach proposal would raise its U.S. taxes and give it an incentive to ship their cars to the U.S. at cost costs only. Toyota’s 10-K indicates that its 2015 sales were $260 billion with over $100 billion to the U.S. Its operating margin was 10 percent with the U.S. getting about half of that on its U.S. sales. So on U.S sales, Toyota has U.S. profits near $5 billion and Japanese profits near $5 billion – both taxes at fairly high rates. The Auerbach tax would give Toyota the incentive to have all $10 billion sourced in the U.S. But one would certainly expect the Japanese tax authorities to strongly object. Summers example reminds me of Boeing which sells over $90 billion a year with 58 percent of those sales to foreign customers. It currently incurs near $1.9 billion in U.S. taxes given its 7.5 percent profit margin and the fact that it allocates over 95 percent of its income to the U.S. The Auerbach tax would cut this tax bill to zero. It would also cut the U.S. tax bill for companies such as Starbucks. So what about Ford and GM? Alas Dylan Matthews has this all wrong with:

For example, suppose that a car company — let’s just call it, uh, General Motors — makes $1 billion in profit manufacturing cars in the US and selling them domestically and exporting them to subsidiaries abroad. That would normally subject it about $350 million in taxes, since the US has a 35 percent corporate tax rate. But GM could instead have its foreign subsidiaries pay $1 billion less for the cars they buy from the US branch of the company. That wipes out GM’s US profits, leaving it with no US tax liability and shifting the profits to the subsidiaries abroad. If those subsidiaries are in countries with a low or nonexistent corporate income tax, that could wind up being a very good deal ... This makes most tax evasion schemes pointless.

I doubt Dylan looked at the 10-K filings of either Ford or GM when he drafted this base erosion fairy tale. Ford sources less than 17 percent of its income to foreign affiliates and GM sources almost none of its income abroad. So the Auerbach tax would represent a major reduction in their U.S. tax bills. These foreign affiliates are not in tax havens unless you think Canada, Mexico, and our European trading partners have zero corporate tax rates (hint – their tax rates are 20 percent or more). Think of their operations as having a European component and a North American component. The European affiliates produce and distribute cars paying royalties back to the U.S. parent. Under the Auerbach proposal, they might want to increase those royalties to bleed their European affiliates dry. But of course the tax authorities in France, Germany, and the UK are not stupid. In North America, Mexican maquiladoras make the components, Detroit assembles, and a Canadian distributor sells to Canadian customers. The Auerbach tax would give Ford and GM the incentives to manipulate transfer pricing to strip all Canadian and Mexican income so the last line from Dylan that I quoted is quite wrong. But it would also be wrong to assume that the Canadian Revenue Agency and the Mexican authorities would just roll over.