Tuesday, November 28, 2017

American Current Account Deficits in Relation to Taxes and Capital

This post will be with regards to the issues the US faces due to its large, persistent current account deficit (CAD), what causes that deficit, and how it can be resolved. I have previously written a good deal about what drives the American current account (mostly balance of trade from Eurasian capital flows) and why it's a concern. This post will begin where the last post ended and will be split up accordingly:
1. Why has US run large, persistent CAD going back 40 years?
2. How US corporate tax law results in more total debt?
3. Reversing these structural imbalances can be relatively painless

1. Why Has the US run a Large, Persistent CAD for 40 Years?
As I began earlier, the US has been running LARGE AND PERSISTENT current account deficits almost continuously since the late 70s/early 80s. Also note that the US is the world's reserve currency, which means other countries need to accumulate USD or USD assets in order to make payments to one another. Due to the fact that they need to accumulate net USD assets, that implies the rest of the world has no choice but to run a capital account deficit.

Now that we've established how the rest of the world runs a capital account deficit, that implies the US must run a capital account surplus since those two must net out to zero (the world cannot export capital outside of the planet). We also know that the capital account balance plus the current account balance must net out to zero by definition. Hence, the capital account surplus ran by the US implies the US has no choice, but to run current account deficits.

That said, the US can run current account deficits to ensure other countries can accumulate USD assets without those deficits being large and persistent like they've been for most of the past 40 years. Problem right now is that some countries abuse the system by taking up policies to turbo-charge capacity and recycle the excess savings they don't invest by capital exports.

When Asian (and European) countries run those surpluses, someone else must pick up the slack. The only economy that is both large enough, willing enough, and flexible enough to absorb those corresponding surpluses is the US. There are, quite literally, no other options because every other country is either not large enough or is too unwilling to run those deficits (i.e. the other countries generally run surpluses).

2. How the Structure of US Tax Law Results in More Debt?
Note that US tax law provides friendly deductions for things like interest on mortgages for homes, which increase consumption. That pushes upward pressure on current account deficits and funnel them into housing booms. There's many such provisions in the US tax code that create a misallocation of capital and need to be removed.

US tax law also has a very high statutory corporate tax rate with somewhat high deductions. Eliminating all deductions from corporate tax law would fully fund a shift in corporate tax rate from 35% to ~26%. If we compare OECD statutory corporate tax rates, we see that ~20% is the middle of the pack. High corporate tax rates create many economic and financial distortions--we are comparing corporate taxes relatively and not talking about absolute terms.

In a nutshell, high corporate taxes creates the following distortions:
1. Incentivizes companies to offshore (why stay when they can pay lower tax elsewhere)
2. It's double taxation cuz income taxed on corporate side is also taxed as individual income
3. Labor or consumers usually eat the tax, and when they don't, it shows up as lower profit margins
4. Incentivizes companies to register export income in other countries (cuz they pay less tax)
5. Companies end up holding cash abroad that's technically tax-deferred

As a direct result of high corporate taxes, we witness American companies like Apple registering >60-70% of their export earnings offshore. Due to the fact that their export earnings aren't showing up as American exports, the US current account (trade) deficit shows up as higher than it otherwise should be. We also have a policy that taxes capital gains and dividends at a preferential rate to income. A better policy alternative is to simply eliminate the corporate income tax and finance it by taxing capital gains and dividends as income.

Identity: current account balance=private sector balance+public sector balance.
Given the identity above, we can pretty easily show that a larger current account deficit either has to show up as a private sector deficit (borrowing) or a public sector deficit (higher public debt). There is no other option. Any policy that either expands current account deficits directly or directs capital flows into private sector or public sector deficits (like the mortgage interest rate deduction) automatically increases debt for the economy as a whole.

3. Reversing Structural Imbalances Painlessly
It becomes very important to recognize that global structural imbalances, and US domestic imbalances, are not due to the US running current account deficits. These imbalances are driven due to the fact that the US is running LARGE AND PERSISTENT current account deficits. If current account deficits are either relatively large, but not persistent; or persistent, but not large; we do not have a problem.

Hence, correcting these imbalances necessarily means either reducing the overall size of the current account deficit or it means reducing the persistent nature of the large current account deficit. There's two aspects to this. One is the large surpluses coming from most of the Eurasian landmass due to the high savings rates of Eurasian economies which gets recycled into the purchase of USD-assets and results in the accumulation of USD-assets in foreign banking systems, often by central banks. The other factor is tax law. High corporate tax rates encourage companies to shift export earnings abroad which pushes upward pressure on the current account deficit longer-term due to lower exports from global tax minimization efforts by corporations. Also, policies like the mortgage interest rate deduction.

Offshore earnings show up as "reinvested earnings receipts" abroad. The gross amount of reinvested earnings receipts abroad annually amounts to ~1.5-2% of GDP for the last ~7-10 years, but we're more interested in the net reinvested earnings receipts because that's what determines the impact of high corporate tax rates on the current account. If we look at that, we see that net reinvested earnings receipts add up to ~1-1.5% of GDP for the last ~7-10 years.

If we look at US current account deficits for the past few decades, we notice that they've been ~3% of GDP ever since the 2008 crash (which makes sense since a housing investment and consumption boom collapsed). Due to the fact that net reinvested earnings abroad have been ~1-1.5% of GDP for since 2008, we can definitively say that US current account deficits would be ~1-1.5% lower if the US did not have a corporate income tax because all that profit registered abroad would now be registered here.

There is one caveat to the directly lower current account deficit: if companies that do register these export earnings in the US and they invest more as a result, there is no reason for the current account deficit to fall by that much. Instead, the current account deficit would fall by the difference between the exports now registered in the US and the amount of new investment.
Note: That said, I do not buy the idea that reducing corporate tax rates will create more investment. Private investment is driven by demand for goods and services in a normally functioning market economy and corporate tax rates do nothing to increase demand for goods and services.

If NGDP growth is ~4%, the US can run current account deficits of ~4% of GDP without having total debt grow faster than the economy as a whole. So even slicing the current account deficit from ~3% of GDP to 1.5-2% of GDP via elimination of corporate tax rates could easily bring down the growth of debt to levels low enough to allow the US economy to deleverage very rapidly (both public and private sectors). These are MEDIUM-TO-LONG-TERM effects, not short-term.

So the simplest ways to rebalance are to:
1. Eliminate corporate taxes and replace revenue stream by taxing capital gains/dividends as income
2. Eliminating mortgage interest rate deduction and other similar policies
3. Taxing the accumulation of USD-assets in foreign banking systems, especially by central banks

If we only care about reversing the large and persistent nature of US current account deficits going back 40 years, then any one of those policies could do the trick (especially (1) and (3)). If you'd like to see the current account deficit eliminated completely, then all three of those policies outlined above would do the trick if put into practice.

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