U.S. Corporate Taxes, Inversions and Surplus Savings

Source: Goldman Sachs Global Investment Research,
Congressional Research Service. Company Filings.

Walgreen's decision to go ahead and buy the 55% of Alliance-Boots that it does not own, but not move their headquarters may mark the beginning of the end of the so-called inversion boom. Inversion is simply when a U.S. business buys a foreign company in a lower tax country and moves its headquarters there.

As this Great Graphic from Goldman Sachs and published on Business Insider by Joe Wesienthal illustrates, there has been an explosion in such deals this year. The latest legislation was in 2004 that seemed to prevent or deter inter-company inversions, requiring actual transactions to accomplish this. There is a push for new legislation to close this loophole and there is some idea that the legislation could be retroactive.

[Read: Does the U.S. Have the Highest Corporate Tax Rates in the World?]

While there is genuine concern, perhaps it is not too cynical to suggest that it also makes good copy for some candidates ahead of the November elections. The counter argument is two-fold. First is that addressing the perverse incentive structure should be part of the a larger tax reform effort. Second, in some quarters the tax avoidance strategy is condoned as part of a criticism of the double taxation on corporate profits.

One of the big arguments is that the 35% top U.S. federal corporate tax rate is among the highest in the world. It is little wonder then that corporations seek to minimize their tax burden, with inversions being simply one of the ways. Yet, we think the debate is all too often based on tax scheduled rates and not actual rates. What is the average rate that the large U.S. multinational companies, who are doing these inversions to reduce their taxes, actually paying?

Source: GAO representation of OMD data.

Large companies operating in other countries have to file special tax forms (M-3). According to the Government Accounting Office, the effective tax rate that is actually being paid is 22.7% in 2013. If only profitable companies are included, the effective tax rate is 17%.

This helps explain why corporate tax collection is relatively low. It is low on two counts. First, it is low relative to what the federal government has historically collected, as this Great Graphic posted by Danielle Kurtzleben on Vox depicts with the falling share of Federal corporate tax revenues compared with size of the economy and other taxes and revenues.

In 1952, corporate tax revenues accounted for nearly a third of the federal revenue. By 2013, it had fallen below 10%.

Source: CRS graphic based on data from OECD, Revenue Statistics, Comparative Tables, https://stats.oecd.org/Index.aspx?DataSetCode=REV.

Second, the taxes actually collected are relatively low as a percentage of GDP compared with other OECD countries. This final chart was also posted on Vox by Kurtzleben. It shows that, on average, OECD countries collected 3% of GDP in corporate taxes. The U.S. stood at 2.3% in 2011. Several countries that are considered tax havens, like Ireland and Luxembourg, have larger corporate tax revenues as a percentage of GDP than in the U.S..

We remarked recently that several major central banks, including the Federal Reserve, the Bundesbank, the Bank of Japan and the Bank of England all want to see an increase in wages. Higher wages are seen as either a signal that their economies have recovered sufficiently to normalize monetary policy (U.S. and UK) or to ensure the economic recovery is not derailed (Japan and Germany).

If the problem is understood as insufficient aggregate demand, then boosting taxes on consumption (demand) as Japan did on April is counter-productive. Businesses, on the other hand, in the U.S., Europe and Japan are flush with cash and savings. Yet, despite low interest rates, net new capital investment (net of depreciation) remains meager at best. Besides, it has been several business cycles since investment led a recovery. Recent earnings data confirm that, generally speaking, profit margins remain fat. Cutting corporate taxes (as Japan plans and other countries consider) also seems counter-productive.

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While some observers have attributed the financial crisis to global imbalances, perhaps there is another imbalance that contributed. Retained earnings that are not reinvested in plant and equipment have to be invested into something. If not real assets, the money is invested in paper assets. In addition to the large pools of capital by reserve managers (central banks and sovereign wealth funds) and large asset managers (pension funds, life insurers and mutual funds/unit trusts), corporate balance sheets should be included when analyzing why interest rates remain low.

Conventional wisdom holds that core bond yields are low because of QE in both the U.S. and Japan. That is, the low long-term interest rates are artificial and a function of manipulation by central banks. One implication of the analysis here is that perhaps what is happening is a return of the Greenspan Conundrum.

The Greenspan Conundrum refers to the question the former Federal Reserve Chairman asked in early 2000s: Why were long-term rates falling even though the Fed was raising short-term interest rates? Larry Summer's resurrection of the secular stagnation hypothesis is a similar but different answer than Bernanke's answer to the conundrum: surplus savings.

Bernanke argued that the key was that after the Asian financial crisis, many countries in the region shifted from current account deficits to surpluses, yet did not have the capacity to absorb the new savings. They chose to export it and often bought U.S. bonds. Bernanke also attributed a role to oil exporters as well, and recognized a role for demographics. The vast retained earnings of corporations in the high income countries maybe should be added to such surplus savings.

About the Author

Managing Partner and Chief Markets Strategist
Bannockburn Global Forex