Tuesday, June 18, 2013

A note of caution on harmonization of policies

In a recent FT op-ed, Google Executive Chairman Eric Schmidt suggests that corporate tax reforms, aimed at resolving the ongoing controversy about firms evading taxes by exploiting the variations among different national tax jurisdictions, should occupy the agenda of a multi-lateral forum like the G-8. This suggestion is in line with the belief that in a closely integrated world, the rules of the game governing such trans-national issues should be formulated in multi-lateral forums. While the importance of a trans-national consensus on such issues cannot be denied, this should not be taken to mean a one-size-fits-all harmonization of policies.

The political indignation in UK forced Prime Minister David Cameron to push in the direction of a global consensus on corporate tax rates. Some of the reforms being suggested, most notably disclosure requirements like country-by-country reporting of revenues and profits, are undoubtedly desirable. But the danger remains that it is only a short step from here for someone to suggest harmonization of corporate tax rates. I believe that this would be undesirable.

The Great Recession has unsettled the conventional wisdom in several areas. The four largest economic entities - US, Europe, Japan, and China - have been pursuing domestic economic policies that not only go against economic orthodoxy but also may be adversely affecting other countries. Consider the following four sets of macroeconomic policies.

1. In an age of global production chains, multinational corporations have sought to limit their tax liabilities by exploiting the vast variations in tax rules across the world. For some time now, concerns about high profile firms like Google and Apple avoiding taxes through complex webs of cross-national ownership holdings and revenue transfers have been brewing. Fundamentally, they seek to transfer income from a higher tax country to lower tax ones through complex accounting transactions.

Recently Apple, despite sitting on $145 bn cash reserves, two-thirds located outside the US, decided to take a $17 bn loan to buy back some of its own shares, clearly to avoid paying taxes in the US. A US Congressional investigation has found that in the 2009-11 period, Apple Inc paid only $5.3 bn in taxes instead of the $21 bn it would have had to pay at 35% corporate tax rate. At a time when governments, especially in the developed world, are fiscally constrained and economies are weak, this massive revenue loss has become a matter for serious concern.

Ireland has been at the center of this controversy, thanks to its very low corporate tax rate of 12.5%. All the major corporates have "letterbox subsidiaries" in Ireland or other low-tax jurisdictions, whose utility is exclusively to avoid taxes. Critics argue that such low tax rates are beggar-thy-neighbor and recently, as part of the Irish bailout package, the European Union aggressively pushed for raising Ireland's corporate tax rate. But it cannot be denied that the low corporate tax rate played a not insignificant role in Ireland's emergence as a poster child of successful globalization.

2. The US Federal Reserve has been pursuing extraordinary monetary accommodation through its quantitative easing policies in its attempt to restore economic growth. The balance sheet of the Fed has surged nearly four times since late-2008 to over $3.3 trillion, unleashing a massive volume of credit. Apart from generating domestic asset bubbles and other distortions arising from resource mis-allocation, the ultra-low interest rates and liquidity glut has increased the vulnerability of developing countries.

The sharp spurts of capital inflows have affected exchange rate stability and imported inflationary pressures, thereby increasing the macroeconomic challenges faced by many developing economies. In addition, as Morgan Stanley's Ruchir Sharma, among others, have argued, the easy money has fueled a commodity bubble. This has adversely affected the current account of countries like India. The same set of expansionary monetary policies are at the center of European efforts at economic recovery. The European Central Bank's quantitative easing has only served to amplify the Fed's actions.

3. In Japan, in an effort to pull the economy out of a prolonged deflationary slump, the government of Shinzo Abe has embarked on a policy of aggressive monetary expansion and currency devaluation. The Bank of Japan (BoJ) has expanded credit supply through both large quantitative easing and by communicating a higher inflation target. In recent months, the Japanese Yen has depreciated by nearly a fifth of its value, thereby artificially boosting Japanese economic competitiveness. In fact, the sudden and sharp devaluation of the yen, coupled with its explicit pursuit by the Japanese government, has aroused fears of global currency wars. The Yen has depreciated significantly against all the emerging market economies.

4. The spectacular economic growth of China has in no small measure been driven by external markets. Chinese exporters and infrastructure firms have benefited enormously in their conquest of overseas markets from several implicit subsidies. These subsidies include cheap land and labor, low cost unlimited capital, cheap inputs like electricity and water, and fiscal incentives. To this long list we must also add the benefits of the dollar-renminbi peg. It is undeniable that all these give Chinese exporters an unfair advantage against firms, especially from other competing developing countries, in the global export markets.

All these have been the result of policies explicitly aimed at supporting Chinese businesses in export competition. These policies have been critical to their external competitiveness and helped Chinese firms establish a firm foothold in all markets. The massive scale of such support and the unique nature of the Chinese political economy means that these policies are not replicable elsewhere.

In all the four cases, the respective policies are being driven in pursuit of perceived core national economic interests. The five governments see these policies as critical to either economic recovery or fundamental to their economic growth model. Given the level of political support for such policies and central role it plays in the nation's growth model or macroeconomic policies, it is difficult to believe that they can be taken off the table. Further, the relative size of these economies, except Ireland, mean that these policies have deep impact on the global economy.

The real economic effect of all these policies are no different from traditional protectionism. Protectionists erect tariff barriers to external competition. Ireland's low corporate tax rate clearly under-cuts its partners in the competition to attract investments. The expansionary central banks are, in one stroke, effectively exporting inflation, raising global capital market volatility, and manipulating their currencies. And China is directly subsidizing away competition. All these policies hurt other economies as much as it benefits the country pursuing it.

The movement to harmonize global trade policies was a result of efforts to contain protectionism. By the same logic, in the current circumstances, demands for harmonization of corporate tax rates or exchange rate policies or co-ordination of monetary policies or restrictions on national subsidies cannot be seen as far-fetched. Eric Schmidt may or may not have had tax rate harmonization in his mind, but this issue is certain to be attractive for Congressional leaders in the US and elsewhere at a time when they are perceived as victims of low corporate tax rates in certain economies. But this would be a gross simplification of the complex forces that drive the world economy.

As the costs imposed by the Eurozone's experiment of monetary union without fiscal integration has shown, we need to be cautious about the benefits of excessive harmonization. Apart from the obvious differences in their economic profile and level of development, national economies will always be exposed to asymmetric economic and other shocks. What may be good for one country at a point in time may be the antidote for another at that time. In the circumstances, instead of being boxed into straitjacketed one-size-fits-all policy choices, nation states will require the freedom to pursue policies that are suitable for them at any point in time.

It is also a reminder that there is no orthodox policy toolkit that can help economies successfully navigate these environments. In these conditions, India needs to adopt a heterodox approach towards macroeconomic policy management. Industrial policy, capital controls, and the like have an important role to play in macroeconomic management. In fact, in light of recent events, even the traditional upholders of economic orthodoxy, the Bretton Woods twins, have advocated heterodox policies like fiscal expansion, higher inflation target, capital controls, and industrial policy. In the circumstances, harmonization of macroeconomic policies, while logically appealing, may not be the most appropriate response to the challenges we face.

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