Profit shifting by multinational companies in two graphs

NBER summary of the research by Gabriel Zucman et al shows that close to 40% of profits booked by multinational corporations outside their headquarters' country are shifted to tax havens, with US MNCs booking a "particularly large fraction of their foreign income in low-tax places".

They compare the profitability of foreign versus local firms in tax havens and find that while the ratio of pre-tax profits to wages is around 30-40% for local firms, it's orders of magnitude larger for foreign firms. In Ireland, for example, it's above 800%, or for $1 of wages paid to Irish employees, foreign MNCs booked $8 in pre-tax profits. 

The graph plots the difference between the profits-to-wages ratio of foreign and local firms against the country’s effective corporate income tax rate in 2015. Bubble sizes are proportional to the amount of profit which we estimate is shifted. In high-tax countries, foreign firms tend to be slightly less profitable than local firms, while in tax havens — shown in blue in the figure — foreign firms are abnormally profitable. Leveraging this differential profitability, we estimate that 36 percent of multinational profits are shifted to tax havens globally. US multinationals appear to shift more than half of their multinational profits, compared with about a quarter of profits for corporations headquartered in other countries.

Subsequent to the reforms under the US Tax Cuts and Jobs Act, 2017 which lowered the US corporate tax rate to 21% and reduced the incentives to shift profits out, US corporations have booked a larger share of their profits in the US after 2018. This change is however very small, an increase of 3-5 percentage points.

The share of foreign profit booked in tax havens remained stable at around 50 percent between 2015 and 2020. Since the share of profits outside of the United States has only slightly declined — to about 27 percent for all US corporations — the share of total (domestic plus foreign) profits booked by US corporations in tax havens has remained between 13 and 15 percent, a historically high level, throughout the period.

Zucman and co-authors find that some of the largest US MNCs have shown a greater share of profits in the US after the reforms. 

In these cases, there has been a more than 20 percentage points decline in foreign profits.

Examining more myths on energy transitions

Happy New Year!

I'll kick off the new year with a post questioning some principles of one of the most powerful enduring narratives, on energy transition. In an earlier post, I had shown using an economic model how economic transitions impose costs, whose allocation is always a problem. 

Consider these claims. There are trillions of private dollars waiting for opportunities in developing countries, especially in infrastructure sectors. There are hundreds of billions available for investment in green energy projects. There are tens of billions waiting to invest in businesses that help the poor. 

There are powerful proponents and supporters of these narratives that it's almost impossible to make a contrarian voice heard. These supporters are very rarely the capital providers themselves, but consultants, think-tanks, boosters, commentators, do-gooders, lobbyists, retired investors, philanthropists, and so on. 

For practitioners who engage from the other side of attracting these trillions and billions (like governments,  and green energy and impact entrepreneurs) and who have experienced the repeated frustrations from such engagements, nothing could be farther from the truth. I feel the same would apply to fund managers and investors who taken in by the hype trawl the market only to find little of substance. These are all pure ideological tropes at best, self-serving market making advocacy at worst. 

I have blogged on multiple occasions and written a long paper here questioning these narratives. The essence is this. The amount of foreign private capital available for infrastructure, green energy, and development in general for developing countries is much much smaller than is claimed. The risk appetite and returns expectations of the trillions of investment capital sloshing around is very different from that available (or even possible) in/from developing countries like India. After all, even theoretically these are different asset categories. Besides there are fundamental mismatches - foreign capital investment and local currency revenues.

For sure the regulatory environment can be improved and government policies can be made more predictable. And the envelope of investible projects can be expanded with support from development finance institutions. But these are all tinkering at the margins compared to the requirements. A continental economy like India can make large strides on its energy transition predominantly only with domestic capital, which includes significant concessional capital from its government. And it also requires demand-side acceptance of some of the costs associated with these transitions - see this for a model for economic transitions. 

A recent oped in Business Standard was effusive on the foreign capital supply-side of the climate financing problem, 

Climate financing for investment is a largely solved problem: The highway to near-infinite resourcing from foreign capital has been established in the form of ESG investment. This involves pensioners and insurance customers in DMs who get a sub-market rate of return for their investments in return for funding the Indian energy transition. Global ESG investment has reshaped the facts on the ground in investment finance in Mumbai.

The confidence - "largely solved problem", "near-infinite resourcing from foreign capital" etc - is mind-boggling. Such articulation does tremendous dis-service to the cause itself. It reinforces the already strong narrative of private and foreign capital being the solution to many complex development problems. It misleads the highest level decision-makers and forces policy makers into expending their efforts chasing chimeras. 

The oped then lays the blame for the lack of availability of demand side on the easiest target, governments.

The ESG world is quite able to support the Indian energy transition, subject to the limitations of present and future Indian financial regulation, capital controls, tax policy and rule of law. It is now hard to find financial closure for fossil fuel energy businesses in Mumbai. It is easy to find financial closure, at concessional rates, for economically sound clean energy businesses. 

The climate financing glass is thus half full for the Indian energy transition. On the one hand, infinite capital is available from the global financial system for sound projects. But on the other hand, there are limitations in the Indian electricity sector that limit what is possible. Our foundational problem is that we have an electricity sector that operates through state control instead of one which operates through the price system.

This is illustrative of a typical problem with armchair prescriptions. Such prescriptions are made on the assumption that there is a clean slate and governments have the agency to do whatever is technically right. 

Consider the problems with the above. India is what India is. Its financial market regulation, for sure, could and will improve. Its bond markets will deepen. Taxes will come down. But it's not at all clear that all this deregulation and lower taxation will lead to significant increases in capital inflows.   

On reforms to the electricity sector as a whole, it's easy enough to advocate cost-recovery pricing. In a country which is poorer than conventional wisdom appreciates, and where meaningful pricing reform on the farm power side is years away, the accounting reality is that aggregate cost recovery tariff schedule, even with cross-subsidisation, will require significant increases in tariff for the lowest category of consumers and large increases for middling consumers. Would our political economy, the shaping of which is a responsibility of the same commentators, allow any government to survive an electoral cycle after having raised tariffs as proposed? As Jean Claude Juncker famously said, we'll know what to do, but the problem is to win elections after having done that.

I have yet to see an oped by any esteemed commentator illustrating how less in purchasing power terms our higher category electricity consumers pay compared to similarly placed consumers in developed countries. Or a research work documenting the extent of farm power subsidy captured by undeserving large farmers, or a campaign exhorting governments to end free power subsidies to those large farmers. Most importantly, apart from articles blaming governments, I have not seen any oped or sustained efforts which seek to marshal hard facts to mobilise public awareness campaigns that creates the political space to undertake reforms.  

Take the example of privatisation of power sector assets, as a source to finance one-time expenditures. For a start, these are heavily regulated assets, whose upside potential is tightly capped. Further, almost all public sector generation and distribution companies have significant volumes of unregulated debt on their balance sheets. Besides, many also carry on their balance sheets debts raised on behalf of their state government to finance subsidies, debts which cannot be assumed by fiscally constrained governments. Finally, the political economy related uncertainties associated with the distribution sector also means that private investors will hedge and heavily discount any power sector asset purchased from the government. If all the liabilities are netted off and discounts applied, the likely returns from even the most competitive privatisation of power sector assets will be small, even negative. One should ask officials in any state where governments have seriously explored these options about the nature of these challenges. 

However, this is not to overlook the near certain improvements to efficiency and reduction in further bleeding from privatisations. But these are all in the future, and cannot make up for the legacy burdens. 

Commentators should acknowledge (as markets do) that developing countries like India, no matter what kinds of regulatory facilitators are put in place, are a different asset category from developed markets. It's fundamentally wrong to believe that even a significant proportion of the large volumes of private and public capital chasing infrastructure and green energy projects will flow into these markets. It's just as wrong to assume that the regulatory and political economy constraints that deter these investors can be addressed or alleviated significantly in quick enough time. 

The first requirement to create conditions for meaningful efforts at energy transition (or anything else) is to acknowledge the real extent of the problem/issue. Then, it's required to usher stability and predictability in policies, expand the envelope of investible projects, create enablers for effective intermediation of domestic risk capital into these projects, and of course create conditions to attract whatever foreign capital is available. All this has to be coupled with serious reforms on the power sector side in loss reduction, utilities performance improvements, and tariff increases. This will require a mix of regulatory oversight, state capability and governance improvements, and private participation where appropriate and possible. None of these are anywhere near close to being "solved problems". 

A graphical summary of 2022

1. A headline story of the year was the return of inflation and high interest rates.

US inflation hit 9.1% in June, the highest since 1981. After lagging behind, core inflation rose sharply, pointing to the broad-based nature of inflation.

US interest rates have risen from 0.25% on March 17, 2022 to 4.5% by December 14, 2022, the fastest rate hikes ever.

2. The other headline story was the performance of the capital markets. It was the worst year for the 60/40 investment portfolio since 1930.

Not just in the US, globally too bonds and stocks both had a disastrous year, breaking the inverse correlation. 

The bond market returns for the year till end-November were already the worst for over a century.

As regards the stock markets,

3. In general, it was a bad year for everything other than dollar and commodities

4. Commodity prices spiked and then retreated

European natural gas prices had risen above 300 euros per megawatt hour, or more than $500 a barrel in oil equivalent, but has now settled back though still elevated compared to normal times. 

5. Pandemic induced supply chain squeezes eased, despite the Ukraine invasion

6. The Ukraine invasion galvanised the comatose western coalition, and nowhere was this most visible than in the unprecedented exit from Russia by western corporates.

By the end of April itself, 70 percent of the Fortune 500 companies operating in Russia prior to the invasion opted to leave or scale back their business once the conflict began.

7. The year saw the re-emergence of America as the pre-eminent global superpower. Scott Galloway has this graphic which shows that US has pledged $47 bn in military aid, more than the combined contribution of all others.

In terms of all financial aid to Ukraine too, things don't change much

8. Livemint's asset returns quilt

BlackRock's asset returns map shows how bad has 2022 been for asset markets.

9. Chinese property market has been on the downswing since the pandemic, and it fell steeper this year.

10. Finally, a pointer to a list of links

• New York Times - year in charts and this excellent compilation of visual stories from the year.
• McKinsey's year in charts.
• FT's year in charts. See this for FT's data journalism stories.
• World Bank's year in charts.
• Data visualisation stories of the year.
• Bloomberg - graphical stories of the year, and world economy in graphs.
• WSJ visual stories here.

India income distribution graphic of the day

Fascinating graphic on income distributions and income gaps in 16 countries.

India has the highest income gap between the 90th and 99th percentile, the most closely bunched distribution between 20th and 80th percentile, the poorest first quintile, and the lowest median income. It points to an important insight about the nature of India's income distribution - the extremes of wealth and poverty, much higher than elsewhere, and a very narrow base of consumers.

This squares us with data from elsewhere. The Pew Research Centre, using the updated ProvcalNet household consumption based income database also used by the World Bank, found that at the end of 2020 while only 5% of Indians live on less than $2 per capita (at PPP) per day, 87% live between $2-10, 7% between $10-$20, 2% live between $20-$50, and just 0.2% (or 3 million people) earn more than $50 per day. 

All this points to the very narrow base of India's consumption class and the large base of those requiring welfare support. As I have blogged on several occasions, and also written in Can India Grow, the growth of the consumption class requires making the nature of economic growth more broad-based. 

Ambition and achievement in perspective

Lucy Kellaway has a brilliant article about her impressions of relocating to the poor North East of England  from London (HT: Ananth). It will count as one of my reads of the year. 

This contrast between the students in her schools in Hackney and up North East is fascinating, 

The first difference is that in my last school barely 2 per cent were white; in this one it is about 90 per cent. The second is that they have lived in the same place for generations. One day I was talking about structural unemployment and giving an example of the region’s defunct coal mines, shipyards and steel plants. On a whim, I asked them if all four grandparents were born nearby — almost three-quarters of the class raised their hands. I remembered a related question being put to my Hackney school where an assembly hall of students were asked if both parents were born in London. Out of 200, barely 10 put up their hands, most of them of African-Caribbean heritage... According to the University of Essex’s Understanding Society study, the North East is the least mobile place in the country, with 55 per cent of survey respondents living within 15 miles of their mother — more than three times as many as in the capital... It seems to me that London’s extreme mobility and the North East’s lack of it explain so much about the differences between the two places and the best and the worst things about each.

She writes about its consequences,

This stability cuts across everything. It may account for the lack of curiosity. It may also lead to insularity and innocence in how they view the world. All London schoolchildren know a lot about different cultures; my students know only their own. When last year their beloved Newcastle United football club was bought by the Saudis, in a surge of joyous exuberance some of them took to the streets wearing tea towels on their heads. They were baffled when the club put out an announcement telling supporters to leave all tea towels at home. Any London teenager could tell them about cultural appropriation, but when I tried to explain, one shook his head in disbelief: “Miss, we were showing respect! We were saying thank you for buying our club.” A bigger difference concerns competition. In London every day 9 mn people fight it out for scarce resources: for a seat on the Tube, a flat to rent, success, jobs, money or fame. Everyone is striving for something — and immigration intensifies this. When families travel thousands of miles from their homes to make a better life for their children, they don’t let them sit around doing the minimum. 

The Hackney schools I taught in were monuments to striving and, as a result, the children did very well indeed. Last month, I did a Zoom call with some of my most driven students and heard how they were applying to Oxbridge and the London School of Economics and Russell Group universities. I felt a sudden pang for my current students who, despite going to one of the best schools in the area, have few such ambitions. They mostly do the work I set them and mostly do it more or less adequately. But, for most of them, that’s as far as it goes. Early on, in a bid to change this, I told my Year 12s that to do well at A-level they would need to do six hours’ independent work a week per subject. The class gawped in disbelief. Patiently, one explained he couldn’t do that because he worked weekends in a restaurant in the Metro Centre and needed to see his mates and watch football. I replied that, in that case, the best grade he’d get would be a C — or maybe a B if he was very lucky. “What’s wrong with a B?” he said. “I’d much rather get that than spend six hours every week on business studies.”

And the toll associated with pursuit of ambition and achievement,

In my current school the teachers seem happy and have no plans to quit. Many have taught there for 20 or 30 years and educated the parents of the current students. Indeed, teacher turnover is so low that I very nearly didn’t get a job. When I started looking last spring, there were 120 vacancies for business studies and economics teachers in London; in the whole of the North East there were only three. In the highest-achieving London academies a quarter of the staff quit every year — not just because they can’t afford flats but because they are wrung out by the scale of the work. This is the trade-off: this sort of system gets the best possible GCSE results, but the teachers, and sometimes the students, get burnt out achieving it.

The dynamics and structures of free market capitalism elevate the unbridled pursuit of ambition, efficiency, incomes/profits, and wealth. There is an increasing monotonicity associated with these pursuits. This, in turn, is fuelled primarily by excessive individualism. 

The problem with all these four pursuits is that apart from their increasing monotonicity, they are almost unconstrained. The extant norms are self-reinforcing. Prevailing management theories and econometric models are primed to maximise efficiency, incomes, wealth etc. Resilience, sustainability, social stability, and other qualitative considerations of human well-being are absent in these narratives. 

Weekend reading links

1. From an FT long read about how Germany's search for profits and efficiency had led to outsourcing of core national interests

Constanze Stelzenmüller, director of the Center on the US and Europe at the Brookings Institution, has said Germany is a case study of a western state that made a “strategic bet” on globalisation and interdependence — and was now suffering the consequences. “It outsourced its security to the US, its export-led growth to China, and its energy needs to Russia,” she wrote in June. “It is now finding itself excruciatingly vulnerable in an early 21st century characterised by great power competition and an increasing weaponisation of interdependence by allies and adversaries alike.”

And things have changed sharply,

“The German business model has to change,” Christian Lindner, the country’s finance minister, tells the Financial Times. “It was based on low energy prices . . . on an abundance of skilled workers, and open markets for Germany’s high-tech products.” But “this model doesn’t really work any more because many of the core elements have changed.”

2. Is a spate of sovereign debt restructuring around the corner?

The World Bank projected this year that about a dozen countries could face default in the next year, and the I.M.F. calculated that 60 percent of low-income developing countries were in debt distress or at high risk of it... The Council on Foreign Relations said this past week that 12 countries now had its highest default rating, up from three 18 months ago... Brad Setser, a senior fellow at council, estimates that $200 billion of sovereign debt in emerging markets needs to be restructured... Restructuring debt can include providing grace periods for repayment, lowering interest rates and forgiving some of the principal amount that is owed... However, the emergence of commercial creditors that lend at high rates and prolific loans from China — which has been loath to take losses — has complicated international debt relief efforts.

3. On the faculty shortages in India's premier higher education institutions

Over 11,000 faculty positions are vacant in central universities, IITs and IIMs across the country, according to Ministry of Education (MoE) statistics... In 45 Central Universities, a total of 6,180 posts of Professor, Associate Professor and Assistant Professor, out of 18,956 sanctioned posts are vacant. Similarly, in Indian Institutes of Technology (IITs), a total of 4,502 posts out of 11,170 sanctioned posts are vacant. In Indian Institutes of Management (IIMs), 493 posts out of 1,566 faculty posts are vacant.  

The idea of establishing too many higher education institutions with the objective of enabling geographical access is only limiting access to quality, since these new institutions are unlikely to be able to attract high quality academics.   

4. The ongoing chaos in airports is a teachable moment. The opeds and opinion makers have predictably lost no time to lay the blame on the doors of the government. 

On the contrary, I believe this is a classic problem of private sector failure. In the aftermath of the pandemic, the airport operators immediately cut down their staff in response to reduced demand. Now that demand has recovered and spiked with holiday season, the operators, true to their style, have been slow in expanding their services manpower. And governments and regulators get the blame. 

5. Physicists at the US Government's Lawrence Livermore National Laboratory in California announce a major breakthrough in fusion reaction. The breakthrough is that of producing more energy in the reaction than was use to trigger the reaction, or net energy gain. 

... uses a process called inertial confinement fusion that involves bombarding a tiny pellet of hydrogen plasma with the world’s biggest laser, had achieved net energy gain in a fusion experiment in the past two weeks... Although many scientists believe fusion power stations are still decades away, the technology’s potential is hard to ignore. Fusion reactions emit no carbon, produce no long-lived radioactive waste and a small cup of the hydrogen fuel could theoretically power a house for hundreds of years... The fusion reaction at the US government facility produced about 2.5 megajoules of energy, which was about 120 per cent of the 2.1 megajoules of energy in the lasers, the people with knowledge of the results said, adding that the data was still being analysed.

6. Russia copes with its international trade isolation. As imports decline a lower quality Soviet-era import substitution regime is emerging, coupled with an active illegal trade system. 

7. Ruchir Sharma has some sobering observations about the private markets,

The rage for private investing began in the early 2000s, after the success of the Yale University endowment fund led by David Swensen, who embraced private investments to diversify away from stock and bond markets and stabilise returns in the long run. Swensen’s definition of “long” was decades... Unlike Swensen and other pioneers of private investing, who bought low in private markets and sold high in public markets, private managers — flush with an overabundance of new funds — are chasing deals, buying high and hoping to sell even higher and running up record debt in the process. The typical company owned by a private equity firm has debts of more than five times its earnings, versus one to three times for publicly traded companies. Today, nearly 100 per cent of the loans private funds use to finance buyouts are “covenant lite”— condition free — up from about zero per cent a decade ago. Investors are piling into private deals which the doors are closing on, as the market for initial public offerings evaporates... Since 2000, the assets managed by private markets have risen elevenfold — over four times faster than stock markets. That gap has widened particularly fast since 2018, when a period of market volatility ended with the Fed abandoning a turn to tighter monetary policy. 

Though many investors are drawn to private funds due to their superior reported returns, those returns are juiced by heavy leverage and the valuations are often based not on market prices but on guesstimates by private firms of what the companies they own will be worth years from now. These calculations are drawing scepticism for both overstating and “smoothing out” results. Private equity firms reported gains of about 3 per cent this year, when public markets were down 20 per cent or more and tighter money battered all markets similarly. Use realistic returns, subtract fees, and private funds may end up returning less than public funds. Yet private equity funds raised more than $1tn last year, up a record 20 per cent, according to the most recent data. Investor Cliff Asness wrote recently of the “mind blowing” possibility that investors now knowingly accept lower returns “for the privilege of not being told the prices”. Hiding from reality creates an illusion that private investments are less risky than their debts clearly demonstrate, which draws in more money, raising risk further. The moment of reckoning likely comes when and if the downturn drags on, and private markets have to finally reveal losses in a down market. 

8. Japan ramps up defence spending

On Friday, Prime Minister Fumio Kishida’s cabinet also approved a record budget totalling ¥114.4tn ($862bn) for the next fiscal year from April as Japan significantly increased its defence spending to counter China’s military rise. As part of an ambitious five-year plan to expand its military capabilities, the government will increase its defence spending by 26 per cent from a year earlier to ¥6.82tn in fiscal 2023. The spending plan includes ¥211.3bn to buy Tomahawk cruise missiles from the US, ¥250bn to buy 16 of Lockheed Martin’s F-35 stealth fighters and ¥105bn for a new fighter jet programme with the UK and Italy.

9. Fascinating Virtual Reality site that tries to reconstruct Rome. 

A model of economic transitions

I'll argue that any forced transitions to formality or higher labour or environmental standards is a supply shock induced demand compression, which invariably lowers the output. In general, any economic transition increases costs which if not supported by associated increases in demand, will necessarily lower output.  

I have blogged earlier in the context of formalisation of the economy that formality introduces layers of production costs which increases the market prices, which in turn reduces market demand. At the higher price, only a smaller number of customers can afford the good or service. The cost structure of the formal market can be met by only a small proportion of the total demand. The market settles down to a lower equilibrium output. 

In fact, it can create perverse incentives. In case of goods and services which are essential (or which have inelastic demand), the reduced affordable formal supply has to invariably result in substitution with lower cost informal supply. If formality is tightly enforced (as in case of certain goods and services), the informal market supply becomes an illegal (or harmful) market supply. 

Supporters will point out that increased formality will raise wages, productivity, profits, and quality which in turn will benefit workers, firms, and consumers in a virtuous loop. But this simplified belief assumes away the considerable adjustment requirements on all sides, which in the real world takes an inordinate time, and in many cases never materialises. It's for these reasons that such transitions have historically taken time, as with the developed countries of today. This ain't an area for leapfrogging. 

The supply will be constrained at both the intensive and extensive margins. At the intensive margin, the informal workers will not be able to acquire the skills required and the informal businesses will not be able to put up the capital for the increased production costs. At the extensive margin, supply of both new sets of workers and businesses will not expand as required. And, in any case, demand cannot expand enough in quick time to create a market which can absorb the higher production costs. 

This dynamic is just as true of labour or environmental or any other set of standards, which can all be seen as dimensions or aspects of formality. Each of these standards adds a layer of production and supply cost to the industry. And these costs must be passed through in the form of higher costs. 

In fact, we can extend this logic to economic growth itself. Economic output can grow sustainably only if the demand side can grow at the same pace as the expansion in supply. While it's possible for the supply to expand rapidly (say, with foreign capital), it cannot do much in the short-run to increase demand. In other words, sustained high economic growth requires the growth to be broad-based enough as to support growth in demand. 

The exception, which China and East Asian economies benefited from, is if the increased demand can come from an external market. In this case, the local economy can benefit with more investments and jobs, and greater productivity and higher incomes, without the proportionate expansion in demand. This positive supply shock will, in course of time, create the foundations for sustained broad-based economic growth. But this opportunity appears to have shrunk considerably. 

In the circumstances, any action plans for economic transitions, like that involving informality or renewables, should acknowledge its limitations and financial costs.