US tax reform: Big controversy but bigger yields

Last December, US President Donald J Trump signed into law his country's first major tax reform since the Reagan era. Sometimes new legislation is seismic in its effects, directly altering the playing field on which the citizens of the country operate. At other times, a new law can serve as a useful signpost for greater changes that are already under way. In this case, the tax reform represents a bit of both: it will have important ramifications itself, and it will inform the wider trends that occur over decades.

From a geopolitical perspective, the move will have three main effects: It will lead to a repatriation of sizable amounts of cash by American corporations, provide a stimulus for the domestic economy and increase the country’s debt. The combined dynamics of these effects will play a key role in shaping the outlook for the US economy – and its place in the world – for many years to come.

Melting the ‘cashbergs’

Under the previous system, US corporations had incentives to hold their spare cash offshore in tax havens. A high corporate tax rate, coupled with an absence of time limits as to when companies had to repatriate their foreign earnings for taxation purposes, resulted in firms accruing ever larger piles of cash in friendly offshore jurisdictions that were willing to offer favorable terms in exchange for hosting the American giants. The realities of the modern economy greatly impacted this trend. Technology firms whose value largely lies in intangible assets such as intellectual property (iPhone software, for example) found they could choose where they booked their profits because the product was not physical, making its location harder to pinpoint. Accordingly, they often opted to park their profits in tax-efficient locations. The upshot has been the emergence of giant “cashbergs” in offshore havens. One study found that 63 percent of US offshore earnings were reported in six jurisdictions: the Netherlands, Bermuda, Luxembourg, Ireland, Singapore and Switzerland. The main beneficiaries of this trend have been companies that rely heavily on intellectual property, such as technology firms like Apple, with an offshore stash of an estimated $216 billion, and Microsoft at $109 billion.

The new system implemented after the December 2017 law was designed to close these loopholes. US corporations will have to pay tax on foreign earnings as well as domestic revenues, and there are specific new provisions designed to eliminate “profit-shifting,” or the retention of profits in more favorable jurisdictions. American companies will thus no longer have the incentive to park their earnings offshore, meaning the cashbergs will likely soon start melting. To sweeten the deal, such firms are only required to pay a reduced tax on these repatriated earnings of between 8 and 15.5 percent (Apple will need to pay a one-off $38 billion bill), making the whole exercise relatively painless for all concerned – except for, naturally, the countries that have been playing host to these vast sums of money. Ultimately, the United States will soon have a tax system in which the financial activity of American companies pads US government revenues, which has not always been the case in the recent past.

The second effect of the tax reform is the positive boost it will give to the domestic US economy. Officials have cut the corporate tax rate from 35 to 21 percent in a move that has dual benefits. First, the United States will become much more competitive in relation to the outside world, potentially attracting more foreign companies to the country as a base for their operations due to the size of the domestic market of consumers. Second, US companies themselves will immediately witness an improvement in their profit and loss columns as their tax bills decrease. US firms could choose to use this windfall in various ways. The prevailing trend in recent years has been that companies have used any extra funds they have accrued (profits have generally been pretty healthy as of late) to buy back their own shares, driving up stock prices and keeping their shareholders happy. But companies could also put this money to work in other, more productive ways. If US corporations were to see new potential in the US economy or in new technologies, they could invest the money in modernizing their activities or in research and development, which could feed back into potential growth. Indeed, this may already be happening: in January, Apple pledged to invest an extra $30 billion in its US operations as a result of the tax reform.

The end of the party

So far, so good, but as always, every positive comes with a corresponding negative – in this case, it’s in the shape of the debt. By definition, a fiscal stimulus means a short-term reduction in government revenues (or increase in spending), which necessarily results in increased government borrowing. Moreover, the government’s subsequent decision to raise spending on entitlements and defense in the latest budget has increased this effect. The overall result is that the previous targets to balance the budget have now been blown out of the water. Goldman Sachs forecasts a deficit of 5.2 percent of gross domestic product in 2019 and even more thereafter. This will play into the US debt balance: the Congressional Budget Office estimates that the debt-to-GDP ratio is currently around 77 percent, and Goldman Sachs predicts that the figure will rise to 85 percent by 2021, based on the current trajectory. This is high by historical US standards, but compared to some other advanced economies, it remains fairly modest.

The danger with increasing debt is always that lenders begin to doubt debtors’ ability to pay it back. This dwindling of faith makes debt holders’ bonds less attractive, prompting investors to demand higher interest rates to cover the risk. This can lead to a vicious cycle as an already indebted country witnesses its debt repayments increase just when it can least afford them. Many countries have succumbed to the resulting death spiral, ultimately requiring a bailout from an external source such as the International Monetary Fund (which, incidentally, could not afford to bail out an economy the size of the United States). One could argue that this effect is already evident in the US bond market. In recent months, interest rates on US bonds have been rising for the first time in a decade (they jumped from 2 percent in September 2017 to nearly 3 percent in February) in tandem with the new debt outlook implied by the tax reform and increased spending. The danger is thus that the negative effects of the increased debt could swamp the positive effects of the tax cut and fatally undermine the health of the US economy.

But the United States is not like other countries – the world's largest economy has an ace up its sleeve in the form of the US dollar. The dollar is the pre-eminent currency in the global economy; it is the unit of choice for central banks looking for a safe asset in which to keep their savings, and 64 percent of global currency reserves are denominated in the greenback. The most common way for anyone, be it a central bank or private investor, to invest in the dollar is to buy US government debt. This results in a unique global demand for US debt that will continue for as long as demand for the dollar holds.

The dollar goes the distance

The critical question, accordingly, is this: how long will demand for the dollar hold? The answer might be found in the experience of the previous issuer of the world’s reserve currency, Great Britain. The pound was the global reserve currency through the 19th century and the first half of the 20th – a fact that reflected the global dominance of the British Empire during the period. The pound’s pre-eminence survived various economic stresses for its issuer: following the Napoleonic Wars, for example, the United Kingdom’s debt levels rose to 260 percent of GDP in 1819, and it remained above 100 percent all the way through 1860, but investors remained committed to the sterling for nearly a century more.

But most striking is the lag with which the pound's demise followed Britain’s. One could argue that the United Kingdom started to wane by 1890, when the United States began to take over as the world’s largest economy. Its descent was certainly under way by 1918, as London owed Washington massive debts accrued during World War I, and it was pretty much complete by 1947, after another world war had battered the United Kingdom and the country lost its key overseas possessions, particularly India. After World War II, the United Kingdom was something of a basket case, suffering currency crises in 1947, 1949, 1951 and 1955. Against this backdrop, it is notable that the pound-to-dollar transition did not occur until 1956, when the Suez Crisis hammered home the British demise. But even then, the process was gradual, as the inertia possessed by a global reserve currency and the energy required to dissuade the world from retaining it are substantial, certainly much larger than the potential debt levels implied by the new US tax reform and spending plans.

There are other differences between the structure of the historical British Empire and today's United States that suggest a similar “demise” is not even possible. The British Empire was constructed by a small nation that managed, step by step, to physically take control of a large proportion of the world's economic output via military power, economic influence and political guile. Like other empires before it (the Spanish and Roman, to name a few), British strength rested on its ability to maintain control of external regions. As it began to lose them, so went its overall importance in the outside world.

The United States is a different story. The dominant US position in the world since 1945 has been the result of a combination of timing and its inherent attributes. Timing because in World War II, the world’s other major economies had largely obliterated one another, leaving the United States producing 50 percent of global output, thus empowering it to establish a global system that locked in some of its gains. But the inherent attributes are particularly key. Unlike the United Kingdom, which is but a small handful of islands – even if it is fertile in places and possesses high connectivity potential – the United States sits astride a continent. It boasts a wealth of natural resources including farmland, metals and hydrocarbons, as well as wind, solar and hydropower sources that could become more important with time, while it also has inherent connectivity in the form of an extensive internal river system.

The country’s position on both the Atlantic and Pacific oceans provides both maximum maritime access to the world's key power centers and isolation from any threat that might challenge it militarily. It can maintain a giant population, but it is not currently overcrowded like other countries. While a loss of influence and control over far-flung possessions scuppered the United Kingdom’s predominance, the United States’ strength comes from within itself. So, unlike the United Kingdom, the United States as a basic unit has a strong claim to being the world’s largest economy just by fulfilling its inherent potential. All of this suggests that the United States is a much more resilient animal than was the British Empire, and will be harder to dislodge from its pole position anytime soon.

China sailing into headwinds

Today’s rising interest rates are probably not the start of the US death spiral, but they are important for understanding the future that the United States will face. Several influential market commentators declared in recent months that the long-term interest rate cycle is reversing. The cycle is the trend in which bond yields follow a rising path for several decades and then fall for a similar length of time before repeating (see the following chart). The peak of the last cycle was in 1981, when yields hit 15.8 percent; since then, they have been drifting gradually downward, hitting 1.5 percent in 2016. Beyond the simplistic thinking that “it’s about time” for the trend to reverse, there is a deeper explanation as to why capital has been so cheap for 30 years and why that might not continue in the future – and that relates to the influence on the global economy of the United States’ great rival, China.

The arc of China’s economic growth since it began its reform process in 1978 is unmatched in history, but the Middle Kingdom has also exerted a seismic impact on the global economy, specifically on capital and labor. The effect on the global labor market was fairly simple. China’s opening (and also that of Eastern Europe, which occurred 10 years later) to the global economy resulted in a massive influx of new labor entering the market. As the Bank for International Settlements presented in a 2017 paper, the working population in China and Eastern Europe in 1990 was 820 million, some 135 million more than in industrialized countries. Accordingly, the opening in China and Eastern Europe more than doubled the work force available for global production. The result has been a global glut of cheap labor over three decades that has driven down wages in the West and largely undermined companies’ need to invest in new technology because of the relative cheapness of manpower.

The effect on capital was more subtle. In the Chinese growth model, leaders focused on taking advantage of the country's labor supply to manufacture vast quantities of products very cheaply before shipping them to the developed world. But instead of directing the capital it received in payment toward investment or consumption, China lent it back to the West, largely by purchasing US bonds and holding them as savings. This resulted in the easy availability of capital in the West, as it effectively provided the latter with the opportunity to spend the same money twice; this explains the falling interest rate of the last three decades.

The reason why there could soon be a reversal of this mega-trend stems from a major change at its source: Chinese demographics. China’s growth since the 1980s has coincided with a remarkable demographic dividend; a burst of young people entered the work force over time, adding willing hands to the work force and, importantly, outnumbering the dependent old and young people who must receive financial support and who provide minimal productivity. But the young must grow old, and China is now entering a phase in which its demographic advantage is fading away, to be gradually replaced by a surfeit of dependents over workers. This development changes the whole shape of the Chinese economy, which has been able to monetize its labor advantage in the world for the last three decades. Instead, that advantage will disappear more by the day, with China already shifting from its export-led model to one with a much larger role for consumption. China will need to start spending its own money instead of lending it back to the West. As a result, capital will become scarcer in general, which should drive interest rates upward. As a result, rising yields on US debt will become less of an issue on a relative basis, especially when the United States’ largest emerging competitor appears to be facing sizable headwinds of its own.

Discovering the New World

The final question to consider is the new growth opportunities in the coming world, and whether the United States is well placed to make the most of them. Tax reform might foster investment and growth, but if the potential growth is in an area that does not play to US strengths, it could still go to waste. The answer again lies in China’s effects on the rest of the planet, specifically the labor market, and in the latest developments in technology.

China’s contributions to the global work force have already begun to shrink, and indeed rising wages in the country have also eroded the efficiency gains provided by its workers. Aging is not solely a Chinese phenomenon, as the trend is striking the developed world just as strongly. In the coming period, the global work force will encounter increasing scarcity, which could drive wages upward. A Western corporation that has relied on cheap labor will now have far greater incentive to invest more in technology in order to increase its productivity – as is already occurring, particularly in the automotive sector. The hunt thus turns to technologies that will increase productivity, which is exactly where recent rapid developments in artificial intelligence enter the picture.

It is hard to overstate how much of an impact artificial intelligence is about to make across all industry sectors. The explosion of data availability and storage in the last five years has provided a perfect ecosystem for artificial intelligence, though its foundational technologies have been available since the 1960s. There is an urgency to the trend: one recent survey of 203 executives found that 75 percent of respondents expected to “actively integrate” AI into their firms within the next three years, yet only 3 percent said they had already done so. The potential of AI lies across the board, with consulting firm McKinsey predicting that financial services, retail, health care and advanced manufacturing will lead the way. Another consultancy firm, Accenture, expects artificial intelligence to be transformative enough that it will serve as a new factor of production, equivalent to labor or capital. In fact, the firm’s model projected that a United States that successfully integrates AI will attain 35 percent more growth by 2035 than one which does not.

Of all the countries in the world, the United States is the best placed to take advantage of this emerging trend. For one, it has enjoyed a head start. In Silicon Valley, the United States boasts the world’s leading center for technological innovation, and AI is no exception. In 2016, the country garnered 66 percent of all external investment (including venture capital, private equity and mergers and acquisitions) in AI, with China lagging behind at 17 percent. The United States has also been producing the most influential research in the area; although China has been publishing a much larger volume of papers, they receive fewer citations than their American and British equivalents. A 2017 McKinsey report identified 39 promising AI startups in the United States but just three in China.

The United States has one of the world’s most flexible labor markets, meaning it should, in theory, be relatively well prepared for this type of disruption. There are caveats though, in that the last great economic shift toward deindustrialization left sizable parts of society behind, especially in more industrial regions. The United States will no doubt need to invest in retraining and education if it is to make the next transition go smoothly. But regardless of the challenges, positivity about the US positioning for the AI wave is reflected in recent studies, with Accenture finding that the United States has the potential to double its GDP as a result of AI, making it the developed country likely to post the highest potential gains (see the below chart).

The shape of things to come

The United States currently finds itself on the cusp of a new economic epoch. The story of the last 30 years has centered on the unleashing of China's giant work force on the global economy, along with the resulting impact. In the coming era, the influence of Chinese labor will fade, and the importance of technology will rise. The leading edge of this trend is in AI, which will arrive on the global economy like a whirlwind in the next few years.

With this in mind, the 2017 tax reform law should be a great enabler. In terms of global AI, the United States boasts market leaders such as Apple, Amazon and Google, and by removing those companies’ incentives to retain their wealth offshore, the US government will tie their fates more closely to that of the national economy. The reform should release the dormant potential inherent within the United States. As economic capacity increases, so should the ambition of American companies, which will be free to invest their windfalls in new technology.

But the costs of reform are also real, specifically in the case of increased US debt. The fact that this move coincides with a potential rise in interest rates could cause some problems, particularly in the short term. The US economy is now approaching its longest ever stretch without suffering a recession and it is possible that disquiet over US debt could coincide with immediate considerations such as the current administration’s trade policies, ultimately triggering a brief downturn. As time passes, however, the shape of the world to come will become more apparent, along with the United States’ strong position in it.

Mark Fleming-Williams is senior global economics analyst at Stratfor, the US-based global intelligence firm, with which Strategic Review has a content-sharing agreement. He covers political economies, trade and global financial trends.