A tax cure for Sisyphean American monetarism?

Eight years into unprecedented monetary and fiscal expansions, the U.S. economy remains sick to its core. Worse, the U.S. malaise is neither unique in the global setting, nor is it cyclical (or passing) in nature.

Let’s sum up the key evidence.

For more than six years now, the U.S. recovery (in terms of economic growth) has been anemic, judging by historical records and the rates expected from a natural business cycle bounce back. All despite the unprecedented increases in the U.S. public debt levels and monetary supports. And the downside risks to growth are still present, even as the Fed and the federal government have run out of room for further easing.

And for more than a decade now, labor markets headline data has been at odds with other economic trends. Most worrying here is the broken lineages between labor productivity growth and headline unemployment statistics. The U.S. unemployment rate has been at around 5 percent mark for a year now. The combination of the steady and low trend unemployment should be associated with preceding periods of high capital investment, accelerated labor and total factor productivity growth and healthy corporate balance sheets.

Alas, today, exactly the opposite holds. Yes, the U.S. economy is officially at or near full employment. But labor force participation remains below pre-crisis levels, although it is rising, at last, over the more recent months. Non-farm payrolls are growing. But the quality of new jobs creation is questionable, with the majority of jobs still concentrated in low value-added services sub-sectors.

Meanwhile, in the corporate sector, two simultaneously occurring phenomena have presented a serious challenge to the “normal recovery” hypothesis that postulates that in a cyclical recovery, companies use the improved quality of their balance sheets to invest in accelerated capex programs. The virtuous cycle of such investment uplift leads to improved equity valuations, leading to a decline in debt-to-equity-linked ratios and a boost to the balance sheets.

What we are witnessing today, however, is the opposite of a “healthy cycle” in corporate finance. Based on the latest data from FactSet and S&P Global Ratings, excluding a handful of flagship U.S. corporates, the majority of American businesses are suffering from a new bout of debt overhang. The headline figures look healthy: there is $1.8 trillion in cash currently accumulated in U.S. corporate accounts. However, just 25 companies out of the total group of 2,000 tracked by the S&P hold over 50 percent of that cash. For the other 1,975 companies, debt has been on the rise as cash holdings have been falling. Cash cover of U.S. corporate debt is currently down to 15 percent (or US$15 in cash held per US$100 in debt) – a figure that is lower than at the height of the Global Financial Crisis (GFC). And, as of July 2016, there are more companies in default on their debt obligations than in all of 2015. After setting a post-GFC record in defaults in 2015, corporate America is on the march to set another record this year.

Earlier in August, BAML research showed that to cover repayment of high yield corporate bonds, U.S. companies’ issues of junk debt securities, will require 8.5 years’ worth of their operating earnings. This is double the burden of debt back in 2008. First-half 2016 also shows declines in corporate profits, further increasing the weight of corporate indebtedness.
With roughly US$11 trillion of global debt trading at negative yields, the road to monetary easing is no longer worth traveling.

How do we know this?

You might excuse growth in debt if the funds were used to finance new investment or other expenditure relating to productivity growth. Alas, nothing of the sort is happening. Per the latest data, the U.S. corporate sector has managed to record a third consecutive quarter of declining real business investment. In historical terms, we have to go back to 1986-1987 to find another three-quarters-long stretch of negative investment growth outside a recession.

Growth in business equipment excluding agricultural and mining sectors is also negative now, having posted declining growth rates over the last four quarters. As Credit Suisse research shows, over the last three quarters, business investment was running below the 2010-2015 growth average in 20 out of 24 major Equipment Investment Categories and in 12 out of 18 major Structures Investment Categories.

And while investment is shrinking, labor productivity growth is outright tanking. In fact, as noted in a recent analysis by the Wall Street Journal, “The longest slide in worker productivity since the late 1970s is haunting the U.S. economy’s long-term prospects.”

I covered the plight of the U.S. labor productivity and the structural nature of decline in productivity growth in these pages before, warning that the trend reflects not a cyclical (or temporary) correction, but a long-term dynamic consistent with the twin secular stagnation theses: the prospect of structurally lower growth in the economy besieged by depressed demand and falling returns on investment in non-financial capital. But it is worth reminding readers just how big the problem really is.

Based on BLS data, non-farm business productivity fell 0.4 percent year-on-year in 2Q 2016. In simple terms, U.S. workers worked long hours producing less output per hour than in 1Q 2016. This marked the third consecutive quarter of labor productivity declines, the longest consecutive streak since 1979. As was noted by MarketWatch, “The average annual rate of productivity growth from 2007 to 2015 has sunk to 1.3%, well below the long-term rate of 2.2% per year from 1947 to 2014.”

This is the main malaise that renders both exceptional monetary and traditional fiscal policies powerless: you can prime the debt pump, but you can’t get any serious returns in terms of real economic activity growth without changing labor and total factor productivities.

Stagnation in labor productivity implies, over the longer run, stagnation in real household incomes, decline in demand, investment and fiscal revenues. No amount of monetary easing can address these negative factors. Neither can monetary policy (as evidenced by the last eight years of endless experimentations) shift the investment cycle in the presence of a productivity trap. In other words, slow productivity is simultaneously caused by, and causes in return, low investment.

Access to cheap money can alleviate the debt service costs to the economy, but it cannot break the vicious productivity-investment tightening loop. The further up the hill Sisyphus climbs, the further downhill he will slide.

Interestingly, many economists today recognize the problem. Stephen King of HSBC, Larry Summers of Harvard, Northwestern University’s Robert Gordon (of the original supply-side secular stagnation thesis fame) – all coming from different sides of economic debate and ideological backgrounds – are case in point. Even the Fed is sensing the dangers, as illustrated by Janet Yellen’s comments made just prior to the Jackson Hole meeting in August. But none so far have managed to grasp the solution. Thus, Gordon and Summers tend to support the idea of large-scale public investment to compensate for lagging private investment. The Fed is pushing for fiscal supports (in wages and investment terms) to be thrown behind its monetary efforts. And in a lengthy editorial on the future of Fed’s policies, the Wall Street Journal called for shifting the Fed inflation target to accommodate for more open-ended monetary easing.

In reality, addressing the simultaneous challenges of low productivity growth and shrinking investment by corporate America requires, in the long run, removing barriers to demand growth and in the short run, increasing investable funds available to the U.S. companies. The former can be achieved only via continued de-leveraging of households and a simultaneous increase in real after-tax income available for investment.

Fortunately, the entire agenda can be supported by the reforms of the U.S. tax system. Take for example the estimated cash holding of U.S. corporations amassed outside the U.S. Based on data compiled by Moody’s and S&P at the end of 2015, U.S. multinationals held some USD 1.7-1.8 trillion in funds outside the U.S. Some of these funds are, undoubtedly, held for investment purposes relating to these companies’ global operations. But a good chunk of it relates to legal tax optimization strategies pursued by these companies in order to maximize their returns to shareholders.

Currently, there is a cost for onshoring these funds into the U.S. when it comes to paying dividends. On the upper side, the cost of direct compliance with the literally insane U.S. tax system that levies double taxation of income and, worse, treats all worldwide income as if it was earned within the U.S. On the lower side, the cost is legal tax shifting strategies, such as using debt issuance to pay dividends in the U.S., for example. The latter runs around 2-3 percent of funds involved, and with currency risks as well as other risks can rise to 3-4 percent.

Now, suppose the U.S. authorities offer a tax amnesty for repatriation of funds accumulated above with a one-off tax rate of 5 percent (just above the lower cost margin). Assuming 60 percent of all corporate cash holdings abroad relate to tax optimization strategies, the net revenue earned by the U.S. federal government from this transaction will be around US$51 billion-$54 billion.

Should the U.S. opt to apply the same rate on future cash repatriations, using data from Moody’s over the period of 2007-2015, and assumptions above, direct net annual benefits to the U.S. Treasury from the tax code revision will be around US$3.75 billion-$4 billion.

Indirect benefits (outside the fiscal balance sheet) will see a substantial injection of investable funds into U.S. corporate sector. Over the last eight years, U.S. companies accumulated, on average, US$120-$125 billion of foreign earnings in offshore accounts per annum. Bringing even half of it back into the U.S. will increase corporate investment (net of dividends) by around US$65 billion. Take a usual multiple to this number and see how much more fiscal room the feds will have.

These revenues should be pumped back into real investment, by broadening tax incentives for households and small businesses undertaking real investment and/or funding pensions. These incentives today, in turn, will see reduced demand for federal spending in the future (due to improved private pensions coverage) and increase indirect revenues accruing to the government from new investment and business formation.

Differential taxation on foreign and domestic earnings will help several other areas where the U.S. economy is struggling. One, it will incentivize greater exports from the U.S., not only for larger enterprises, but also for smaller and medium-sized ones. This, in turn, will help reduce non-sustainable current account deficits the U.S. been running. Two, onshoring earnings will help reduce corporate leverage, simultaneously alleviating the problem of debt overhang and improving corporate balance sheets’ resilience to future shocks. Three, it will encourage innovation and, with it, labor productivity growth. Currently, returns to technological innovation in global markets can exceed the returns in the U.S. The reason for it is the profit margins that are being compressed by innovation: in the competitive markets, like the U.S., new technology earns less per dollar of disruption it induces on completion than in less competitive and less developed markets in much of the rest of the world. Encouraging exports, therefore, should not only improve profitability, but also productivity (value added) and innovation.

In time, of course, the U.S. needs to lower the corporate tax rate across the board, to bring it closer in line with international standards. Taking the first step with lower foreign earnings tax will help to create a learning curve for such a move and free some resources to fund the broader rate changes. Also in time (although the sooner the better), the U.S. should end the practice of double taxation of corporate dividends. This will discourage corporates from gaming their dividend policies and improve the quality of American pensions.

Strangely, to the best of my knowledge, no political candidate, nor any notable academic economist, has spotted this opportunity to date.

Previous articleThe emergence of Unconstrained Mutual Funds
Next articleBritain’s Brexit vote opens way for a regulatory rethink
Constantin Gurdgiev
Adjunct Assistant Professor, Trinity College, Dublin

Trinity College Dublin

Trinity College builds on its four-hundred-year-old tradition of scholarship to confirm its position as one of the great universities of the world, providing a liberal environment where independence of thought is highly valued and where staff and students are nurtured as individuals and are encouraged to achieve their full potential.  The College is committed to excellence in both research and teaching, to the enhancement of the learning experience of each of its students and to an inclusive College community with equality of access for all. The College will continue to disseminate its knowledge and expertise to the benefit of the City of Dublin, the country and the international community.


Trinity College
College Green
Dublin 2

T: + 1 896 1000
E: [email protected]
W: tcd.ie