Regarding Trade Deficits and Cross-Border Investment
November 13, 2017
In a recent blog, New York Times columnist Paul Krugman raises a number of questions about the results of the Tax Foundation’s scoring of the Senate’s version of the Tax Cuts and Jobs Act proposal, in which we find that the plan would boost the long-term level of GDP by 3.7 percent (equivalent to boosting the annual growth rate by about 0.37 percentage points for ten years), which would reduce the federal revenue loss of the plan by $1.2 trillion.
Krugman is correct to claim that an increase in net foreign investment in the United States implies a corresponding increase in the U.S. trade deficit. He writes:
First, during the process of large-scale capital inflow, you must have correspondingly large trade deficits (over and above baseline). And I mean large. If corporate tax cuts raise GDP by 30%, and the rate of return is 10%, this means cumulative current account deficits of 30% of GDP over the adjustment period. Say we’re talking about a decade: then we’re talking about adding an average of 3% of GDP to the trade deficit each year — around $600 billion a year, doubling the current deficit.
However, it is unclear why Krugman discusses a scenario in which “corporate tax cuts raise GDP by 30 percent.” After all, the Tax Foundation’s model predicts that reducing the corporate tax rate would increase the size of the economy by 2.7 percent after about a decade.
Perhaps Krugman is claiming that, in order to raise the level of GDP by 3 percent in the long run, it would be necessary to increase net foreign investment by 30 percent of GDP cumulatively over the course of ten years, assuming a 10 percent return. In this case, the relevant question is whether the U.S. can sustain something like an additional $7 trillion of net capital inflows and trade deficits over the next ten years. Given that, over the next ten years, the world economy will save at least $180 trillion, according to extrapolations from World Bank data, this does not seem unreasonable to us. In addition, the U.S. trade deficit has been much higher in the past, averaging over 4 percent of GDP from 2002 to 2008, compared to about 2 percent of GDP today, indicating substantial room for an increased trade deficit.
While Krugman is correct that the Tax Foundation doesn’t explicitly model capital flows or the trade deficit, other models that do attempt to do so get similar results as ours. For example, the overlapping generations (OLG) model designed by Boston University economist Laurence Kotlikoff explicitly models international capital flows and finds that the House version of the Tax Cuts and Jobs Act generates enough new revenue due to the enhanced economic growth that is essentially revenue neutral.
In another independent analysis of the House plan, the Penn-Wharton OLG model found that the plan would generate about $920 billion in revenue feedback under the 100 percent open economy and high return to capital setting.
Krugman also worries about the consequences of such a large influx of foreign capital investment in the U.S.: “[M]ost of any gain in GDP accrues to foreigners,” he writes, “not U.S. national income.” While the interest and dividends from foreign investment in the United States would accrue to foreigners, this is not the full story. After all, U.S. workers would receive the wage gains from the capital deepening caused by increased foreign investment, while the U.S. government would collect tax revenue on the increased corporate profits from foreigners’ additional investments.
It is worth emphasizing that U.S. GDP is a highly relevant variable for assessing the outcome of a federal tax change. Because the United States generally taxes income on an origin basis, the most important determinant of federal revenue is domestic product. Given the importance of determining the feedback of the economic effects of tax changes on federal revenue, the magnitude of change in domestic product is of primary importance in such an analysis.
Very large cross-border capital flows have been the norm for several decades. Diverting a small fraction of that toward the United States would swamp any vestige of “crowding out” and make the gains in capital formation a dead certainty.
America was built on foreign investment. It was British investors who provided the funds to build the railroads in the 19th century. To be sure, those investors took home some healthy returns from that investment, but they couldn’t take home the things that really matter to Americans: the jobs that laid the tracks, the jobs that built the locomotives, nor the railroads themselves. That is a trade worth making.