Monetary Policy
Not surprisingly, no action was taken at the April meeting of the policy-making Federal Open Market Committee (FOMC), in line with the public expectation fostered by the Fed officials before the gathering. While much attention focused on whether the Fed would give any additional signals about the timing of an expected interest rate increase, none emerged. Instead, the Fed left its forward guidance on rates unchanged from its March statement.
The latest disappointing data on economic growth came out in the middle of the FOMC meeting, likely affecting the decision on the timing of the initial rate increase. Looking at all the data on the Fed’s plate, four aspects of the economy stand out.
First, the latest GDP data showed worse-than-expected growth at an annualized 0.2 percent rate during this year’s first quarter, compared with 2.2 percent in the last three months of 2014. Second, the strong U.S. dollar continued to weigh on exports. Net exports in the first quarter stayed unchanged year-over-year, compared with an 18.6 percent gain in the fourth quarter of 2014. Third, inflation remains considerably below the Fed’s 2 percent target rate. Last but not least, labor market improvements have slowed. Nonfarm employers added only 126,000 jobs to payrolls in March, compared with 264,000 in February and 201,000 in January.
All in all, the U.S. economy is growing more slowly than anticipated, with some headwinds that may last for a while, such as the strong dollar. Both measures of the Fed’s dual mandate, price stability and maximum employment, remain below targets. Normally this would call for an accommodative monetary policy, postponing any interest rate increases until later in the year. Rather than pushing rates higher at the June FOMC meeting, a liftoff is more likely in September or even later, given current economic conditions.
Besides the timing of the initial rate increase, another important issue is the effect it will have on various sectors of the economy. For businesses, higher interest rates would make borrowing more expensive, hurting expected or realized profits and thus shrinking investment. For savers, higher rates bring better returns. For investors, higher interest rates should make bond markets more attractive, thus curbing demand for stocks and restraining equity prices. In addition, higher rates will make dollar-denominated assets more attractive, lifting demand for American securities and the U.S. currency and thus bolstering the recent strength in both.
Fiscal Policy – Reforming Corporate Taxation
Pre-tax corporate profits have recovered nicely since the end of the Great Recession, reaching almost $2.5 trillion last year. Despite this, federal revenue from corporate income taxes remains low. In 2014, corporate income taxes accounted for only about 10 percent of all tax receipts. This mismatch is the impetus behind the discussion of reforming corporate taxes.
Currently, the United States taxes corporations on profits earned in this country and on earnings abroad only when those profits are repatriated into the U.S. Companies also get credit for taxes paid to foreign countries, to avoid double taxation. Since the U.S. tax rate on corporate income, at 35 percent, is higher than in most other nations, repatriating profits almost always triggers additional tax liability.
This way of taxing corporate profits creates two problems. First, because overseas earnings are taxed only when they are repatriated, U.S. companies have an incentive to avoid bringing that money home. Some use it to expand overseas, instead of for domestic investment, which potentially slows the growth of employment and output in the U.S. This effect is not small. While it is difficult to accurately estimate the amount of corporate profits “parked overseas,” some studies put it as high as $2 trillion.
Second, the higher corporate tax rates faced by U.S. companies put them at a competitive disadvantage in the global marketplace. It should be noted that the effective tax rate is often lower than the statutory rate because of many deductions and exclusions, some of which are the result of heavy lobbying by businesses. This, however, only highlights the problem – high statutory rates are a main reason for corporate lobbying.
Corporate tax reform could mitigate these negative consequences. In general, changes may go in one of two opposite directions.
The first would abandon taxing corporate profits earned overseas and apply U.S. levies only to earnings from operations within the country. This is called a territorial tax system. Many countries around the world and most countries in Europe follow this approach. It would remove the incentive to “park profits overseas,” since no tax penalty would apply to repatriated profits. Thus, companies can invest where it would be most profitable without having to worry about tax implications. But under this system, if U.S. corporate tax rates remain higher than levies in other countries, a disincentive for locating a business in the U.S. would remain.
A different approach is to tax all corporate profits, wherever earned, at the time they occur, irrespective of whether they are repatriated. This approach is referred to as a global tax system. In theory, it would remove the disincentive of bringing home profits since that would no longer trigger additional taxes. But in practice this approach could create bigger problems.
A global system would mean taxing U.S.-chartered corporations on their profits worldwide, while foreign-based companies would fall under a different tax regime. Because they would pay U.S. levies only on profits earned in this country, non-U.S. companies with American operations may face an easier tax burden compared with domestic corporations.
If U.S. corporate tax rates remain higher than those in other countries, a global system also would create a powerful incentive for companies to be chartered outside of the U.S. It is hard to say whether long-standing American corporations would choose to change their “corporate home.” For new companies, however, this could be an important consideration, especially for those who expect a lot of business growth to come from non-U.S. markets.
When policy makers compare the merits of the two tax systems, one consideration ranks high – federal revenue. Which system results in higher receipts? This is difficult to determine because changes in taxation lead companies to change their behavior.
At first glance it may seem that taxing global profits would bring in more revenue. But this impression may be false if too many companies change their corporate base to ease U.S. levies. Taxing only profits earned within the U.S. may end up boosting receipts if it leads to a significant increase in domestic investment, accelerating economic growth.
What is clear, however, is that the current system of only taxing foreign profits when they are repatriated may leave the U.S. in the worst of both worlds by creating disincentives for domestic investment while letting un-repatriated foreign profits go untaxed.
In his budget proposal for fiscal year 2016, President Obama called for moving to a global system at a lower corporate tax rate than today’s 35 percent. In Congress, tax reforms backed by Republican Senators Marco Rubio and Mike Lee would implement a territorial system, while also lowering the corporate rate. It is unclear whether such a thorny issue as corporate tax reform will be addressed before the 2016 elections, but given the tax code’s sorry state in this area, calls for an overhaul will continue.