Thursday, August 28, 2014

Comment on Starrs' 'American Economic Power Hasn't Declined'

I was linked to this Dec. 2013 International Studies Quarterly article by Sean Starrs of City University HK earlier today:

Sean Starrs, 'American Economic Power Hasn't Declined—It Globalized! Summoning the Data and Taking Globalization Seriously', International Studies Quarterly, Vol. 57, Issue 4, (Dec. 2013), pp 817-830.
This paper argues that a fundamental failing in the debate on the decline of American economic power is not taking globalization seriously. With the rise of transnational corporations (TNCs), transnational modular production networks, and the globalization of corporate ownership, we can no longer give the same relevance to national accounts such as balance of trade and GDP in the twenty-first century as we did in the mid-twentieth. Rather, we must summon data on the TNCs themselves to encompass their transnational operations. This will reveal, for example, that despite the declining global share of United States GDP from 40% in 1960 to below a quarter from 2008 onward, American corporations continue to dominate sector after sector. In fact, in certain advanced sectors such as aerospace and software—even in financial services—American dominance has increased since 2008. There are no serious contenders, including China. By looking at the wrong data, many have failed to see that American economic power has not declined—it has globalized.
Starrs first justifies looking at the profits of transnational corporations (TNCs) as a lens for estimating national power by arguing that:

"[C]orporate profit-making is inherently a power process, not only because of class struggle (the more profit for owners, the less wages for workers, and vice versa) but also because accumulation is differential vis-a-vis competing corporations. Thus, as profit is both means and end of accumulation, it indicates both potential and actual power." (p 18)

His argument against using old measures such as GDP relies heavily on the growth in intra-TNC transactions and how this masks a growing divide between where economic activity occurs and where profits accrue to. His examples include the dominance of Coca-Cola and Pepsi in the Chinese beverage market despite being American-own, and the fact that while Chinese workers assemble Apple's electronic products, the profits flow back to the United States through IP licensing.

Starrs goes on to look at the dominance of U.S. companies based on the "national distribution of profit across the twenty-five broad sectors of the top 2000 corporations in the world" (p 820). His conclusion is that the U.S. is still dominant across 18 out of 25 sectors, and has in fact grown in relative dominance between 2006 and 2012 in six sectors.

Then, Starrs does something interesting and important: he examines who owns the corporations in his previous analysis. So, instead of just rolling profits up to the tax domicile of each TNC, he attempts to assign nationality with one further level of granularity--by shareholder. First, he looks at cross-border TNC-to-TNC acquisitions, finding that American corporations owned 46% of the listed shares of the world's top 500 corporations, despite only accounting for 167 of the top 500. Then, he examines the share ownership pattern of the top 20 firms in four regions: the United States, the EU, Japan, and China (HK-listed H shares). The data shows that U.S. shareholders owned 86% of shares in the US, 24% in the EU, 20% in Japan, and 31% in China/HK. Starrs acknowledges that his exercise in assigning nationality to shareholders is limited by the fact that many shareholders are large investment firms that aggregate funds from individuals of all nationalities. However, he makes an assumption, relying on the proportion of millionaires that are American (76%) as a proxy for nationality distribution of managed funds, that most of these individuals are Americans.

Starrs conclusion is that the United States is still dominant. In fact, in some respects, it is more dominant because it owns and derives profits from more of the world in comparison to its GDP and other traditional measures than it did before.

I like this article a lot. It recognizes important implications of widely accepted but misunderstood patterns. However, I think Starrs overlooked a couple factors that I've come across recently in my day job that I'll explore below.

Starrs explanation of how profits relate to power (^^look  up there^^) is not wholly convincing. He cites several theorists on how the United States has power because of structural factors, resources, or a large market. Then he puts forward his "profit is both means and end of accumulation" argument and moves on to discussing why old measures fail. It is, I think, deceptively attractive to think that simply because Americans are making the most profits, then Americans must be the most powerful state. Part of power is the ability to maintain a standard of living, as much as simply have a standard of living. Power is forward looking; accumulation today does not mean accumulation tomorrow, and changes in profits can lag behind changes in power. The capability to maintain future profits matters.

If we take a very simple line of critique (I haven't thought this through too hard) and argue that profits are power because, ultimately, they can be taxed and grant states greater politico-military capabilities, then I think Starrs' argument runs into trouble. While greater profit would imply greater state revenue ceteris paribus, we live in a world where taxation policy, particularly corporate income tax, is strongly warped by nearly century-old structures that maintain a distribution of power that has long passed the world by.

The short of it is that the soft laws on corporate tax, constituted by the OECD model tax treaty and transfer-pricing rules that spell out how companies can value intra-TNC transactions, were established in the 1920s and strongly favor investors over 'source' countries (territories where resources and labour were located). One reason is because those soft law principles were written by the former colonial powers, who invested at roughly reciprocal levels between each other, but on severely non-reciprocal levels with their colonies.

Double taxation treaties have extended this principle around the world, leading to a situation where investor (more frequently referred to as 'residence') countries get first dibs on a TNCs profits, while source countries agree to lower withholding taxes and recognize high thresholds to local TNC activity before a right to tax emerges.

Exacerbating the problem are increasing problems with transfer-pricing brought about by the very growth in intra-TNC trade that Starrs discusses in his article. The arm's-length principle, which is the basic rule by which transfer-pricing must be done, stipulates that a TNC treat its subsidiaries as separate business entities. When making a transaction (say, a sale of iron ore from South Africa to Switzerland), the price of the transaction as documented by each legal entity must reflect market prices. The profits of each local subsidiary is calculated using those prices and taxed accordingly. This rule may have made sense in the 1920s, when communications and transportation limitations meant that subsidiaries of a single firm effectively operated independently. But with the spread of activities across borders, the situation has changed. Supply-chains now stretch across continents because of central design; in fact, TNCs arose in part because cross-national supply-chain management allows these firms to create products at lower cost than if the local subsidiaries were independent companies. That is, there is no comparable market price for many transactions within TNCs. Thus, the arm's length principle has become a central vector for profit stripping, whereby TNCs attempt to decrease prices within firms so that source country subsidiaries book lower profits while residence country parent companies, often located in low-tax jurisdictions, book higher profits. This is referred to as transfer-mispricing and fits in the gray area between tax evasion and tax avoidance/planning.

Similarly, profit stripping also functions through IP, intra-TNC services, and debt. A parent firm can charge a manufacturing subsidiary substantial royalty fees that cancel out any local profits the subsidiary would otherwise report. Alternatively, a parent firm could charge a local subsidiary inexplicably high management fees that likewise strip away the sub of its profits (the NGO ActionAid argues that Associated British Foods has been doing this to its sugar-manufacturing subsidiary in Zambia via a management subsidiary in the tax haven of Ireland). Finally, a parent firm can choose to finance a subsidiary's operations through debt and demand back large interest payments that nullify the sub's profits and can be used to obtain a residence country tax credit in some cases.

There are many other forms of intra-corporate tax shenanigans. I won't go into them. The debate on the scale at which these activities occur is heavily debated, but concern about them has increased to the point that the OECD has launched a project on what it and the G20 refer to as 'Base Erosion and Profit Shifting'. While driven by very specific U.S. and European concerns about their ability to tax corporates, the project's overarching goal is to align profits with value - that is, remove incentives to shift reported profits around the globe and alienate it from the economic activity that created it. 'Value', throughout the life of this project, has been hard to define. But the ol' "you-know-it-when-you-see-it" test for obscenity applies, particularly as there exists an entire industry--and industry whistleblowers--focused on innovative tax planning.

The OECD is not the only actor pushing back against the existing global tax regime. Brazil, India, and China have made ways by unilaterally introducing new deviations from OECD recommendations that allow them to claim more of a TNCs profits within their borders. Two common strategies involve hard-setting transfer prices for certain goods or services and lowering the threshold of activity a TNC needs to perform in a jurisdiction before the source country can tax it. Each of those three countries made contributions to the transfer pricing manual developed by the UN ECOSOC Committee of Experts on International Cooperation in Tax Matters spelling out their concerns about profit shifting and how they were modifying their corporate tax code in response.

So, if profit shifting is a fact, and emerging market states are pushing back against it, what does this mean for Starrs thesis? Taking a big leap, we could argue that it means the disproportionate accrual of profits to U.S. shareholders is 'artificial' and misaligned with real economic activity, however the latter is defined. In fact, this artificial accrual is an effect of the growth of TNCs, but not in the benign way that Starrs describes. Further, we could argue that other states are waking up this reality and pushing back to limit the profits that TNCs can take home to the United States. As a consequence, it is possible that over time the trend Starrs detects will be reversed and U.S. companies will become less dominant as compared to foreign competitors as they incur larger tax costs.

This is all a stretch, but I think it's something Starrs needs to take consideration of. A further point might be that, in fact, perhaps state capabilities are not ultimately derived from the ability to tax corporates, but from the ability to tax rich shareholders. Here again, Starrs would run into a problem. If U.S. corporates become less profitable in their home domicile due to more taxation abroad, then shareholders will also take back less in dividends. At the same time, because developing countries rely more on corporate tax than developed countries, they will strengthen in capabilities while the U.S. weakens.

I will readily admit that the above is half-baked. But, even if there may be problems with my little thought experiment, I think it illustrates well why I believe Starrs needs to explicit lay out a more detailed justification of how profits mean power.