On Thursday, Brad Setser of the Council of Foreign Relations — prized by cognoscenti for his forensic analysis of balance of payments data — testified before a Senate Judiciary Committee on global tax evasion by drug companies. This issue may not be that big on many people’s radar screens, and with everything else going on, you may wonder why you should care. But there are at least two reasons why you should.
First, at a time when people are once again worried about budget deficits – much of the fear is disingenuous, but still – it is certainly relevant that the US government is missing out on a lot of revenue because multinational corporations are using accounting tricks to avoid paying taxes on here earned profit.
Second, as it seems increasingly likely that Donald Trump will be the Republican presidential nominee, it seems pertinent to note that his one major legislative success – the 2017 tax cut, which was supposed to bring corporate investment back to America – was, in practice, a “America’s last” bill that encouraged companies to move even more of their reported profits, and to some extent their actual production, overseas.
On pharma: The US healthcare system, unlike healthcare systems in other countries, is not set up to negotiate lower prices with pharmaceutical companies. In fact, until the Biden administration passed the Inflation Reduction Act, even Medicare was specifically prohibited from negotiating drug prices. As a result, the US market has long been the pharmaceutical industry’s cash cow: prescription drugs here cost an average of 2.56 times — 2.56 times — as much as in other countries.
Oddly enough, however, pharmaceutical companies report that they hardly make a profit on their sales in the US. Setser provided a striking chart comparing 2022 sales and earnings for six major pharmaceutical companies:
As he noted, 2022 was an exceptionally profitable year for these companies, but the pattern — big earnings in the US market, with very low reported profits — has been consistent over time.
How do the pharmaceutical giants do that? Primarily by assigning patents and other forms of intellectual property to foreign subsidiaries in low-tax jurisdictions. Their US operations then pay large fees to these overseas subsidiaries for using this intellectual property, magically making profits disappear here and reappear elsewhere, where they remain largely untaxed.
The pharmaceutical industry, where patents rather than manufacturing facilities are the company’s main assets, is ideally suited to this kind of tax play. But it’s not unique. Over time, we have increasingly become a knowledge-based economy, in which a large portion of business investment is spent on intellectual property rather than plant and equipment:
And while factories and office buildings have specific locations, intellectual property is virtually everywhere a company says it is. If Apple decides to transfer a large portion of its intellectual property to its Irish subsidiary, causing a huge increase in Ireland’s reported gross domestic product, no one can say at this point that it can’t.
How do we know that large foreign profits mainly reflect tax evasion rather than economic reality? That’s simple: look where the profit is reported. As Setser, following the work of Gabriel Zucman (who has just won the American Economic Association’s prestigious John Bates Clark Medal; congratulations, Gabriel!), provided the vast majority of reported overseas earnings of US companies in small economies that They may not be major profit centers, but they do offer low taxes on reported income:
Which brings us to Trump’s tax cut. At the heart of that tax cut was a cut in the corporate income tax, based on the assumption that America’s relatively high official corporate tax rate caused large-scale capital movements abroad. But that corporate capital flight turned out not to be real; it was a statistical illusion created by tax avoidance.
By the way, this is not just an American problem. The International Monetary Fund estimates that about 40 percent of global foreign direct investment — investments involving control of foreign subsidiaries, as opposed to portfolio investments, such as the purchase of stocks and bonds — are actually “phantom” investments that are driven by tax avoidance that don’t correspond to anything real.
Unsurprisingly, Trump’s tax cut never delivered the promised investment boom. Coincidentally, we’re seeing a huge surge in manufacturing investment right now — but that’s being driven by the Biden administration’s green industrial policies rather than blanket tax cuts.
But wait, it gets worse. A particularly poorly drafted feature of the 2017 tax bill, using the acronym GILTI (I’m not making this up), ultimately gave companies an incentive to move both actual production and reported profits abroad. As Setser points out, GILTI is likely a major factor in a recent surge in US drug imports:
Now there are some very well thought out proposals to tackle corporate tax avoidance. Unfortunately, they are almost certainly questionable as long as the House is controlled by a party that wants to deny the IRS the resources it needs to crack down on tax evasion.
But you should keep in mind that tackling tax avoidance can significantly reduce budget deficits. And you should also keep in mind that the Trump administration’s only major domestic policy initiative was a flop.