Monthly Archives: April 2021

The Next “Lost Decade”?

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The 1980s were a “lost decade” of economic growth for those developing countries in Latin America that were enveloped in a debt crisis. Many now fear that we are on the verge of another debt crisis in the wake of borrowing by governments to support their economies during the pandemic. A concerted response will be needed to avoid it.

Countries such as Mexico and Brazil had borrowed during the 1970s to finance oil bills that had skyrocketed after OPEC had raised petroleum prices. International banks were happy to recycle the dollars that the oil-exporters had placed on deposit with them. The crisis came when the Federal Reserve under Paul Volcker raised interest rates, and the U.S. experienced back-to-back recessions that lowered the demand for these countries’ exports. It took a decade of negotiations and failed initiatives before the bank debt was refinanced as bonds or written off.

The IMF’s latest Global Financial Stability Report provides data on the recent rise in government debt: “Government debt in emerging markets (excluding China) is expected to reach 61 percent of GDP in 2021, and gross financing needs are anticipated to remain elevated at 13 percent of GDP in 2021, coming off record levels in 2020.” This escalation follows the pre-pandemic period when public debt/GDP levels had already risen in emerging market economies and advanced economies outside Europe.

The governments issuing debt were able to finance their expenditures at very low interest rates that reflected the 2020 collapse in economic activity and the rapid response by central banks. The “sudden stop” of capital flows to emerging markets last spring was reversed as investors returned seeking the higher yields that emerging market debt could provide. Moody’s reports record sales of Eurobonds in 2020 by emerging markets of $639 billion. Foreign investors also purchased sizable amounts of local currency debt in many of these countries.

But the favorable conditions of the past year are changing. Economic recovery will be much slower for countries such as Brazil and India, where the numbers of people infected by the coronavirus continue to soar. In April’s World Economic Outlook, the IMF reported improved prospects for growth in the advanced economies but less a less favorable outlook for the emerging and developing economies with the exception of China. Second, interest rates have risen from their very low levels In the U.S., reflecting expectations of increased growth and inflation. Third, a strong U.S. dollar makes servicing dollar-denominated debt more expensive.

Many of those issuing bonds relied on the analysis of Olivier Blanchard, until recently chief economist of the IMF, to justify their borrowing. Blanchard had pointed out that an increase in public debt may be sustainable if the rate of economic growth exceeds the interest on the public debt. The governments of some emerging markets used this line of reasoning to justify their borrowing as they responded to the worldwide lockdown and the need for medical equipment and supplies.

But emerging markets face different circumstances than those of advanced economies. They pay a risk premium that can escalate when conditions deteriorate.  IMF economists Marcos Chamon and Jonathan D. Ostry warn that borrowing costs for emerging markets and developing economies may become significantly higher relatively quickly. The Economist cites a bank study that lists Brazil, Indonesia, Mexico and South Africa as among the countries most vulnerable to any jump in interest rates.

If (or when) conditions do deteriorate, what responses will be available? The IMF, the World Bank and the Group of 20 have suspended the debt servicing of their loans to low-income countries via a Debt Service Suspension Initiative (DSSI). The response has been limited, perhaps due to fears of what acceptance would imply about domestic economic management. Moreover, DSSI does not apply to private bondholders, and the commercial share of the holdings of public debt rose over the last decade.

During the 1980s the IMF worked with the governments in distress and the international banks that were their lenders. This time, however, there is a more disparate group of lenders, and it will be more difficult to formulate a common response. China has become a major lender, and China has joined the DSSI. But some of their loans were made state-owned banks and agencies, which may be classified as private lenders. Some foreign bondholders claim they are concerned that any debt relief they extend will be used to pay the Chinese lenders.

The IMF intends a more direct response through an issuance of Special Drawing Rights (SDRs), the official currency of the Fund. These can be sold or used as foreign exchange reserves, thus freeing up other reserve assets. Their allocation are based on the quotas which reflect a country’s size and international economic activity, so favors the advanced economies. But there are mechanisms that allow countries that do not need the new allocation to lend or donate them to countries that do. The U.S. had withheld its approval of the increase, but Treasury Secretary Yellen reversed that decision and the allocation is expected to take place next summer.

Kris James Mitchener of Santa Clara University and Christoph Trebesch of the Kiel Institute for the World Economy review the literature on sovereign debt in their paper, “Sovereign Debt in the 21st Century: Looking Backward, Looking Forward.” While their survey emphasizes debt problems in advanced economies, they point out implications for the emerging market economies. For example, they find that the enforcement of debt contracts via legal challenges has become more common. Distressed debt funds purchase debt that has been discounted in value because of concerns over default, and then demand full repayment from the issuing government in court in London or New York. They show that such tactics were used in the cases of Argentina, Greece and the Ukraine. Similar challenges may emerge if emerging markets attempt to restructure their obligations.

The record of the last debt crisis makes clear the adverse implications for allowing debt problems to fester. The pandemic has already undone much of the progress in reducing poverty, pushing tens of millions many back below the poverty line.   A new debt crisis would exacerbate the divergent impacts of the pandemic on the developing economies and the advanced. Just as it is in the self-interest of all countries to contain the virus itself, all have a stake in dealing with its financial fallout.

The Need for a Global Corporate Tax Regime

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When the Organization for Economic Cooperation and Development began its call for a reform of the rules of global taxes in order to clamp down on the avoidance of taxes by multinational corporations, its efforts looked quixotic. But the OECD persisted, and U.S. Treasury Secretary Janet Yellen is now participating in negotiations with the other OECD members to reform the (non-)system. While there is much left to negotiate, the broad framework of an agreement to establish a new regime, which governs where taxes are assessed and the determination of a global minimum tax, now exists.

A new volume edited by IMF economists Ruud A. de Mooij, Alexander D. Klemm and Victoria J. Perry, Corporate Income Taxes under Pressure : Why Reform Is Needed and How It Could Be Designed, presents the case for implementing a global approach. The first part of the volume describes the reasons for taxing corporate profits, explains the emergence of the rules governing how multinationals could be treated, and shows the complications that the growth in services and digital trade placed on an already fragile system. The second section examines the workings of the current system, including the difference between source-based and residence-based taxes, the use of bilateral tax treaties to allocate taxing rights, and the ability of corporations to use the differences amongst tax regimes to lower their liabilities by shifting the source of their profits to low-tax jurisdictions. The third section analyzes the relative merits of various reform proposals.

The magnitude of lost tax revenues can only be estimated, since multinationals are not required to report all the data on their operations. But economists have used the available data in inventive ways to estimate the losses.  Kimberly Clausing of Reed College explains the data limitations and the attempts to provide reasonable estimates with the data that are available in a recent paper,  “How Big is Profit Shifting?”. Most of the profit shifting undertaken by U.S.-based multinationals occurs with a few tax havens: Bermuda, Cayman Islands, Ireland, Luxembourg, Netherlands. Singapore, and Switzerland. Clausing calculates that U.S. tax revenue losses from such activities may gave reached $100 billion in 2017, about a third of federal corporate tax revenues.

The OECD has made available a great deal of documentation on the challenges of profit shifting and the proposals to arrest these activities. Many of these analyses are summarized in Addressing the Tax Challenges from the Digitalisation of the Economy: Highlights. The first part of the document explains the proposals under negotiation, known as Pillar One and Pillar Two. Pillar One expands the right to tax a firm beyond its physical presence in a jurisdiction to include “…a significant and sustained participation of a business in the economy of the jurisdiction, either physically or remotely.” Pillar Two ensures a minimum level of tax on the profits of multinationals.

The OECD estimates that if both proposals were implemented, there would be revenue gains for low, middle and high income jurisdictions. The impact of “investment hubs” is more ambiguous, but they would lose some of their tax base. But could these changes adversely affect business activity? The OECD acknowledges that investment costs would rise, but estimates that the impact on investment would be minor.

Tibor Hanappi amd Ana Cinta González Cabral of the OECD Centre for Tax Policy and Administration present a detailed examination of the effect on investment costs in their paper, “The Impact of the Pillar One and Pillar Two Proposals on MNE’s Investment Costs: An Analysis Using Forward-Looking Effective Tax Rates.” They estimate that the rise in the effective average tax rates (EATR) of multinationals in their sample of 70 jurisdictions would be 0.4 of a percentage point, which is small compared to the existing weighted average 24% EATR. Moreover, the reduction in tax differentials would make other factors, such as education and infrastructure in host countries, more important in determining the location and scale of investments.

An agreement on multinational taxes would benefit the Biden administration, which needs revenue to pay for its ambitious infrastructure plans. The administration could use the implementation of a global tax to counter claims that an increase in the U.S. corporate income tax rate, which fell from 35% to 21% in the Trump administration, would make U.S. firms uncompetitive. A coordinated system of taxes would also be a response to the challenge to the ability of governments to tax businesses that profit shifting has posed. Only a global system would stop the “race to the bottom” of national corporate taxes that has resulted in the current tax regime.