Karen Dynan and Louise Sheiner provide a nice overview of this mechanism in their essay \”GDP as a Measure of Economic Well-being,\” written for the Hutchins Center at the Brookings Institutions (Working Paper #43, August 2018). Their paper offers a detailed and readable overview of man problems that arise in measurement of real GDP: problems in measuring the size of the digital economy, problems in adjusting for changes in the size of nonmarket work, and potential biases in the measure of inflation (which in turn lead to errors in estimating the size of the real economy), and others.
Here, I\’ll just focus on their comments about how US multinationals shift sales and profits to other countries (footnotes omitted).
\”[T]he rise of global supply chains and the legal latitude that companies have in declaring in which countries their economic activity takes place lend material downward bias to estimates of U.S. nominal GDP. In particular, “transfer pricing” and other practices allow multinational enterprises (MNEs) operating in the United States to underprice the sale or lease of intangible assets—such as blueprints, software, or new drug formulas—to affiliates in low-tax jurisdictions so that more of their profits are booked in these countries. The economic importance of such transactions has been documented in a variety of ways. For instance, in 2012, a Senate subcommittee questioned Microsoft about its agreements to shift some R&D costs and regional royalty rights to affiliates in Singapore and Ireland (U.S. Congress Senate Committee on Homeland Security and Governmental Affairs, 2012). In 2013, the subcommittee found that Apple used favorable transfer pricing agreements to shift billions of dollars of profits from the United States to Ireland (U.S. Congress Senate Committee on Homeland Security and Governmental Affairs, 2013). More generally, Hines (2005) and Lipsey (2006) show that U.S. MNEs register more profits in tax havens than can plausibly be accounted for by economic activity. Jenniges, Mataloni, Stutzman, and Xin (2018) find that U.S. companies that have a cost sharing agreement with a foreign entity appear less productive than similar companies without such an agreement, and foreign companies that have a cost sharing agreement with a parent company in the U.S. appear more productive than similar foreign companies. A 2016 OECD brief described how such transactions drove a 26 percent increase in measured GDP in Ireland in 2015. And, Tørsløv, Wier, and Zucman (2018) estimated that nearly 40 percent of multinational profits are shifted to low-tax countries each year.
\”Under current methods, transfer pricing and profit shifting have led to an understatement of both nominal GDP and nominal gross domestic income (GDI). Consider the example of a smartphone whose software, blueprints, and branding are developed in the United States. If the phone is assembled in the United States, then the full value of the phone (priced at its market price) is included in GDP. If the phone is assembled abroad, then so long as the contract between the company doing the assembly (e.g. Foxconn) is an arm’s length transaction, GDP will still be correctly measured, as it will include the value of the phone less the amount paid to the foreign assembler. However, if a foreign-affiliate of the U.S. company is introduced in the transaction, GDP could end up understated.
\”Here’s one way this could happen: the U.S. company leases the rights to the intangible capital—the software, blueprints, and branding—to an affiliate in a low-tax country (say, Ireland) and it prices that lease at a value that is much less than its market value. Then the Irish affiliate contracts with Foxconn to do the assembly. Phones are then exported from Ireland to the United States and from Ireland to the rest of the world. In this case, only the value of the lease from the U.S. company to the Irish company will be included in U.S. GDP, and if this lease is priced at an artificially low level, U.S. GDP will be too low as well. Under current methods, estimates of imports associated with sales of the phone in the United States will be too high because the economic activity associated with the leased assets is unlikely to be attributed to this country. In particular, imports will be too high (because they will overstate the Irish content of the phone imported from Ireland), and exports will be too low (because they will understate the U.S. content of phones exported from Ireland to the rest of the world). The same bias would occur in GDI because of the understatement of the company’s U.S. earnings. Note that this transaction works because there is intangible capital that is hard to value and hard to pin to a location, and because the Irish company is an affiliate of the U.S. company, so that it does not matter to shareholders whether the Irish affiliate or the U.S. headquarters books the profits.
\”This problem is of increasing concern both because of the evidence discussed above regarding the importance of profit-shifting in today’s economy and, more generally, because of the growth in MNE activity in recent decades. MNEs are now a large part of the global economy—according to Guvenon et al. (2017), they accounted for $4.7 trillion of global value-added in 2017, an amount that was about the size of the fourth largest economy in the world at the time. The statistical community recognizes the issue, and the international statistical guidelines most recently adopted by the United Nations Statistical Commission (System of National Accounts 2008) called for estimates of the production activity of MNEs to reflect the economic ownership of intangible assets rather than the legal ownership (Moulton, van de Ven 2018). There are practical challenges associated with how to do so, and the BEA has yet to change its official methods to follow this guideline.
\”Guvenon et al. (2017) explore one way in which the guidelines might be at least partially implemented. The authors use confidential MNE survey data collected by the Bureau of Economic Analysis and reapportion the earnings of U.S. MNE foreign affiliates based on labor compensation and sales to unaffiliated parties. The authors’ findings suggest that current practices have materially distorted estimated productivity growth at some points in the past—with an average annual understatement of growth of 0.1 percentage point from 1994 through 2004 and 0.25 percentage point from 2004 through 2008 (though no effect between 2008 and 2014). These figures represent a lower bound on the distortion, as foreign MNEs are probably also shifting some of their profits out of United States. Using this method, Bruner, Rassier, and Ruhl (2018) find that accounting for profit sharing would increase the level of U.S. measured GDP by 1.5 percent in 2014.\”