Topic: International Economics and Development

Rule-of-law and U.S. Competitiveness

Policies such as Sarbanes-Oxley are reducing America’s competitiveness, but an equally worrisome problem is the erosion of the rule-of-law.

Stability and equal treatment are among the characteristics of an advanced legal system. Unfortunately, America’s legal system is now riddled with uncertainty, since investors and companies have no way of predicting outcomes.

The New York Sun has a column noting how America’s justice system is now an obstacle rather than an inducement to international investment:

[T]he American share of global initial public offerings declined to 5% from 50% in the last five years. Foreign companies are being scared away in part, both reports conclude, by soaring costs of American law.

The highwater mark for securities lawsuits was reached in 2005, with over $9 billion in class action settlements. The zeal of American prosecutors in corporate scandals is also of a different order of magnitude. In 2004, government fines in America totalled $4.74 billion, over 100 times more than in Britain, which had a total of $40.48 million. Sarbanes-Oxley, the federal law that imposes higher accountability standards on corporate boards, has almost tripled auditing costs for small public companies.

Perhaps the most chilling parts of the Bloomberg-Schumer report are the surveys of foreign business leaders who suggest, overwhelmingly, that they no longer trust American law. For most of the last century, trust in American commercial and securities law was one of our greatest competitive advantages. Investors flocked to our markets because securities laws guaranteed transparency and honesty. American contract law was the gold standard for world business, in part because of a long tradition of judges rigidly applying guidelines of liability and damages.

Economist Douglass North received a Nobel prize in part for his work on the vital role of legal stability in economic prosperity. An “essential element of the concept of justice,” legal philosopher H.L.A. Hart observed, “is the principle of treating like cases alike.” That’s why law is the foundation of freedom — people know where they stand. They can act freely instead of looking over their shoulders all day long.

But that trust has now capsized. Companies are afraid that if a few employees out of thousands do something wrong — even if not material to the bottom line — the company faces the prospect of ruin. An indictment, not a conviction, could put a company out of business. Why roll the legal dice in America when legal systems in Britain and elsewhere focus on punishing the individual wrongdoer, not shooting everyone in sight?

It’s impossible to measure how much distrust of law has contributed to declining competitiveness. But the evidence is all around us. Just talk with foreign business leaders.

The main victims of this trend, however, are employees and their pension plans. Drying up of markets means that countless people lose job opportunities and that innovation moves offshore. Trust, once lost, is hard to regain.

Tort reforms limiting damages don’t get close to the heart of the problem. American justice has a deeper flaw — it no longer reliably distinguishes right from wrong. Instead, decisions are made on an ad hoc basis, jury by jury, without predictable boundaries.

Hong Kong to Lower Flat Tax?

Thanks to strong growth, which is in part due to a tax system that minimizes the burden on productive activity, Hong Kong leaders are considering reducing the flat tax to just 15 percent.

Tax-news.com reports:

Donald Tsang has pledged to cut Hong Kong’s individual and corporate income taxes if re-elected as the Special Administrative Region’s Chief Executive next month. Tsang officially announced that he would seek election to a second term of office last week and said that one of his key policies would be to return some of Hong Kong’s fiscal surplus back to the population through a “gradual” reduction in salary and profit taxes to 15%.

Dutch Tax Haven Pressures Greedy Governments

The New York Times has a thorough article today detailing how both individuals and companies are using the Netherlands as a haven for productive activity.

This is good news for all taxpayers. The rich directly benefit, since greedy politicians are unable to seize as much of their money. And the rest of us benefit, since this puts downward pressure on tax rates as governments try to keep the geese that lay the golden eggs from flying away.

[L]ast August, according to details disclosed in documents maintained by the Handelsregister, the trade registry of the Netherlands, Promogroup helped the three [Rolling Stones] performers set up a pair of private Dutch foundations that will allow them to transfer assets tax-free to heirs when they die. Other Dutch shelters that Promogroup has arranged for the three have already paid off handsomely; over the last 20 years, according to Dutch documents, the three musicians have paid just $7.2 million in taxes on earnings of $450 million that they have channeled through Amsterdam — a tax rate of about 1.5 percent, well below the British rate of 40 percent.

The rock powerhouse U2 has transferred lucrative assets to Amsterdam, as have other pop singers and well-known athletes….

While old-school, offshore tax havens — the warm ones with tropical fish, off-the-shelf holding companies sporting post-office-box addresses, and scant regulation or transparency — still attract money, they are largely patronized, tax lawyers and entertainment bankers say, by hedge funds and private equity firms looking to protect lush trading profits from taxes. But for earnings derived from intellectual property such as royalties, the Netherlands has become a tax shelter of choice.

Many of the world’s multinational corporations, like Coca-Cola, Nike, Ikea, and Gucci, have set up holding companies here in recent years to take advantage of tax shelters nearly identical to the ones that the Rolling Stones and U2 use.

The Netherlands is home to almost 20,000 “mailbox companies,” Dutch shorthand for corporate shells set up by foreign companies and wealthy foreigners who use them to relieve taxes on royalties, dividends and interest payments….

Globally, some 1,165 companies use Dutch tax shelters to reduce or eliminate taxes on royalties and patents.

Not surprsingly, international bureaucracies and left wing groups despise tax havens — precisely because tax competition makes it more difficult to increase the size of government. The story in the Times elaborates, including completely unsubstantiated accusations that low taxes somehow facilitate dirty money:

Some experts see a darker side to the emergence of the Netherlands as a sought-after tax shelter. In 2000, the Organization for Economic Cooperation and Development, based in Paris, black-marked the country as one of the world’s top five industrialized tax havens for promoting “treaty shopping” for low-tax jurisdictions.

…In its report last fall, SOMO, the research group, said…that “tax haven features of the Netherlands also facilitate money laundering and attract companies with a dubious reputation.”

Endorsing the U.S. Trade Complaint Against China

On Friday, the U.S. Trade Representative initiated a formal challenge of various Chinese tax programs within the dispute settlement system of the World Trade Organization. It was only the third formal challenge of Chinese policies since that country joined the WTO in 2001.

Specifically, the United States alleges that Chinese tax policies that encourage production for exportation and that discourage the use of imported materials and components in the production process constitute subsidies that harm U.S. interests and violate the obligations China undertook when it joined the WTO in 2001.

I have been critical of the administration’s various trade policy errors of commission and omission over the years. Last week I lamented U.S. trade representative Susan Schwab’s failure to articulate the broad case for trade.  Today, I have only kudos for the USTR. Not only was the United States well within its rights to bring this case, it was the right thing to do, politically and economically. 

Free trade purists might disagree, arguing that if China wants to subsidize its exports to the United States, Americans should write the Chinese thank you letters for financially supporting our consumption. And accordingly, we shouldn’t intervene if the Chinese want to squander their resources that way. I think that argument holds water up to a point — a point that we are well beyond and where the costs of the status quo outweigh its benefits. 

Yes, we benefit as consumers from subsidized Chinese production, but only until the consensus for a liberal trading order collapses. At that point, retrograde protectionism threatens not only the benefits of that subsidized consumption, but the benefits of trade more generally, and the conditions that make relatively freer trade possible. Furthermore, the U.S. trade relationship with China is wealth-creating in both countries without need of subsidization. Safeguarding continuation of the flow of the benefits of trade to both countries by expecting China (and the United States) to play by the established rules seems a reasonable compromise to me.

The rules-based trading system has been remarkably successful at promoting trade and investment, and its continued success depends upon adherence to its rules and respect for its institutions — particularly by the world’s large economies.

China has demonstrated that it doesn’t respond well to bilateral threats — if for no other reason than its desire to avoid the appearance of being bullied. China knows what its obligations are. But it also knows that one of the many benefits of its membership in the WTO is that its policies are above board unless and until the dispute settlement body of the WTO finds against them. If China wants to drag its feet with respect to compliance and reform, bringing cases against China within the WTO might become fashionable.  

We are already witnessing a deterioration of support for trade and its institutions in the United States precisely because of perceptions that policymakers are doing too little to enforce the existing rules. I don’t advocate knee-jerk invocation of our rights to dispute settlement — there is plenty of room for deliberation and consultation (which is perpetually in play under the radar). 

To the extent that Friday’s actions serve as a release valve for some of the political pressure that has been building in Congress for unilateral actions against China, it is already a success. By bringing the case through formal WTO channels, Congress will see that there are, in fact, alternatives to dangerous, unilateral sanctions. In that sense, this case could reduce the likelihood that Congress intervenes and mucks everything up and it could actually improve long-term prospects for the U.S.-China trade relationship.

EU vs. Gas-guzzlers

The commissioners of the European Union endlessly preach about the need for carbon taxes and costly regulations that will reduce the quality of life for regular people. But those same commissioners get driven around in low-mileage vehicles. Fortunately, they are getting attacked for this hypocritical attitude.

Sadly, the embarrassment will have little impact. American politicians — including President Bush — want to force Americans into smaller (and more dangerous) cars, yet periodic efforts to require them to live by the same rules have proved fruitless.

The EU Observer reports on the controversy in Brussels: 

EU commissioners are finding themselves under scrutiny to see if they are putting into practice the green values that Brussels is increasingly preaching, with most of the 120-strong fleet of officials cars comprising gas-guzzling, C02-emitting giants.

…[T]he vast majority of the 27 commissioners use the standard-issue vehicles such as Audis or Mercedes — high on security features but rather lower on environment friendliness — to be ferried here and there across Brussels; sometimes even the few hundred metres between commission buildings.

…A commission spokesperson said, “It’s an individual decision for commissioners what their service car should be but as a general rule, the commissioners choose cars that are functional and safe for what they are doing.”

A French Global Warming Tax Against the U.S.?

Al Gore has a new ally in his fight for new taxes and regulations to limit carbon emissions. The New York Times reports that, for all intents and purposes, Jacques Chirac is blackmailing the United States: 

President Jacques Chirac has demanded that the United States sign both the Kyoto climate protocol and a future agreement that will take effect when the Kyoto accord runs out in 2012.

He warned that if the United States did not sign the agreements, a carbon tax across Europe on imports from nations that have not signed the Kyoto treaty could be imposed to try to force compliance.

Trade lawyers have been divided over the legality of a carbon tax, with some saying it would run counter to international trade rules. But Mr. Chirac said other European countries would back it. “I believe we will have all of the European Union,” he said.

With Trade Advocates Like These…

My colleague Dan Griswold salutes President Bush for ditching the traditional script and touting the broader benefits of trade in a speech yesterday in New York City. I would like to emphasize how rare, refreshing, and late-in-coming the President’s comments were.

One explanation for the growing resistance to trade liberalization in the United States is that the Bush administration’s “pro-trade” message has been weak, even self-defeating. Typically, when the President or members of his administration take to the podium, the message on trade is monothematic: exports are great and our trade agreements promote them.

The following is an excerpt from a speech the President gave at the headquarters of Caterpillar, Inc. in Peoria, Illinois on Tuesday:

Last year we exported a record $1.4 trillion worth of goods and services. Now, in order to export something, somebody has to make it. In other words, when I talk about numbers, behind the numbers is [sic] people who are providing the service and/or making the product. So the more one exports, the more likely it is people are going to be working.

Not once in the speech did the President allude to the benefits of imports, which are also important to Caterpillar, as sources of components and raw materials. Certainly, the mention of $1.4 trillion worth of exports in the context of the relationship between exports and jobs might invite the slightly curious to scratch their heads and wonder whether last year’s record $2.2 trillion worth of imports had an adverse impact on jobs.

Indeed, that is the central premise of many of trade’s opponents: exports create jobs, thus imports destroy them. By not mentioning that our record level of imports last year occurred alongside economic growth of 3.4 percent, the creation of 2 million net new jobs, and an unemployment rate that ended at a slim 4.5 percent, the President sacrificed an opportunity to drive home the point that imports do not undermine economic growth or job creation.

In fact, Dan Griswold has written extensively on the strong positive relationship between import growth and the growth of U.S. manufacturing output. (Here’s one of his offerings.) Basically, U.S. businesses account for about half of all U.S. imports. If you want to curtail imports, all we need is a handsome recession.

Now consider Exhibit 2. In response to the President’s announcement that he will seek extension of trade promotion authority, which expires at the end of June, U.S. Trade Representative Susan Schwab, yesterday, offered: 

The agreements enacted under TPA have helped us dramatically increase exports, which are likely to be an engine that drives the American economy to continued strong growth this year. U.S. exports to the 10 countries with which we implemented free trade agreements between 2001 and 2006 grew twice as fast as U.S. exports to the rest of world.

Okay, perhaps U.S. exports to those countries have increased faster. But is that all there is to tout?  What about the fact that we can purchase fresh grapes and blueberries, imported from Chile, in the middle of winter, at about the same price we purchase the same fruit from U.S. growers in the summertime?  (Just check the origin labels at your local grocer). By focusing exclusively on export potential, our trade advocates reinforce the myth that trade is exclusively a boon to business (“BIG BUSINESS,” of course), which comes at the expense of ordinary, “middle class” Americans.

Still, worse than the failure of policymakers supportive of trade to articulate its full benefits is when policymakers betray their own ignorance in a way that gives fodder to those counseling retreat from the global economy. Ways and Means Committee Ranking Member Jim McCrery (R-LA) claimed yesterday that “Our free trade agreements since TPA went into effect have reduced our trade deficit by $5.5 billion.”  I’m not sure how that was calculated or what exactly the figure represents, but presumably the comment is intended to demonstrate that trade agreements are good. I think it backfires.

If the exclusive purpose of trade policy is to promote exports, then it’s pretty easy for trade’s detractors to point to the massive and growing trade deficit and conclude we are losing grievously at trade. Our $800+ billion trade deficit is larger today than when TPA was enacted in 2002.  Using McCrery’s logic, trade is thus a menacing plague. I don’t know, maybe this is just a naïve thought but if you base the thrust of the case for trade on the export side, then the massive and growing trade deficit is all of a sudden an albatross around the necks of liberalizers. But the truth is that the trade account has virtually nothing to do with trade policy and efforts to somehow connect the two cannot serve a pro-trade agenda.

It’s no wonder we are having a national debate on the merits of trade, despite the overwhelming evidence of the relationship between greater openness and economic growth. Policymakers who claim to favor trade liberalization have been incapable or unwilling to articulate the complete and proper argument. That will have to change soon.