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There is lots of activity among major economies concerning the taxation of corporations. First, US President Biden proposed to increase the US corporate tax rate from 21% to 28%, and then he and some key Senate Democrats have also proposed significantly increasing what is essentially a US minimum tax on income earned by US-owned foreign corporations. Then US Treasury Secretary Yellen said the United States would support the adoption of a global minimum corporate tax in order to reduce tax arbitrage and create a more level playing field—a position being negotiated with 139 countries through an OECD/G20 process. A global minimum tax would also reduce the competitive disadvantage the United States could face by raising its corporate tax rate. Now it is reported that the United States has offered a new plan meant to unblock a separate part of those multilateral negotiations, proposing that the world’s 100 largest multinationals pay taxes to each country based on the market for their goods or services in that country.
This latter proposal may be seen by other leading nations to both give and take. It would likely create a less complicated and less subjective system than has been discussed within the OECD talks to date, targeting a smaller number of companies but expanding the scope beyond what had previously been contemplated—from consumer-facing and digital only to all sectors—and likely capturing more companies headquartered outside of the United States. To many other countries, the goal of this global agreement (also called Pillar 1 of the talks) is to collect taxes from some of the high-tech giants—which are largely US-based—that are able to make money in jurisdictions without necessarily having any physical nexus. To address this and ease political pressure from their constituents while these global negotiations occur, a number of countries, especially in Europe, have imposed digital services taxes (DSTs). The United States has been staunchly opposed to these DSTs, and a condition of any agreement through the OECD is expected to be the repeal of such unilateral measures.
France’s Finance Minister said he is “delighted” about the proposal. The Dutch government also expressed support for the proposal as did the British government. The US proposal sets the stage for a renewed set of negotiations.
The related talks around a global minimum tax (the so-called Pillar 2) likely also will get a second wind, both because of Yellen’s explicit support and because some countries don’t want to talk about Pillar 2 without also dealing with Pillar 1. Ireland, for example, has benefited from a low corporate tax rate and is far from enthusiastic about a global minimum that could be set higher than its own 12.5% rate and make it less attractive to investors. However, its government this week expressed willingness to engage in discussions. Notably, Italian Prime Minister Draghi has endorsed the new US proposal support for a minimum tax. Given that Italy has a DST, Draghi’s support could be important in driving European amenability to the proposal.
The US proposal mentions “We wish to end the race to the bottom over multinational corporate taxation and establish a tax architecture in which countries work together towards more equitable growth, innovation, and prosperity.” The United States hopes that the proposal would severely undermine so-called tax havens.
Meanwhile, it seems unlikely that the Biden administration will get the 28% corporate rate that it has sought because there is resistance within his own Democratic Party. Moderate Democrats have expressed willingness to consider a 25% rate. Yet that means that, if the administration wants to generate sufficient revenue to pay for a large share of its infrastructure investment plan, it will have to look elsewhere. This might entail higher tax rates on upper-income households (which is already likely to be used for funding Biden’s next spending plan), or perhaps some kind of taxation of energy. Biden said that he was willing to negotiate on the details.
The worst damage to the global economy in the past year was due to the closure of and aversion to consumer-facing industries. The necessity of social distancing led governments to halt or restrict the operation of such industries. In addition, the fear of social interaction led many consumers to avoid such industries. The result was mass unemployment, declining revenue, and the need for government support. Even as such support led to economic recovery and a substantial increase in consumer and business spending, periodic outbreaks of the virus and periodic implementations of economic restrictions kept activity of consumer-facing services below the prepandemic level. This included such sectors as restaurants, pubs, movie theaters, shopping centers, entertainment venues, cultural institutions, airlines, hotels, and personal services.
Now, the hope is that, with mass vaccination under way, we will ultimately get to the point where most consumers are no longer fearful of the virus and where most governments can feel comfortable in relaxing most restrictions. When that happens, there could be a surge in expenditure on consumer-facing services. This will be helped by the fact that consumers in rich countries saved an enormous share of their incomes during the pandemic, thereby setting the stage for them to easily fund a substantial increase in spending. The extra money provided by government stimulus, especially in the United States, will play a significant role in fueling this incremental expenditure.
Last week, IHS Markit released its purchasing managers’ indices (PMIs) for services in multiple countries in March. Based on these numbers, the evidence suggests that the rebound in services is already under way in some locations. PMIs are forward-looking indicators meant to signal the direction of activity in the broad services industry. Services includes such sectors as retailing, wholesaling, transportation, warehousing, telecoms, finance, professional services, hospitality, tourism, utilities, education, and health care. PMIs are based on sub-indices such as output, new orders, export orders, employment, pricing, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa. The latest PMIs mostly improved from February to March. The global PMI increased from 52.8 in February to 54.7 in March, a 79-month high and a level suggesting strong growth of global services activity. Moreover, the data shows that consumer services and business services surged in March, while financial services were stable after having surged several months earlier.
Markit found that there was exceptionally strong growth of activity in the United States, moderately strong growth in China, and a continued decline in the Eurozone. However, the rate of decline in Europe eased from February to March. Here are the details.
In the United States, the services PMI increased from 59.8 in February to 60.4 in March, a seven-year high. This was largely driven by a surge in new orders as well as an increase in export orders. That being said, a sharp rise in input costs was passed onto consumers in the form of higher output prices. Markit commented that “while consumer demand is rising especially strongly for goods, the surveys are now also showing rising activity in the consumer services sector, linked to the vaccine roll-out, looser virus containment measures and the fresh injection of stimulus in March.” Markit also noted that strong growth of financial services was largely due to the strength of the US housing market. The strong numbers in February and March, combined with strong numbers for manufacturing, bode well for rapid economic growth in the first quarter. Nonetheless, bad weather in February had a negative impact on some industries, thereby temporarily slowing the US economy.
In the Eurozone, however, the services PMI increased from 45.7 in February to 49.6 in March. Thus, having contracted sharply in February, service activity was almost stable in March. The continued weakness reflects economic restrictions related to recent surges in infections. However, the improvement since February reflects new optimism. As Markit noted, “the hard-hit service sector has come close to stabilizing as optimism about the outlook improved further during the month. Firms’ expectations of growth are running at the highest for just over three years amid growing hopes that the vaccine roll-out will boost sales in the coming months.” In addition, Markit said that the survey indicates that lockdowns have not been as onerous as previously believed because companies and consumers have “increasingly adapted to life with the virus.” Still, as lockdowns are lifted in the coming months, it is likely to have a positive impact on growth. Of the four major Eurozone economies, only Germany showed growth in services (the PMI was 51.5 in March). France and Spain also saw improvement in the PMI but continued decline in service activity. Italy showed no improvement due to continued economic restrictions.
Markit reports that the services PMI for China improved from 51.5 in February to 54.3 in March, a level indicating strong growth. Markit noted that both domestic supply and demand were strong, although export orders remained weak. The easing of new outbreaks of the virus helped to improve consumer interaction. Inflationary pressures were up due to increased prices of raw materials, labor, and energy.
In the United States, there have been three instances in the past year in which households received relatively large stimulus payments from the Federal government. First, a large share of Americans received payments of US$1,200 starting in April of 2020. Then in December, about 85% of Americans received US$600. Finally, last month payments of US$1,400 started to be sent to 85% of Americans. The immediate economic impact depends, in part, on what share of these payments are spent versus saved or used to pay down debts. Any incremental saving, of course, sets the stage for increased spending once the pandemic subsides, possibly in the second half of 2021. In addition, the degree to which the stimulus payments are inflationary also depend on the timing of spending versus saving. Consequently, it is helpful to know more about the behavior of households. The Federal Reserve Bank of New York has been studying this based on survey data and has some interesting findings.
The New York Fed found that households spent 29.2% of their stimulus payments early last year and 25.5% of their December payments, and they intend to spend 24.7% of the most recent payments. Thus, behavior has been relatively steady. The part not spent was roughly evenly divided between direct saving and paying off debts (which itself is a form of saving). In addition, the Fed found that lower-income households were far more likely to use the money to pay off debts and were slightly less likely to directly spend the money. Likewise, less-educated households were slightly less likely to directly spend the money. However, when it comes to spending on essential goods, lower-income households were far less likely to spend than upper-income households. Overall, the survey found remarkable stability in household behavior. In addition, it suggests that the pool of household savings is increasing rapidly in response to stimulus money. This means that, once a large share of the population is vaccinated and people are feeling safer, this money could play a major role in funding a revival of spending on consumer-facing services, such as restaurants, theatres, airlines, and hotels. If businesses are not prepared to a wave of increased demand, the result could be a temporary surge in inflation.
Around the world, there are an increasing number of stories about shortages and supply chain disruptions leading to a surge in prices of goods. In China, this is clearly the case. The government reported that, in March, factory gate prices (producer prices) were up 4.4% from a year earlier, the fastest in two years. In addition, factory gate prices were up 1.7% from the previous month. This surge in wholesale prices has not yet translated into a surge in consumer prices. The government also reports that consumer prices were up a modest 0.4% in March versus a year earlier. This was the biggest increase since October. Prices were down 0.5% from the previous month. Core consumer prices (which exclude the effect of volatile food and energy prices) were up 0.3% in March versus a year earlier. The difference was due to a big increase in energy prices. Food prices, however, fell.
Although consumer price inflation in China remains tame, the surge in producer prices has evidently alarmed officials. In fact, the Financial Stability and Development Commission, which is headed by Vice Premier Liu He, issued a statement saying that “We must keep the basic stability of prices and pay particular attention to the trend of commodities prices.” This seemingly innocuous statement was widely viewed by analysts as a warning about an impending acceleration in inflation and the disruptive impact it could entail. In addition, the Commission stated that “the primary target of macroeconomic policies is to protect jobs and market entities. We must pay attention to ‘adding water to farm fish’, providing relief for corporations and better invigorating market entities.” In other words, the role of policymakers is not only to quell inflation but to ensure that the economy remains on a stable path, led by the private sector. For the central bank, it means finding the right balance between averting a significant acceleration in inflation and maintaining steady employment growth. This is a balancing act that many central banks will likely attempt in the coming year, especially given the rise in inflation related to supply chain disruption.
As previously discussed in these pages, the massive US fiscal stimulus is having a disruptive impact on many emerging markets. Specifically, anticipation of higher inflation generated by the boost to US demand has fueled a rise in US bond yields. This, in turn, has generated capital outflows from emerging nations, putting downward pressure on their currencies. In order to avoid depreciation and/or depletion of foreign currency reserves, many emerging country central banks have boosted interest rates. This has the potential to cause a slowdown in growth.
One major emerging nation, however, has so far avoided disruption. That is India. The reason is that India has accumulated a massive pile of foreign currency reserves in the last few years. Reserves have doubled since 2014 and have increased by roughly 50% since 2018. This means that, unlike many of its peers, India can afford to allow a decline in reserves in order to stabilize its currency without resort to raising interest rates. In fact, India probably has room to cut rates. In the past, Indian business investment has been stymied, in part, due to high costs of capital. India is now in a good position to change this and allow for an acceleration in investment.
Still, this does not mean that India’s outlook is entirely rosy. After a period in which many observers were confident that India was on the verge of herd immunity, the country faces yet another serious outbreak of the virus which is likely to hurt economic growth. Although vaccinations are under way, the speed of distribution has not been sufficient to offset the transmission of new variants. In a country where urban areas are densely populated and where a large share of the urban population works in service enterprises, it is difficult to contain the spread. In addition, new restrictions have been implemented this month which are likely to temporarily stifle growth.
Then again, not only does India benefit from a high level of reserves, it also is lucky to have relatively low inflation and, as a result, low bond yields. India is in the midst of a strong economic recovery, with growth this year widely expected to be in double digits. The latest PMI for services in March was 54.6, a level indicating strong growth in activity. Output and new orders were up strongly. Business optimism was evident in the survey.
As an economist, I often find working in a business environment to be exhilarating. One frequently hears exciting predictions about the revolutionary impact of new technologies, lifestyles, demographics, or geopolitical trends and how they will create new business opportunities and improve how we live and work. Sometimes these predictions turn out to be true. Still, as an economist, my job involves throwing cold water on optimistic predictions and providing a viewpoint about downside risks. This is one such time. With light at the end of the pandemic tunnel, one could be forgiven for thinking that all will be well within a year. And it might be. Yet even after the pandemic ends in major economies, there will likely remain significant problems that could postpone a full return to normalcy around the world. Here are three that come to mind:
The COVID-19 situation on the European continent is worsening despite a significant increase in the number of people being vaccinated. French President Macron announced a new nationwide 30-day lockdown meant to quell the outbreak at a time when hospitals are being inundated with new patients. The lockdown, which polls indicate is popular, will involve an evening curfew, the shutting down of nonessential retail venues, closure of schools, and restrictions on travel. Among major Eurozone economies, France now has the highest number of daily infections—the highest rate seen since November. France is not alone. Lately there have also been sizable increases in the number of daily infections in Italy, Belgium, and the Netherlands. There have lately been more modest increases in the infection rate in Germany and Spain. It is worth noting, however, that the death rate in all these countries has remained muted. Moreover, the number of people being vaccinated each day has risen sharply in each of these countries, with an especially high number in Spain. However, all these countries currently have a daily vaccination rate that is less than half that of the United Kingdom. The European Union (EU) has been slow to ramp up its vaccination program and, as a result, is far behind the United Kingdom and the United States in immunizing its population. Thus, it is a race against time as new variants of the virus propagate. Meanwhile, aside from France, economic restrictions of varying degrees continue in some other European countries. Thus, the rebound in the large service sector of the economy is likely to be postponed, thereby suppressing economic growth in both the first and second quarters of this year.
Despite the bad news regarding the virus, Europe’s manufacturing sector continues to perform exceptionally well. This is according to the final purchasing managers’ indices (PMIs) for March released last week by IHS Markit. PMIs are forward-looking indicators meant to signal the direction of activity in the manufacturing sector. They are based on sub-indices, such as output, new orders, export orders, input and output pricing, inventories, pipelines, employment, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth. The latest PMIs suggest that manufacturing activity in the Eurozone is growing at a record pace. The Eurozone manufacturing PMI increased from 57.9 in February to 62.5 in March, a record. Moreover, although Germany was the star performer, the strong growth was consistent across the region. The PMIs were 66.6 in Germany (a record high), 64.7 in the Netherlands (also a record), 59.3 in France (a 20-year high), 59.8 in Italy (a 21-year high), and 56.9 in Spain (a 14-year high).
The performance was especially strong for producers of investment goods and intermediate goods. The high PMIs were driven by record increases in output, new orders, and export orders. This reflected strong domestic and external demand. In fact, demand was so strong that supply chains were stretched, thereby leading to long lead times and shortages of inputs and components. This, in turn, led to the biggest increase in input prices in 10 years. Still, Markit expects the inflationary impulse to ultimately ease. Current levels of demand reflect the rebound from lockdowns. Strong demand also led to a surge in hiring by manufacturers.
Meanwhile, a similarly large increase in manufacturing activity took place in the United Kingdom where the PMI hit 58.9 in March, a 10-year high. Britain’s strong performance reflected growth of output, new orders, and employment. Stress in the supply chain led to increased lead times. The improvement in performance was attributed to the easing of economic restrictions and the successful distribution of the vaccine. As in the Eurozone, supply chain issues were a problem. Markit noted that, in the case of the United Kingdom, post-Brexit issues continued to disrupt supply chains. Meanwhile, although export orders “bounced back,” Markit expects that weak exports and supply chain issues will constrain growth of manufacturing in the months to come.
Bond yields in the United States have risen significantly since the start of the year. Because they have started from a very low base, even small basis point increases in bond yields lead to big declines in bond prices. That reflects the fact that there is an inverse relationship between bond prices and yields. Hence, if the yield rises from 1.5% to 1.7%, there is a much bigger decline in bond prices than if the yield increases from 5.5% to 5.7%. In the first quarter of 2021, the price of the US 10-year bond fell by the largest amount since 1980.
What accounts for this? Essentially, investors now expect faster growth and higher inflation than they previously expected, owing to massive government stimulus and rapid rollout of the vaccine. The 10-year breakeven rate,2 which is a good proxy for inflation expectations for the next 10 years, has risen from roughly 1.8% at the start of this year to almost 2.4% now. Meanwhile the yield on the 10-year bond increased from roughly 1.0% to 1.7% in the same period. Thus, most of the increase in the bond yield can be attributed to an increase in expectations of inflation.
Why such a big increase in a short period of time? The principal reason is likely the passage of an unexpectedly large fiscal stimulus bill. At the start of the year, then President-elect Biden was talking about a large bill, but many observers expected his plan to be whittled down in negotiations. That didn’t happen. To the surprise of many, Biden got the bill he wanted. Moreover, since the start of the year, the rate of vaccination has been much higher than many observers had even hoped. That, in turn, has stimulated economic activity. Depending on how quickly the stimulus money is spent (and there is considerable debate about this), it is possible that it will cause the economy to overheat, thereby creating inflationary bottlenecks. The Federal Reserve even acknowledges that inflation will rise temporarily. Yet it also says that higher inflation will be due to temporary factors and will not be sustained. The central bank does not expect the kind of wage-price spiral that ordinarily creates longer-term inflation.
The big debate now concerns whether the Fed is right. Plus, Fed Chair Powell has said that, if needed, the Fed will reverse its easy monetary policy in order to contain inflation. Yet some critics wonder if Powell is being realistic. Once the inflation genie is out of the bottle, it is not necessarily so easy to contain it. Thus, investors expect that, over a 10-year period, inflation will be above the Fed’s 2.0% target. Interestingly, the 10-year bond yield has been relatively steady in the last two weeks. Perhaps investors have incorporated their new inflation expectations and no longer expect any further surprises. The market did not react much to the recent proposal by President Biden for a large infrastructure program, perhaps because that money is meant to be spent over a much longer period and because it is meant to be funded by a tax increase. So, is the bond market correction over? Or is this the start of the much-heralded end of the three-decade bull market in bonds? If I knew the answer, I’d probably own a private island in the Bahamas.
In March 2021, employment in the United States grew at the fastest pace since August 2020. How can we account for this surge in employment? Certainly, the further easing of economic restrictions contributed to a burst of job growth in the hospitality sector. In addition, there is the question of the government stimulus. In December, a relatively modest US$900 billion stimulus (compared to the US$1.9 trillion stimulus that came later) led to a surge in retail spending in January. Observing this and being aware that a much-bigger stimulus was coming in March, businesses likely accelerated hiring in order to take advantage of the expected increase in demand. The US$1.9 trillion stimulus was signed into law on March 11 and the data from the latest employment report was accumulated during the week of March 15. Thus, there was little time for the stimulus to have a direct impact on job growth. Rather, it was the anticipation of the burst of demand that had an impact. Moreover, it is likely that businesses anticipated positive effects from mass vaccination. In the April jobs report (to be released a month from now), we will likely see the impact as businesses digest a change in aggregate demand for the economy.
So, what exactly happened in March? There are two employment reports released by the US government—one based on a survey of establishments, the other based on a survey of households. Before looking at the March establishment report, it is useful to look back at the past year in order to put things in context. In March and April of last year, there was a catastrophic drop in employment as the virus surged and state governments shut down. Then, as governments reopened, job growth was exceptionally rapid in May through August with payroll rising an average of 2.7 million in each of those four months. However, another surge in the virus began in the early Autumn, leading to a change in consumer behavior. The result was much slower job growth in September through November with payroll rising an average of 553,000 in those three months and an actual decline in payroll employment in December of 306,000. Then, job growth recovered modestly, with payroll up 233,000 in January and 468,000 in February.
Last week, we learned that payroll was up 916,000 in March, the strongest growth since August and a considerable acceleration since February. There was strong growth in such industries as construction, manufacturing, and especially leisure and hospitality. The establishment report is very positive. Still, employment remains 8.5 million below the level from a year ago and even farther below the level that would have occurred had the pandemic not happened. There remains a long way to go, which suggests that we are not yet at the point where wage pressures will create serious inflation. However, the Biden administration is hoping that the stimulus will cause a further acceleration in job growth, pushing the economy toward full employment sometime in 2022. Moreover, rapid vaccination of the population sets the stage for a resumption of normal social interaction and economic activity, thereby creating further opportunities for rehiring.
The separate household survey revealed that participation in the job market increased faster than the growth of the working-age population. As such, the participation rate increased slightly. Employment grew even more rapidly, leading to a decline in the unemployment rate from 6.2% in February to 6.0% in March. There was an especially large decline in teenage unemployment. By education level, there was a massive decline in unemployment for the least educated and almost no change for the very educated.
The United States and Japan are concerned about the current global shortage of semiconductors and its impact on economic recovery. From a longer-term perspective, they are also concerned about geopolitical risk to semiconductor availability. For example, tensions between the United States and China create a risk regarding US access to semiconductors made in China. The increasing view that China might invade Taiwan puts access to Taiwanese semiconductors at risk. Thus, Japan and the United States are creating a joint task force to design alternative supply chains and reduce dependence on China and Taiwan. The two sides will consider the division of labor regarding research and development, production, and distribution. Moreover, they intend to create a less concentrated supply chain, one that is less reliant on one or two locations and, therefore, less vulnerable to disruption. The task force will be comprised of national security and economic planning personnel from both governments. This will include people from Japan’s Ministry of Economy, Trade, and Industry and the US Department of Commerce. There does not appear to be discussion about imposing trade restrictions. Rather, both sides evidently want to provide government subsidies for making changes. For example, the Biden administration will ask Congress for US$50 billion to subsidize growth of semiconductor production in the United States.
It is reasonable to wonder whether government planning of supply chains will lead to the most efficient outcome. Governments have a history of supporting inefficient businesses and providing subsidies to the politically best connected. The joint plan sounds uncomfortably like the kind of planned trade that was characteristic of centrally planned economies in the past. However, there is a storied history of US government incentives (mainly military) leading to the development and proliferation of new technologies. This included the worldwide web, global positioning satellites, facial recognition, and virtual reality, to name a few.