Friday, February 25, 2022

When will US GDP be revised up?

The publication in July 2016 of Ireland’s National Income and Expenditure (NIE) Accounts for 2015 generated somewhat of a storm.  These were of course the revisions that introduced us to the 26 per cent growth rate.  As is now well understood this was as a result of Apple transferring to Ireland a license to use its significant intangible assets (brand, designs, patents etc.) in markets outside the Americas.

For the past year we have been waiting for something similar to arise in the national accounts of the United States.  Now obviously, something that is similar in nominal size (in the scale of tens of billions) will have a far lower relative impact on the GDP of the US than it would for Ireland but the principles and drivers are the same.  It is all down to the location of intangible assets.

Outbound royalty payments from Ireland to pay for the use of these intangible assets sum to huge amounts.  The full-year total for 2021 is likely to exceed €100 billion.  Recently, however, the changing nature of these royalty payments has been important to consider.

Royalty Imports US v ROW 2012-2021

Up to the end of 2019, most of the licenses which were responsible for the outbound royalty payments from Ireland were held in jurisdictions with no income taxes such as Bermuda (as with Google) or the Cayman Islands (as with Facebook).  This has changed over the past two years and now around four-fifths of the royalty payments from Ireland are directed to the United States. 

These Irish imports are US exports and contribute positively to US GDP.  For 2021, royalty imports from Ireland to the US are set to be about €80 billion higher compared to what they were in 2019.  Even in the scale of nominal US GDP ($23 trillion in 2021) this is a pretty significant sum.

However, the GDP impact will be less than the change in royalties.  This is because some of the royalty flows that went from Ireland to Bermuda and the Cayman Islands were, in turn, transferred on to the US in the form of payments for R&D activities.  These were a US export so would already be accounted for in US GDP.

As an example of this here are the accounts of Google’s holding company which was based in Bermuda.

Google Ireland Holding 2020 Accounts

We immediately note that the company had no turnover in 2020.  This is because Google ended its licensing arrangement via Bermuda.  For the previous year, we see that the company had a turnover of $26.5 billion.  The main source of this was the royalty payments made from Ireland.

On the outgoings side the company had $14 billion of administrative expenses.  A further breakdown provided in the accounts shows that the company incurred $10.4 billion of expenditure on research and development.

Google Ireland Holdings Expenses 2020

This $10.4 billion is the payment that has to be made back to the parent for the license to use Google’s platforms and technologies around the world.  Google and its subsidiary in Bermuda entered a cost-sharing agreement (CSA) whereby each party contributed to the overall group’s research and development costs based on the size of the market it had responsibility for.

In 2019, Google had a total R&D expense of $26 billion and it looks like the subsidiary in Bermuda paid for around 40 per cent of that.  The $10.4 billion paid went to the US and would likely have entered the US national accounts as an R&D service export.

As the income statement shows, the subsidiary in Bermuda had a profit of close to $14 billion in 2019.  This portion of the royalty flows from Ireland was not further transferred to the US and did not contribute to US GDP (but would be counted in US GNP as a factor income inflow).

With the royalties now flowing in full to the US this split no longer applies and all of the amount should be counted in US GDP – a outcome that better reflects the fact pattern and substance that generates Google’s profits.

We can see further evidence of this from Google’s overall accounts.  Here is the domestic/foreign split of Google’s profits for the last three years.

Google Foreign Domestic Income 2021

For 2019, Google reported that around 60 per cent of its profit was due to foreign (i.e. non-US) operations.  The $23.2 billion of foreign income for 2019 would have included the $13.7 billion of profit reported by the subsidiary in Bermuda.

For 2020, this profit was no longer reported in Bermuda and we see there was a commensurate fall in income from foreign operations.  As the royalty payments now go direct to the US, this profit is now included in domestic income and the share of Google’s profit that is attributed to US operations has increased.

In 2021, Google had a huge jump in profits to over $90 billion and $77 billion of that (85 per cent) was attributed to domestic operations.  This wasn’t because Google’s growth in 2021 was concentrated in the US.  Indeed, the share of Google revenue that came from customers in the US declined (from 47 per cent in 2020 to 46 per cent in 2021).

Google Revenue Geography 2021

The reason most of the additional profit that Google made in 2021 was attributed to domestic operations is because the functions, assets and risks that are responsible for that profit are located in the US.  The innovation and development that delivers Google’s technologies and platforms is undertaken in the US.  And the value-added of those activities should be counted in US GDP, not Bermuda’s (or Ireland’s).

And we can see the same if we look at other US companies.  Here is the domestic/foreign split of Facebook’s profit.

Facebook 10K 2021 Domestic Foreign Income

For 2019, Facebook reported that almost 80 per cent of its profit was due to foreign operations.  Most of this was attributed to a Facebook subsidiary in the Cayman Islands that held the license to use Facebook’s platforms and technologies around the world. 

In mid-2020, Facebook changed its licensing arrangements and began to license its IP to its international headquarters in Ireland from the US rather than the Cayman Islands.  Thus, the royalties that Facebook continues to pay from Ireland now go direct to the US rather than to the Cayman Islands.

For 2021, Facebook reported that over 90 per cent of its profit was due to domestic activities.  And, as with Google, as the US is where the main functions, assets and risks that generate Facebook’s profit are located this is much more in line with the substance of the company which the profit division for 2019 did not represent.

Similar profit splits can be seen for other US MNCs.  Here is Amazon which reported that 94 per cent of its profit in 2021 was due to its operations, including R&D, in the US. Unlike Google and Facebook, however, this split has been evident for sometime and seems is not the result of a restructuring of its licensing arrangements.

Amazon Domestic Foreign 10k 2021

For other US companies their split of profit between domestic and foreign operations remains incongruous.  Here is the split for Apple.

Apple Domestic Foreign 2021

In recent years, the share of Apple’s profit that is attributed to foreign operations has been relatively steady at around two-thirds.  Unlike the companies above this is not in line with the substance of the company.  And we know that as a result of the 2015 restructuring a large share of Apple’s foreign income is reported in Ireland and included in Irish GDP.

Anyway, our interest here is US GDP not Ireland’s.  To what extent are the restructurings of Google, Facebook and others reflected in the national accounts of the US?  There is strong evidence of them in Irish figures compiled by the CSO – the opening chart in this post is an example of that – but it is not clear that the equivalent flows are reflected in US figures compiled by the BEA.

Unfortunately, we cannot directly compare CSO and BEA data.  While trade with the US might be a key components of Ireland’s national account the reverse of that is not necessarily true. It can also be the case that different definitions are used – including for geographic allocation. 

However, given the size of the companies and the nature of the restructurings undertaken it  should be possible to see the impact of them in the overall service export figures of the US.  The two we will look at are “research and development services” and “charges for the use of intellectual property”.

As Google and Facebook, and likely more besides, have ended their cost-sharing arrangements with companies in Bermuda and the Cayman Islands we would expect US exports of research and development services to decline (though it may have been that the BEA was reporting that these payments came from Ireland).  And as the companies are now licensing their intellectual property from the US we would expect to see an increase in US royalty exports (in line with the increased payments to the US evident in the Irish data.

So what do we see if we look at US exports of research and development services and charges for the use of intellectual property? 

BEA Service Exports Royalties and RandD

The above shows them in overall terms and does not use a geographic split.  Google changed its structure from the start of 2020; Facebook did so from the middle of 2020.  But there doesn’t appear to be any evidence of these in the royalty or R&D exports figures published by the BEA.  Perhaps, it is other categories that should be looked at but looking through the BEA data does not reveal any that stand out.

The BEA figures for total royalty exports show pretty much no change in 2020, going from $115.5 billion in 2019 to $113.8 billion in 2020.  In contrast, the CSO figures show Irish royalty imports from the US going from €13.1 billion in 2019 to €53.0 billion in 2020. 

We can’t do a similar comparison for R&D services (Bermuda never included these flows in its balance of payments statistics) but a look at the geographic split shows few changes.  The slight fall in US R&D exports shown in the chart above is due to Switzerland which didn’t feature as part of the company examples set out above.

It is hard to know what is going on. Maybe the BEA had already fully accounted for the profits of Google, Facebook etc. and was overlooking the tomfoolery that was going on with Bermuda and the Cayman Islands.  But that seems unlikely.  Company accounts are the source data for many measures in the national accounts.  It was by following company accounts that led the CSO to publishing the 2015 NIE with its 26 per cent growth rate.

And even if relatively small in the context of US GDP the amounts involved are non-trivial.  Looking at the performance of Google and Facebook in 2020 suggests that something of the order of $40 billion may have to be accounted for with possible twice that amount for 2021.

Last year we estimated that US 2020 GDP could be revised up by 0.1 per cent as a result of the changing royalty flows.  That was with data that went to Q3; with full-year data it is possible that if a revision for 2020 is necessary it will be closer to 0.2 per cent.  US GDP growth for 2020 (and also for 2021) would be revised up.

It still only speculation to say this will happen.  But the shifts in the domestic/foreign split of the profits of Google, Facebook and likely more are pretty significant.  The BEA will publish its full-year balance of payments data at the end of March.  It will be interesting to see if the significant changes showing in both the CSO’s statistics for royalties and the companies’ figures for their profit splits show up.