US tax reform will boost European exports, but lure investments to America at Europe’s expense, writes a leading German economist.

When I use all my fingers it adds up.

The major tax reform approved by the US Senate last weekend was one of Donald Trump's more sensible election promises. The legislation will clearly boost the US economy. Europe will also benefit in the short term, but the pressure of tax competition will increase massively, at a time when the era of zero interest rates is coming to an end.

Income tax reduction is at the core of the US tax reform, which reduces the top tax rate from 39.6 to 38.5 percent. However, the top rate only applies to income above $1 million (€840,000) instead of the current minimum of $427,000. The personal exemption is increased and tax rates are flattened, bringing relief to all taxpayers. Nevertheless, the tax reform will benefit high income earners the most. The average tax relief for all taxpayers is 1.2 percent of net income, while those with incomes in the top 1 percent will see gains of 4.5 percent. However, these figures do not take growth effects into account, or the consequences of possible spending cuts or future tax increases to compensate for revenue shortfalls.

The tax rate on corporate profits will be reduced from 35 percent to 22 percent, perhaps even 20 percent. There is also an immediate write-off for investments. Profits earned abroad by American companies are exempt from US taxation. Until now, these profits were taxable if they were transferred to the United States. Although taxes paid abroad were offset against domestic tax liabilities, the high US tax rate made it worthwhile to leave the money abroad temporarily. US companies had hoarded an estimated €1.3 billion abroad by the end of 2016.

The reform will invigorate exports to the US, but also intensify international tax competition.

What does this reform mean for Europe? In the short term, the economic stimulus will invigorate exports to the United States. The US foreign trade deficit will increase as a result, and calls for protectionist measures are likely to grow as well. At the same time, the reform will intensify international tax competition. The combination of a massive reduction in the tax rate and an improvement in tax depreciation creates considerable incentives to relocate investments to the US. Other industrial locations will have to react in order to remain attractive, including Germany.

Tax havens will also come under pressure, after having made a good living from the fact that US companies had incentives to avoid the high taxation of profits at home. The increased demand for capital from the United States will also lead to rising interest rates worldwide. The zero-interest period is coming to an end, which will also force Europe to make adjustments.

Europe will also notice that in all likelihood, US companies will stop relocating their headquarters abroad in order to avoid US taxation. The profits accumulated abroad will be subject to a one-off tax, regardless of whether or not they are transferred to the United States. Future foreign profits are to be exempted from taxation in the United States, a practice that is part of a global trend. In the UK, for example, taxation of foreign profits was abolished in 2009, and these profits are exempt from domestic taxation in Germany and most other OECD countries. However, the reform does not just provide tax relief, but also increases tax liabilities in some cases. Above all, the deductibility of interest is restricted in order to prevent tax avoidance through debt financing.

By instituting this reform, the US government has abandoned earlier plans to introduce "territorial" corporate taxation that is based on the country of destination. The conversion effort and the uncertainty associated with the system change were apparently too great.

US growth will increase on the back of rising investments and consumer spending.

What impact will the US tax reform have on the country's economic growth and national debt? Growth will increase on the back of rising investments and consumer spending. However, the extent of these effects is controversial. The US Senate expects the effects to be relatively subdued, with gross domestic product expected to be 0.8 percent higher on average over the next 10 years than it would have been without the tax reform.

This will lead to hefty projected losses in US tax revenues, with only about one-sixth of the tax reduction being offset by growth effects. The bottom line is that the deficit will increase, reaching a peak of $207 billion in 2020.

A study by the US Tax Foundation is more optimistic, predicting a 3.7-percent increase in GDP in the long term. The difference is due mainly to the study's expectations of stronger investment and a slower rise in interest rates. Thanks to this growth spurt, the reform would become self-financing after temporary revenue losses.

The author is head of the Munich-based Ifo Institute for Economic Research. To contact Mr. Fuest: [email protected]