Border adjustability is already fueling tax reform controversy

Tax treatment of cross-border transactions is not just a matter of the tariffs President-elect Trump has been threatening. It is also deeply embedded in the taxation of corporations.

Susan Walsh/AP/File
The Internal Revenue Service (IRS) building in Washington.

Notwithstanding all the happy talk about Congress passing a tax reform bill in 100 days next year, any effort to rework the revenue code will require Congress and the Trump administration to unravel an exceedingly tangled ball of string. And perhaps no problem is more knotty, and more politically explosive, than how the US tax code treats international trade.

Not only is the issue challenging on its own terms, but it will inevitably get mixed up in the new Administration’s extremely aggressive—but still undefined—position on imports. Tax treatment of cross-border transactions is not just a matter of the tariffs President-elect Trump has been threatening. It is also deeply embedded in the taxation of corporations.

Border Adjustability

Consider border adjustability—one way the tax code could treat imports and exports. Today’s code taxes US firms on their worldwide income so that, at least in theory, profits earned overseas are taxed at the same 35 percent rate as domestic earnings. However, taxes on foreign income are deferred until a firm either reinvests those profits in the US or distributes them to shareholders.

But the tax blueprint released by House Republicans last June goes a different route. It adopts a tax system that would be based on where a firm’s products are consumed, rather than where they are produced or where the company is headquartered.  

And the House plan does three other things: It would reduce US corporate tax rates from 35 percent to 20 percent, below the average for developed countries. It would change the corporate income tax to a form of cash flow consumption tax. And would be border adjustable so that exports would be exempt from US tax while imports would be taxed.

Those border adjustments are critical to the House GOP plan because the revenue they raise, nearly $1.2 trillion over 10 years according to my Tax Policy Center colleagues, would help finance its rate cuts. Without the money, lawmakers would have to add even more to the nation's debt or reduce the size of those rate cuts.

Two Big Problems

On the merits, a destination-based consumption tax makes a lot of sense. It would move the US beyond the tax systems of most of our trading partners that have reduced their corporate rates in favor of destination-based Value-Added Taxes (VATs). And it would eliminate the incentive for US-based multinationals to reduce their taxes by shifting reported income to low-tax countries or by using inversions to become foreign-resident companies.  

But the House GOP’s border adjustments raise two big issues, two political and one substantive.

The first political problem is this: US retailers, whose shelves are filled with imported goods, are already gearing up to battle the proposal. Politically influential firms such as Wal-Mart and Target insist such a tax would raise prices on consumers. They say the import tax would exceed their profits and inevitably be passed on to customers.

And they are not alone. The Koch Brothers, who planned to give at least $750 million to political candidates in the current election cycle—nearly all to conservative Republicans—are also opposed to the levy. Their firm, Koch Industries, imports many components for its products. Similarly, other firms that rely on foreign producers in their supply chains--think consumer electronics-- will also oppose the provision.

Economists believe the House GOP’s border adjustability provisions would lead to a stronger dollar which would largely offset the cost of the tax by reducing the price of imports. But business opponents are skeptical.  

The WTO Problem

The proposal’s second political problem arises because it also would reduce taxes on US-based exporters. The optics of Treasury giving big tax rebates to profitable exporters would clash starkly with the populist rhetoric of the Trump Administration, even though border adjustability would also mean these exports might fetch a lower price in US dollars.  

Then, there is the substantive problem.  Remember that the House plan would create a cash-flow tax for business—mostly by allowing firms to write off the cost of capital equipment in the year they acquire it but without the ability to deduct interest payments on those purchases. That is economically-equivalent to a VAT, but the tax on labor would be collected from individuals instead of business, which could deduct labor costs. And that makes the House plan look like a corporate income tax.

The World Trade Organization allows border adjustments for indirect levies such as sales taxes, but not for income taxes.  Thus, the WTO could impose trade sanctions on the US if it went ahead with this form of border adjustability.

None of this is to say that a big tax cut in 2017 is impossible. But it is one powerful example of just how difficult fundamental tax reform will be.        

This story originally appeared in TaxVox.

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