Monday, January 23, 2017

Is a Border Adjustment Tax a Smart Move for Corporate Tax Policy?

Since his presidential campaign, Mexico has been a sticking point for President Trump. Trump wants to deport millions of undocumented Mexicans back to Mexico, which would not be a good idea. During his campaign, he also suggested slapping a 35 percent tariff on Mexican goods, which would be disastrous for the American economy. He even wants to renegotiate the North American Free Trade Agreement (NAFTA), although it is currently unclear as to how he will go about that. There is one Mexico-related policy idea coming from the Republican Party that is not Trumpian in nature: the border adjustment tax.

What exactly is the border adjustment tax? Also known as a destination-based cash flow tax, the border adjustment tax (BAT) is a tax levied on imports while the exports are exempt, i.e., the tax is based on where the product ends up instead of where it is produced. The BAT is different from a tariff in that the BAT simultaneously taxes imports and de facto subsidizes exports, unlike a tariff, which only affects imports. The reason that the BAT would be a de facto export subsidy is because imports would no longer be deductible from taxable income, while exports would be. Another way of framing the Republican Party's proposal is that it would convert the current corporate tax into a destination-based flow tax that would de jure tax imports at the proposed 20 percent while exempting exports from any taxation, which would de facto be the equivalent of an import tariff of 20 percent and an export subsidy of 12 percent. This huge tax break for net-exporting corporations would essentially be a value-added tax with a deduction for wages.

The purpose of the BAT is to incentivize corporations to produce and export more while importing less. Since the BAT does not allow for corporations to reduce their taxable income via deductions of their overseas expenditures, the BAT theoretically is able to create these incentives. The other bit of economic theory is that the import tax portion is to be offset by the export subsidy portion of the BAT, which is why some do not view it as a distortion to international trade. While imported goods would initially be more expensive and exports would be cheaper, what would mitigate the distortionary effects of the BAT is that the dollar would appreciate in value. The appreciation of the dollar would, in theory, offset the trade advantage the United States would have. The catch is how quickly or completely the value of the dollar would change to mitigate these concerns. Goldman Sachs found that the dollar would have to appreciate by 24 percent in order to offset the 20 percent tax, which would adversely affect the global economy.  As the Peterson Institute explains in its latest policy brief on the BAT, if the dollar does not appreciate as a result of the BAT, then consumer prices would increase (p. 8), which would be bad for many Americans.

What would be the outcome of such a tax? It's difficult to say because, as the Department of Treasury brings up in its January 2017 analysis of the BAT, the United States really doesn't have experience with cash flow taxes. Other countries already have value-added taxes, which account for goods produced in a foreign country but consumed in the domestic country. That could potentially give some insight (although border adjustments make more sense for a sales tax than a business tax), but applying the BAT in an American context makes the scenario more unique, which is why economic modeling has to be used to make an educated guess. The BAT might work to the point where it can eliminate the incentive for companies to move their tax residency abroad, raise $1 trillion in tax revenue over the next decade, and rectify trade imbalances since more corporations import than export. It's weird to see both the Left-leaning Center for American Progress and the Right-leaning Tax Foundation agree. However, it's also possible that it would drive up consumer prices, mess up global supply chains, stimulate illegal immigration, cause increased tax fraudexacerbate the woes in the global economybring us closer to a value-added tax, make it more difficult to lower tax rates in the future since it would cause even bigger government growth (which affects tax competition), and/or prompt retaliation from other countries, which could either be in the form of a WTO dispute or even starting a full-blown trade war.

Trump is right in that the BAT is too complicated. Given everything at stake, I don't think it's the best way to go about corporate tax reform. If the BAT is created in part to disincentivize corporations from going overseas, how about simply lowering the corporate tax to an amount that would keep them here instead of creating a corporate tax system of exemptions and loopholes? That way, you can get rid of the major distortion caused by the current 35 percent corporate tax that makes corporations want to move production overseas. Or how about trying something else (see here and here)? If Trump wants to spur pro-growth tax reform, a simpler tax code is a better tax code, and the border adjustment tax does not bring the United States economy towards that goal.

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