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Tax Reform, Border Adjustability, and Territoriality
Home / News / Tax Reform, Border Adjustability, and Territoriality
January 5, 2017

Via Forbes

Everyone anticipates that 2017 will finally be the year that Congress passes comprehensive tax reform. As with any such gargantuan legislative effort, there is a lot to digest. Nothing has been more controversial to date than what the House GOP is proposing on international tax reform.

Back in the summer of 2016, House Republicans released a series of “blueprint” white papers outlining major policy changes they intended to pursue in 2017 under a unified GOP government. The tax proposal was interesting in many respects, not the least of which was the introduction of a “destination based,” border adjustable international consumption tax system.

How would this work, and is it the right solution for tax reform?

There are actually two separate processes in the House GOP plan to reform the international rules. The first is a migration from our current “worldwide” tax regime (where American companies can owe U.S. tax on overseas profits as well as domestic profits) to a more common “territorial” tax system (where American companies would only owe tax on domestic profits). Conservatives have been calling for this transition for many years.

As a bridge to the new system, the House GOP plan taxes the deferred foreign earnings of U.S. companies doing business overseas as controlled foreign corporations. The old tax system mitigated double taxation by allowing these funds to remain overseas indefinitely, but that probably also created some genuine tax loopholes. To get back to square one, the House GOP plan does a “deemed repatriation” tax of 8.75 percent on cash holdings (3.5 percent on asset holdings) in these deferred accounts. The business community by and large views this “reset button” as part and parcel of getting to international tax reform under most any system, and clearing out the complicated underbrush of international tax rules under which they have labored since the Kennedy Administration. It’s important that the tax revenue raised in this exercise be reserved for tax reform, and not spent on infrastructure or some other non-tax reform idea.

The second and related international reform is the creation of a “destination based” border adjustable system. Under tax reform, this system would not tax the exports of American companies, but would tax the gross value of any imports into the country. The new rate of tax on corporations is expected to be 20 percent, so that would also be the de facto rate of tax on imports.

U.S. companies would immediately be on equal footing with their international competitors, the great majority of whom benefit from territorial taxation and border adjustability today. American firms would be further advantaged by tax reform’s low 20 percent tax rate on corporations (down from a global high 35 percent today), and full business expensing of asset purchases (replacing multi-year depreciation deductions). Instead of taxing exports and not imports, we’d be taxing imports and not exports. Instead of reading about corporate inversions and outsourcing, we’d be reading about jobs and firms moving into the U.S. to take advantage of the favorable tax rules here.

If that sounds like something out of a Donald Trump rally, it should. Moving to this border-adjustable, destination-based, territorial, consumption tax system is far superior to a new tariff, and is neatly tucked into a unified tax reform system that makes sense. Like St. Boniface inventing the Christmas Tree out of Germanic arbor worship, expect the Trump Administration to endorse this policy as its own before long.

This international tax reform plan is not a value-added tax (VAT), although it shares many of its characteristics. Like a VAT, this system seeks to tax consumption—defined as business income less business inputs. Like a VAT, the system taxes imports and doesn’t tax exports. Like a VAT, the plan’s authors hope the system is permissibly border-adjustable under arcane World Trade Organization (WTO) rules, resulting in the end of double taxation for U.S. exporters.

So why is this plan not a VAT? It differs from a VAT in one major respect. One universal and constant characteristic of a VAT is that it does not allow a business deduction for wages and other compensation paid to workers. That’s because a VAT only allows deductions for business to business purchases. The House GOP tax reform plan, however, does allow for a business to deduct labor compensation paid (wages are then taxed on the individual level). That is a very, very important distinction. The House GOP business tax is not a VAT just like Star Wars is not Star Trek even though both take place in outer space. This wage deductibility issue was the principle conservative concern with Rand Paul’s and Ted Cruz’s presidential tax plans, which were VATs.

The House GOP plan looks a lot more like the Hall-Rabushka Flat Tax than some European style tax regime. Hall-Rabushka’s business tax base replaces fully the worldwide tax regime which preceded it—so no fear of an add-on VAT. Conservatives legitimately concerned about the House GOP plan creating a slippery slope to the imposition of a VAT in the United States (see Dan Mitchell here and here) should be almost as “worried” about the classic Flat Tax they have supported for decades—which is to say they should not be worried at all. The Flat Tax is basically a modified subtraction method VAT (modified to include a wage deduction) without border adjustability.

Any tax reform system, of course, creates winners and losers. The losers are always by far louder and more persistent than the winners. The two most vocal opponents of this tax reform plan have been the retailers and the refined oil importers. The retailers, in particular, have been out in force. They import many of their goods for sale in the United States from overseas locations like China, and would face the tax on imports for doing so. Even with lower rates, they say they will face an overall higher tax bill which will result in higher prices for retail consumers. If this proposal doesn’t make it, it’s likely to have retail’s fingerprints on the murder weapon.

The classic response conservatives would have to retail concerns is that there is really no way to serve all masters in tax reform. You can’t have a tax reform which doesn’t increase the deficit, lowers tax rates, simplifies the system, is more pro-growth, and in which no set of taxpayers face an overall worse system than before. It’s simply not possible. If the restraint is that no one can be a loser in tax reform, then there simply will be no tax reform. There is a far wider economy than just retail and oil imports, and the rest of that economy is likely to be a winner under this plan, even a big winner.

Monetary economists, in whose ranks I thankfully do not count myself, also assert that the imbalances created by the border adjustable, destination based system will be wholly or partially corrected by a shift in currency exchange rates. The dollar will strengthen as demand for U.S. exports increases and demand for foreign imports decreases. That very well could be the case, but I would count this as a hoped for effect of tax reform rather than a planned one.

The international components of the House GOP plan are part and parcel of a much larger system—a consumption tax which is both pro-growth and pro-family, is simpler than today, and which puts the U.S. on par with other international tax systems throughout the world. Only in the context of the whole package can the border adjustable part be fully understood.

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