Proposed replacement for the corporate income tax
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The policy agenda that House Republicans published before the elections included a tax plan developed under the aegis of Ways and Means Chairman Kevin Brady (R-TX). At the time, SAFE suggested further consideration of the proposed “border adjustment” of corporate income (allowing US firms an exemption for export sale revenue while denying a deduction for the cost of imports). Campaign issues: A better way, point 6, 7/25/16.
We find it hard to understand why imported products should be fully nondeductible by US firms, which would amount to a “buy America” provision that could seriously disrupt global trade patterns. Perhaps our understanding of what’s involved is faulty, but this proposal needs to be much better explained than it has been to date.
Presidential candidate Donald Trump had his own tax plan, which did not include the border adjustment feature. He repeatedly suggested that taxes of up to 35% might be levied on imports, however, to penalize US firms for moving manufacturing operations out of the US and/or to counter unfair trading practices of China, Mexico, et al.
Since the elections, House Republicans have continued to tout their tax plan, which would provide for systematic versus ad hoc border adjustment and be revenue neutral (dynamic scoring basis). The House GOP’s idea for business taxes could win bipartisan support, Peter Coy, bloomberg.com, 12/9/16.
Although Trump has characterized the border adjustment feature as “too complicated,” he may wind up being persuaded by Speaker Paul Ryan et al. Donald Trump warns on House Republican tax plan, Richard Rubin & Peter Nicholas, Wall Street Journal, 1/16/17.
“Speaker Ryan is in frequent communication with the president-elect and his team about reforming our tax code to save American jobs and keep the promises we’ve made,” said AshLee Strong, a spokeswoman for House Speaker Paul Ryan (R., Wis.) “Changing the way we tax imports and exports is a big part of that, and we’re very confident we’ll get it done.”
While other features of the House tax plan seem generally appealing, many conservatives question the border adjustment feature. Discussion follows: case for border adjustment - arguments against it – path forward.
I. For border adjustment – Some observers perceive the corporate income tax as deeply flawed. Wouldn’t it be nice to have a tax system that was simpler (facilitating compliance and enforcement), didn’t provide an artificial incentive for debt financing (by allowing interest expense to be deducted), and would minimize location distortion (manipulating corporate structure and transactions to shift income to low-tax countries)?
Considerable thought has been given to substituting a destination-based, cash flow tax (DBCFT) system for the corporate income tax, although no major country currently has such a system. The closest analogy is value added taxes; most developed countries (other than the United States) impose a VAT in addition to a corporate income tax.
A VAT is a tax (typically at a rate of 15-20%) on the consumption of goods or services. Businesses pay tax on receipts less purchases, with no tax deduction for labor costs, and pass the cost on to consumers. VAT calculations are border adjusted, i.e., exports are not included in taxable receipts but imports are included in purchases.
A recently concluded study by the Treasury Department (co-authored by Elena Patel and John McClelland) simulated the effects of a DBCFT system versus the current corporate income tax using tax return date for the period 2004-2013. The study was limited to traditionally taxed corporations, i.e., excluded business entities (Subchapter K corporations, partnerships, or LLCs) whose income is taxed only at the owner level. Financial service firms were also excluded due to issues as to how they would be taxed on a border-adjusted basis.
Dr. Patel presented the findings of the study last week. Other participants were Douglas Holtz-Eakin (American Action Forum), William Gale (Urban-Brookings Tax Policy Center), and moderator Scott Hodge (Tax Foundation). Talking tax reform: a panel discussion of border adjustability & cash flow taxes, Tax Foundation, video (76 minutes), 2/6/17.
Unlike the current corporate income tax, a cash flow based system would (1) provide for the immediate expensing (versus charges over time) of tangible asset purchases, e.g., buildings, equipment and inventory, and (2) eliminate the deduction for interest expense. It was shown that these changes would have had a relatively modest effect on aggregate tax liability during the study period. Border adjustment would have substantially increased said liability, however, as US imports consistently exceeded US exports.
Participants in the Tax Foundation discussion seemed to view a DBCFT system as a clearly desirable reform of the tax system. The primary focus was on identifying and minimizing pitfalls in the legislative and implementation phases.
#Will elimination of a tax deduction for imported goods result in higher prices for US consumers? One might think the answer would obviously be “yes,” and what’s more that the impact would be widely felt because higher taxes would drive up the prices of imported goods that are sold by high volume distributors like Walmart, Amazon, etc.
Some economists believe the new tax system would strengthen the US dollar versus other currencies, however, thereby offsetting the 20% tax on imports (and also the tax exemption of exports). The House GOP’s good tax trade-off, Martin Feldstein, Wall Street Journal, 1/5/17.
Since a border tax adjustment wouldn’t change U.S. national saving or investment, it cannot change the size of the trade deficit. To preserve that original trade balance, the exchange rate of the dollar must adjust to bring the prices of U.S. imports and exports back to the values that would prevail without the border tax adjustment. With a 20% corporate tax rate, that means that the value of the dollar must rise by 25%.
Feldstein goes on to predict one clear winner in this scenario: the US Treasury would collect more tax revenue.
Although the combination of the border tax adjustment and the stronger dollar leaves exports and imports unchanged, it has the important advantage of raising substantial tax revenue. Because U.S. imports are about 15% of GDP and exports only about 12%, the border tax adjustment gains revenue equal to 20% of the 3% trade imbalance or 0.6% of GDP, currently about $120 billion a year. At that rate, the border tax adjustment would reduce the national debt by more than $1 trillion over 10 years.
This anticipated revenue pickup is one of the chief selling points for an DBCFT; it would go a long way towards offsetting the corporate tax rate cut that Republicans envision. (Caveat: The US won’t necessarily run a trade deficit forever, as William Gale noted in the Tax Foundation discussion, and if the deficit evaporated so would the revenue pickup.) US House tax chief: lower tax rates vulnerable without border adjustment, David Morgan, reuters.com, 1/24/17.
Brady was speaking a day after Trump said his administration is trying to get the current 35 percent corporate tax rate down to between the 15 percent rate he has proposed and the 20 percent rate contained in the tax reform blueprint unveiled last June by Brady and House Speaker Paul Ryan. Analysts say Trump could have trouble getting the rate much below 30 percent without border adjustability.
#If the US Treasury is expected to come out ahead, how will other countries react? It’s been suggested that the World Trade Organization would view the border adjustment feature of the DBCFT as an unacceptable subsidy to US exports. Export-friendly US tax recap risks cool reception at WTO, Greg Ip, Wall Street Journal, 12/21/16.
. . .the WTO operates [according to] trade treaties, which generally treat tax exemptions on exports as illegal unless they are consumption taxes, such as the VAT. *** [Rep. Kevin] Brady says since the tax shares many features of a consumption tax, it should be WTO-compliant. But the U.S. has lost similar disputes before. In 1971 it introduced a tax break for exporters that, despite several revamps, the WTO ruled illegal in 2002. That time, the U.S. changed the law.
At the Tax Foundation event, William Gale said a WTO challenge should be expected. He also suggested a work-around: separate the DBCFT into two pieces - one a straightforward VAT (levy on receipts minus purchases, with border adjustment) and the other some sort of tax credit for labor costs. Perhaps this would be accepted by the WTO, who knows, but it certainly would require a lengthy and involved discussion.
#In the financial system, would anyone be hurt by the anticipated strengthening of the dollar? Americans holding wealth abroad would suffer a loss unless they could anticipate this effect of the new tax regime and repatriate their cash in time. Ditto borrowers that have issued dollar-denominated debt and might not be able to quickly convert it to other currencies.
OK, these aren’t low bracket players, and one might conclude from their plight that the DBCFT would have a progressive vs. regressive impact. Just imagine all those trillions of dollars pouring back into the US and thus becoming available to fund US investments.
II. Against border adjustment – Many conservatives view this feature of the House tax plan as a blunder. Here are some of their arguments.
#The only apparent reason for including border adjustment in the Republican tax plan would be the anticipated tax revenue pickup. Business firms have enough to worry about without being pushed to adjust their strategies to maximize exports and minimize imports. Changing the tax code; Washington must trust, not strangle, the free enterprise system, David Perdue (Senator, R-GA), 2/9/17.
As I saw firsthand in Europe [Senator Perdue is the only Fortune 500 CEO in Congress], this new tax . . . grows the size of the federal government. When EU countries installed a similar tax scheme — the value-added tax (VAT) — central governments grew by more than 60 percent. Also, the argument that currency revaluation will offset this tax does not hold up in the real world.
True, it’s been theorized that currency revaluation would neatly offset the effects of border adjustment, but this wouldn’t necessarily happen in practice. Why Trump is right to oppose part of the House GOP tax plan, Veronique de Rugy, mercatus.org, 1/18/17.
. . . the claims that nominal exchange rates will adjust immediately when the new tax system is implemented without anyone adjusting their behavior in anticipation of the change is at best an article of faith. The issue is far from settled in academia, contrary to what the pro-border adjustment advocates are claiming. If anything, assuming that no one will anticipate the nominal exchange rate shift and change their behaviors is implausible at best. As a result, trade flows will be affected, making this measure protectionist. Most free-trade advocates (the few ones who are left) and consumers should be concerned about this.
Or to put it somewhat differently, the picture being painted - US Treasury pockets $1 trillion in tax revenue over a decade without anyone having to pay for it – seems to violate the “no free lunch” principle.
For consumers, the harm would be two-fold. Some goods that are currently imported would become unavailable, and the prices of other imported goods would rise sharply. Look out! New border tax will increase your cost of living, Logan Albright, conservativereview.com, 2/3/17.
Currently, if a company buys inventory overseas and sells it domestically, it only gets taxed on the profits, not the entire revenue. ***Taxing only the profits allows companies with a large volume of sales but a narrow profit margin to continue to operate successfully. Eliminating this system for imported goods means that many imports will simply not be worth the money. *** That means fewer available options for you and me. Those bananas grown in Costa Rica may disappear from supermarket shelves, forcing us to subsist on less exotic, homegrown produce. *** Other imports will still be profitable, but only at increased prices, so once again, the American consumer is harmed by the tax.
#Much has been said about the need to cut the top corporate income tax rate, which at 35% is called “the highest in the industrialized world.” The US tax code is loaded with preferences, however, which reduce the effective tax rates of most corporations to a fraction of this figure. Based on a myth, Republicans risk leading off with a big tax increase, John Tamny, forbes.com, 1/22/17.
. . . the U.S. corporate tax is very high precisely because myriad loopholes and deductions reduce the effective rate substantially. To be clear, the tax is high so that politicians can hand out favors that reduce it. Indeed, if the latter weren’t true, revenues from the levy would be enormous to reflect the fact that U.S. corporations are some of the most valuable and profitable in the world.
Accordingly, the obvious way to simplify taxes would be to cut rates and “pay for” it by eliminating tax preferences. Ideally, business and individual taxes would be streamlined in one fell swoop given the substantial overlap between these systems. See, e.g., SAFE’s SimpleTax proposal, November 2010.
A thorough overhaul of the current tax system could achieve some of the same benefits as the flat tax or FairTax with less collateral damage. Also, it would be nice to develop a proposal that all fiscal visionaries could support without an intramural debate about theoretical purity. Surely we could all get behind a proposal to slash tax rates, eliminate arcane tax preferences, and junk 80% of the Internal Revenue Code and associated regulations.
Legislators often give lip service to the idea of such tax simplification, but the members of Congress never seem to get around to implementing it. Five don’t dos for tax reform, 4/20/15.
Politicians on both sides of the aisle proclaim their support for tax reform, and yet the Internal Revenue Code keeps getting longer, e.g., grew from 504 pages in 1939 to 74,608 pages in 2014. *** The driving force for tax complexity has been the practice of enacting tax preferences and penalties to influence individual and business behavior, an expedient way of keeping government costs out of the budget so they won’t be subject to close scrutiny.
Offsetting proposed tax cuts with a 20% tax on imports is not a tax cut plan, but rather a plan to substitute a new tax that will be harder to avoid and will likely result in a higher overall tax burden in the future. Based on a myth, op. cit.
Getting right to the point, conservatives aren’t hiding their plan to reduce a tax that American corporations are able to substantially shrink the cost of with one that no American will be able to avoid.
#Politically speaking, inclusion of the border adjustment feature in the tax plan reduces the chances of enacting any tax reform legislation worthy of the name. If Trump and Congress “botch” tax cuts, GOP could lose House, Republican Steve Forbes warns, Matthew Belvedere, cnbc.com, 2/8/17.
"Even if they pass the tax cut late in the year, if they make it retroactive to January 1st, that would cover a lot of sins," said Forbes, a longtime champion of a flat tax to apply a consistent rate across all brackets. Forbes was also adamant that House Republicans should drop the border adjustment to tax imports, as part of the broader package to reform corporate taxes. He said the border provision would cost Americans $1 trillion over 10 years, as importers raise prices to offset the tax.
Democratic support for any “revenue neutral” tax plan is unlikely. Accordingly, the only way to pass a Republican tax bill of this nature would be via the reconciliation process, and that would necessitate GOP unity. [Senator Orrin] Hatch: Partisan only tax reform looks likely, Joseph Lawler, Washington Examiner, 2/1/17.
With only 52 votes in the upper chamber, [Hatch] noted, Republicans have little margin for error. As a result, he suggested it will be difficult to include provisions that have the potential to divide Republicans. One such measure he referenced, without weighing in on it directly, is the House Republican proposal to border-adjust corporate taxes.
III. Path forward - Conservatives are already complaining of delays in unveiling the Republican tax bill. Drudge says Republican Party should be sued for fraud, Philip Hodges, eaglerising.com, 2/9/17.
Here’s what Drudge tweeted out: “No Obamacare repeal, tax cuts! But Republicans vote to shut [down Sen. Elizabeth] Warren? Only know how to be opposition not lead! DANGER.”
The president subsequently let it be known that the tax bill was coming soon and would be worth waiting for. Trump promises tax announcement in two to three weeks, Joseph Lawler, Washington Examiner, 2/9/17.
"Lowering the overall tax burden on American businesses big-league, that's coming along very well. We're way ahead of schedule, I believe," Trump said in a meeting with airline industry executives Thursday morning at the White House. "And we're going to be announcing something, I would say, over the next two or three weeks that will be phenomenal, in terms of tax," the president said.
What exactly should be expected? For now, there are only hints. The leader for this effort is Gary Cohn, formerly CEO of Goldman Sachs, who is heading the president’s National Economic Council. Some details have been discussed with unnamed congressional leaders. The tax plan is described as comprehensive, including tax cuts for lower income taxpayers, versus being limited to business taxes. Trump’s “phenomenal” tax plan said to be overseen by Cohn, newsmax.com, 2/10/17.
White House Press Secretary Sean Spicer told reporters later that day that specifics would emerge only in the coming weeks. Still, he said the White House is at work on an outline of the most comprehensive business and individual tax overhaul since 1986.
Let’s hope Republicans will bin the border adjustment idea and concentrate on eliminating tax preferences to at least partially offset the proposed reduction in the corporate tax rate.
#A tax on imports would raise the cost of imports, while a tax exemption for exports would allow export prices to be set lower. Makes sense that the US trade deficit would be reduced, and perhaps that the US dollar would strengthen. But the dollar is market driven in the Forex market and its value is determined only by reference to other currencies, so the actual effect on exchange rates is far from certain. – SAFE director
#The border adjustment is not free money, but it is one of the least economically harmful ways of broadening the tax base in order to lower the corporate tax rate and move toward immediate expensing. The other key advantage of the border adjustment is that it changes the tax incentives for companies and removes the incentives to move headquarters offshore, use planning techniques to shift income abroad, and move intellectual property to low tax jurisdictions.
You would be hard pressed to find $1 trillion worth of offsets to make up for the revenue loss if you removed the border adjustment from the DBCFT plan. And the best thing about this change to a DBCFT is that it eliminates the corporate tax entirely. How can you be against that? – Scott Hodge, Tax Foundation
Our suggestion: Eliminate most of the dozens of tax preferences for various types of business activities that are embedded in the US tax code; otherwise, the system will keep getting more complicated every year. And the DBCFT wouldn’t truly eliminate the corporate tax, it would change its form and start a long-running battle with other tax jurisdictions.