"Breaking BAT: A primer on the border adjustment tax"

March 6, 2017

 

With Goldman Sachs alumni Steve Mnuchin and Gary Cohn, former Breitbart News chairman Stephen Bannon, and Death by China author Peter Navarro forming the primary nexus of strategic power behind President Donald Trump’s executive economic policymaking, 2017 was looking to be a massively disappointing year for the academic economic community. The policy plans Mr. Trump laid out throughout his journey to the White House caused many a headache among economists — a quick scroll through the University of Chicago’s IGM Economic Experts Panel website, a polling service yielding the views of America’s top academic economists on recent policy issues, suffices to show the community’s consensus.


Nonetheless, the political and economic stars have seemingly aligned for a new project in the beginning of 2017: A border adjustment tax.


Why a border adjustment tax?


Americans heard plenty about border taxes throughout the 2016 presidential campaign period. The resurgence of deeply protectionist sentiments dominated political debates last year; populist candidates Bernie Sanders and Mr. Trump turned otherwise unremarkable trade deals like NAFTA and TPP into veritable hot-button issues. Once Mr. Trump was elected, Americans were assured by the White House that a massive tariff on imported goods was to come. Economists were weary —tariffs tend to bolster prices for businesses in certain domestic industries, a way of scoring political points for corresponding parties at the expense of ordinary consumers’ wallets.


Yet economists and legislators have seemingly turned this “America First” sentiment towards a more agreeable cause for cross-border commerce: corporate income tax reform.


On paper, America has the highest federal corporate income tax (CIT) rate in the developed world, at 35%. In reality, however, corporations go to great lengths to avoid paying the seemingly astronomical CIT. Tax inversions, offshoring, and debt deductibles have become a common practice among America’s largest companies. Observe that there exists an entire industry built around wily accountants willing to help maneuver corporations out of paying the CIT, and it becomes clear how the US Treasury can report that corporations are paying an average effective CIT rate of 22%. 


As a result, corporations are disincentivized from making domestic investments, as corporate profits are far less susceptible to federal taxation when left overseas. America is left with less CIT revenue, businesses bear the burden of high costs in their maneuvering, and the “America First” crowd viciously rues the foreign profits made over the resulting unfriendly domestic business environment.


Our current CIT is distortionary, and much of this characteristic has to do with cash flows across borders. A simple border tax, such as a tariff, would miss the point, replacing an investment distortion with an international trade distortion. This issue requires a more sophisticated fiscal instrument.


A few GOP House members have introduced an idea for one: a border adjustment tax. 


What is the border adjustment tax?


The border adjustment tax (BAT) is an element of the GOP’s tax reform platform. 


The GOP’s new proposed replacement for the corporate tax, a destination-based cash-flow tax, would tax cash flows through firms at a rate of 20%. To clarify, suppose I own a firm producing wooden armchairs. The CIT on cash flows then taxes my revenues less my purchases and domestic salaries and wages — that is, 20% of what I have left over after subtracting what I spent on the lumber, screws, and workers necessary to make my armchairs from the money I make selling them. In that sense, the destination-based cash-flow tax could be described as a common value-added tax, but with a deduction for wages.


It’s important to observe that the tax is destination-based; it would apply only to domestically consumed goods, leaving exported goods untaxed. As a result, US firms would no longer be incentivized to manipulate their transfers and corporate bases to seek lower tax rates, but they would be incentivized to export more goods to avoid the destination-based cash-flow tax.


With exported goods untaxed, how can the state make up for the loss in the effective tax base? Cue the BAT. This element of the tax plan would alter the destination-based cash-flow tax so that imported production inputs are not deductible. In other words, using my wooden-armchair-firm example, if my lumber and screws are from Canada but my laborers are in America, then my corresponding taxable base increases to simply my revenues less the wages and salaries I pay. Effectively, this maneuver complements the export subsidy with an adjustment tax on imports.


What effects would the tax have on trade and government revenue?


It’s easy to assume that the effective export subsidy and import tax would profoundly distort international trade flows. Yet the research of economists Alan Auerbach and Douglas Holz-Eakin of UC Berkeley suggests that the BAT and destination-based cash-flow tax would do no such thing. According to Messrs. Auerbach and Holz-Eakin, the concept of increases in our exports and decreases in our imports would drive up the value of the dollar relative to foreign currencies immediately. This value, set by the supply and demand for corresponding currencies, would affect consumers’ choices in a way that balances out any changes in international trade flows. If my armchair-making firm’s imported inputs become more costly due to the destination-based cash-flow tax, then the resulting stronger dollar should enable me to purchase more foreign inputs with the same dollar-denominated payments. Likewise, though the plan’s export subsidy would make me more willing to export my armchairs to other countries, the adjustment in the dollar’s foreign exchange rate would make foreign consumers less willing to buy them. The effects on the exchange rate and on international trade would thus, according to Messrs. Auerbach and Holz-Eakin, cancel out.


What about tax revenues? Since America runs a current account deficit — American imports are valued at around 15% of our GDP, while exports constitute around 12% — several reports estimate that our tax revenues would be boosted by over $1 trillion throughout the next decade.


Is it feasible?


Reactions to the destination-based cash-flow tax and BAT plans have been mixed. The theory behind the border-adjusted destination-based cash-flow tax has been backed by numerous economists on both sides of the ideological spectrum, from Reagan-era Council of Economic Advisors head Martin Feldstein to the Nobel-winning Paul Krugman. Quite a few industry heads, perhaps most notably Steve Forbes and the Koch brothers, have slammed the tax plan, calling it distortionary. Some might call it a matter of perspective. Others might call it misunderstanding. Others still, noting that border adjustment would depreciate the value of American overseas investments, might call it self-interest. So it goes.


The disparity between the expectations of industrial and academic economists is intriguing; over 100 American firms, many in the import-heavy retail, auto, and energy industries, are currently lobbying against the reform. Meanwhile, firms in export-heavy industries are tending towards neutrality or support.


The fact of the matter is that no one can be sure as to precisely what the effect of the BAT would be. Economists are doing their best to simulate a BAT using models, but no country has ever signed into law a truly comparable tax. It is well-accepted that similar border-adjusted value-added taxes are not distortionary, but such taxes fail to capture the effects of domestic wage and salary tax deductions. 


Will we be seeing a border-adjusted destination-based cash-flow tax in the near future? Mr. Trump promised America a border tax, but it’s unclear whether Americans truly want protectionist measures; according to Gallup, a record-high 72% of Americans see foreign trade as an opportunity rather than a threat. Perhaps Mr. Trump would best be advised to turn his border tax promise into a border adjustment tax promise. Helping get rid of the distortionary incentives in the current CIT structure that led him to his controversial taxpaying practices — or lack thereof — might prove a powerful statement as well

.
As of now, the BAT has considerable support on the executive end, with Mr. Trump, Mr. Navarro, and Mr. Bannon all signaling favorable views towards the plan. On the legislative end, Democrats have remained quiet; Republicans may only need to reign in the members of their majority positions to pass through the CIT reforms. This might prove to be a troubling feat — Senators Phil Gramm, Tom Cotton, and David Perdue have already showed themselves to be vocal opponents of the plan, while Senators John Boozman, Mike Rounds, John Cornyn, Tim Scott, and Mike Lee have expressed ambiguous concerns.


Despite the opposition, there’s no need to rule out the possibility of a BAT just yet. Senate Majority Leader Mitch McConnell has urged that rising debt is an integral issue, and he has emphasized the importance of revenue streams offsetting any future tax cuts. As the issue heats up, we’ll see whether Mr. McConnell will have a word with his colleagues.


In the meantime, I’ll stick with my armchair business.


 

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