What's better than a border adjustment tax?

MUNICH – One of US President Donald Trump’s most significant reform proposals is aimed at the American tax system. His administration wants not only to lower the overall tax burden, but also to “rebalance” the tax system to encourage domestic production and exports, possibly with a destination-based cash-flow tax we may call a border adjustment tax (BAT). Unfortunately, the risks of such a radical reform would most likely overwhelm any rewards. The United States currently taxes corporate profits at 35%. This is a high rate by international standards (though there are many deductions and loopholes); so congressional Republicans and some of Trump’s advisers now want essentially to replace the corporate income tax with a cash-flow tax that resembles a BAT. Under this plan, imported goods and services would be taxed at a rate of 20%, while exports would be subtracted from the tax base, and thus not taxed at all. If the dollar remains stable, the costs of imports into the US would increase by 20%, and American exporters would enjoy a tax subsidy relative to domestic producers. The proponents of a cash-flow BAT argue that it would merely level the playing field, because most of America’s trading partners refund their value-added tax on exported goods and services. But this is a false comparison. These refunds are not a hidden subsidy, but a logical part of a destination-based tax system, whereby taxes are levied in the country where a good is consumed. For example, exports from Europe to the US are taxed twice: first with a corporate-profit tax in the country of origin – say, Germany, where the corporate tax rate is around 29% – and again with varying sales taxes in the US. Meanwhile, US exports are taxed at home as corporate income, and again according to the VAT rate that applies in the importing country, just like any other product consumed there. The difference between the US and other countries is not its lack of a BAT, but its strong reliance on direct taxation. If the US were to introduce a cash-flow tax system with border adjustment, it would exempt its own exports from all domestic taxes. This would give it a competitive tax advantage, so long as other countries do not follow suit and eliminate their own corporate-income taxes on export production. But, because a cash-flow BAT would act like a trade barrier, America’s trading partners would rightly view it as a protectionist measure. A BAT in the US could have far-reaching legal and economic implications. Legally, it might contravene World Trade Organization rules that permit border adjustments for value-added taxes, but not for income taxes. And if US trading partners proved unwilling to wait through lengthy dispute-resolution proceedings at the WTO, they could pursue a policy of tit-for-tat retaliation. Punitive tariffs or other crude economic measures taken by US trading partners could then precipitate a trade war – the last thing the world economy needs right now. It is doubtful that the economic rewards for the US would justify taking such a risk. Much would depend on how the dollar reacted to a new BAT. If the dollar remained stable, the tax would simply push up import prices, and these higher costs would fall on US households and industries that rely on imported inputs. Ultimately, demand for imports would fall, as would the benefits for consumers and new tax revenues for the government. If the dollar appreciated in proportion to the BAT, then import prices in dollar terms would not change. In this scenario, foreign producers would bear the cost, because they would receive fewer dollars for the goods they sell to the US. At the same time, the stronger dollar would make exporting harder for US companies, and nullify the benefit of having a zero-tax rate on foreign sales. The US current-account deficit, meanwhile, would remain largely unchanged: the tax would put money into government coffers, but the US would continue to run up debts abroad. All told, a BAT is not the best way to support US companies and raise government revenue. The US has no VAT and only limited sales taxes, so it instead relies mostly on personal and corporate income taxes. But, owing to its large external deficit, this system falls short on revenue collection. If the US were to raise taxes on domestic consumption, it would collect more revenue from imports, which would allow the government to cut income taxes stemming from US firms’ domestic and foreign sales. From an economic standpoint, therefore, a better way to “rebalance” the tax system would be to reduce the rate of corporate-income tax, and simultaneously introduce or increase sales taxes on imported and domestically produced goods and services. The added benefit of this approach is that it would also strengthen incentives for businesses to invest and innovate. Rather than fundamentally overhauling the entire tax system, the Trump administration could simply improve it. This more reasonable approach would vastly reduce the risks of destructive trade wars and exchange-rate uncertainty that are all but inevitable with a cash-flow BAT. Michael Heise is Chief Economist of Allianz SE and the author of Emerging From the Euro Debt Crisis: Making the Single Currency Work. Copyright: Project Syndicate.

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What's better than a border adjustment tax?