The Border Adjustment Tax: Why This Trillion Dollar BAT Shouldn’t Fly

Sent to us by Tax Revolution Institute

Tax Revolution Institute by Philip Schlosser

US House Republicans have proposed a tax reform plan as part of their Better Way Forward initiative called “The Blueprint,” which, for one, modifies the corporate income tax into what is called a “destination-based cash-flow tax,” or DBCFT. In a nutshell, this means both domestic and foreign firms alike will be subject to a tax on all sales made within the United States, while US exports are exempted.  

The plan drops the tax rate on business income from 35 percent, to 20 percent, which they insist on passing with “revenue neutrality.”

Revenue neutrality entails paying for the 15 percent cut in the business tax rate, which House Republicans have proposed accomplishing via the “Border Adjustment Tax,” or BAT. This new tax is poised to raise $1.2 trillion in revenue over 10 years, thereby paying for said cut. I am admittedly concerned with the BAT for multiple reasons — and, furthermore, hold the opinion that it may not even be necessary.

For one, Republicans seem to be tactically surrendering to the flawed premise that pro-growth tax cuts must be paid for with a new tax rather than allowing economic growth to maximize tax receipts. Simple math with the latest CBO numbers also reveals we could cut taxes by “$3 trillion” while still closing the deficit in 10 years, if we were to simply limit baseline spending growth to 1.96 percent annually.

Outside of the BAT, the destination-based cash-flow tax does have desirable features as far as economic growth is concerned. For one, capital investments would no longer need to be depreciated by firms. Instead, they would now be able to fully write them off.

The plan also moves us closer to a territorial-tax system, rather than our present world-wide system. With a territorial regime, the IRS can no longer tax the profits which US firms earn abroad. In other words, Uncle Sam would only have tax jurisdiction within US borders.

This is preferable not only because it is fair, but also because US firms can repatriate foreign profits without being double-taxed at the border, which can then be reinvested in the US economy, creating jobs. There are $2.5 trillion in US profits presently parked overseas for said reason. The difference between a standard origin-based territorial regime and the House Republican plan, however, is the BAT.

So What Is This Border Adjustment Tax?

The BAT works by applying a 20 percent tax on imports, while exempting exports. In other words, if a US firm sells goods abroad, said sales are exempted from the tax. However, if said firm imports goods — let’s say, inputs required to manufacture a good — the importer’s sales are hit with the BAT. So, on the surface, this screams of mercantilist-style protectionism, yet proponents argue this isn’t so.

At first glance, the DBCFT sounds a lot like a tariff, since we are talking about exempting exports, while applying a new tax on imports at the border. However, although the plan does exempt US exports from the BAT, the same 20 percent tax rate is applied to the sales of foreign imports and domestic goods within the US alike. The DBCFT therefore differs from a tariff, which applies only to imports.

Furthermore, DBCFT proponents argue that the export exemption will be completely sterilized, as US firms will be able to drastically reduce the price of the goods they sell overseas, resulting in a rise in demand for US dollars to purchase said goods. This will thereby result in the value of the US dollar appreciating relative to foreign currencies, offsetting any trade advantage realized from the BAT.

This, they argue, will negate the subsequent need for importers to increase prices on American consumers.

So What Is the Problem with the Border Adjustment Tax?

Let’s start with dollar denominated debt. Outside of the developed world, emerging markets are presently budding across the globe due to economic globalization. In order to offset the BAT as is, the US dollar would have to fully appreciate by 25 percent. Now imagine emerging markets holding dollar denominated-debt abroad; this could absolutely devastate the economies of these budding countries.

Now consider American families holding foreign stocks and bonds, or American companies with investments overseas denominated in foreign currencies. If the dollar were to appreciate by 25 percent, their profits would inversely decrease when converted back into US dollars. To provide but a few examples, the majority of Apple’s profits are made overseas, as well as Microsoft, Oracle, and many others.

In fact, the dollar appreciating by 25 percent in such a short period of time would be historically significant. It would be the one of the greatest appreciations since the Bretton Woods monetary system collapsed in 1971, second only to the rapid ascent of the dollar in the early 1980s which ended with the United States, Germany, France, Britain, and Japan signing the Plaza Accord to depreciate the dollar.

Even the US government would be forced to endure significant losses with respect to its net foreign-asset position. Economists Emmanuel Farhi, Gita Gopinath, and Oleg Itshkoki point out the following effects of a 20 percent dollar appreciation (deflation):

“An appreciating dollar [20%] would erode America’s net foreign-asset position, because an overwhelming 85% of its foreign liabilities are denominated in dollars, while around 70% of its foreign assets are denominated in a foreign currency. With US foreign assets amounting to 140% of its GDP, and its foreign liabilities amounting to 180% of GDP, a dollar appreciation of 20% would result in a capital loss equal to about 13% of GDP.”

To place this into perspective, such a loss translates to nearly $2.5 trillion — around $8,000 for every American.

Next, Adam Michel, Jason Fichtner, and Veronique de Rugy of the Mercatus Center just released a research paper which reviewed the literature to explore how currencies adjust after border-adjusted VATs are adopted. Their conclusion: currencies do not adjust entirely nor quickly in the majority of cases. This means the cost of this import tax may be passed on, at least partially, to US consumers.

Top economists from Citigroup also warned that fluctuations in the value of the dollar typically lag for about five years as per the current account, therefore the immediate adjustments Republicans are counting on may be wishful thinking. Their projection predicts only a 14.6 percent appreciation a full three years after the BAT is adopted, meaning US consumers would be hit quite hard while the dollar adjusts.

In fact, over 100 American companies which rely heavily on imported inputs and goods have already joined in opposition to the BAT. This group, called Americans for Affordable Products, explicitly express a fear that the BAT will force them to raise prices. If this fear were to ring true, Americans would be paying higher retail prices on many essential items such as clothing, food, medicine, gasoline, and more.

While testifying before the House Financial Service Committee, even Federal Reserve Chair Janet Yellen stressed the dollar may only partially adjust. Yet despite warnings from economists of both sides of the aisle, House Republicans continue to insist they are infallible.

International Tax Competition

We also have to consider the consequences this may have on tax competition, as foreign nations often mimic the actions of the world’s largest economy, the United States — not to mention the fact that 140 nations already hold border-adjustable Value-Added Taxes (VATs). Although the DBCFT is not a VAT — since it allows firms to deduct wages — it still walks like a VAT as per the destination-principle.

This means, via the border adjustments and subsequent exchange-rate adjustments, tax competition between said nations and the United States would largely be sterilized. In a nutshell, since a destination-based tax system is based on where products are consumed (destination) rather than where they are produced (origin), it would not matter where one’s corporate headquarters is located.

Now imagine if a US president were to take office in the future and push to grossly raise said tax. There would be no escape. In other words, the incentive to lower taxes to preserve present investment and attract new capital investment would be significantly diminished.

As Veronique de Rugy of the Mercatus Center so eloquently puts it:

“Under that regime, consumers and companies will be like the alien race in Star Trek who the Borg want to assimilate into their collective: Resistance will be futile.”

Furthermore, many Americans believe the BAT is simply a partisan idea poised to make sparks fly with the opposing party. Nothing could be further from the truth. In fact, Alan Auerbach of the progressive Center for American Progress is the literal father of the BAT, and his support of its adoption rivals even that of Rep. Kevin Brady (R-TX). The New York Times maps out the relationship of Brady and Auerbach as per bringing this into action here. Auerbach proudly touts that the BAT will “relieve the international pressure to reduce [tax] rates.”

Another DBCFT study from the Center for Freedom and Prosperity concludes:

“The DBCFT would be a new type of corporate income tax that disallows any deductions for imports while also exempting export-related revenue from taxation. This mercantilist system is based on the same destination principle as European value-added taxes, which means that it is explicitly designed to preclude tax competition.”

The Brookings Institute, America’s leading progressive think-tank, is also a staunch supporter of the BAT, among many, many, others. Put frankly, political interests from both sides of the aisle are eager to adopt a BAT as it concentrates their taxing power. This is concerning. Tax competition is a liberating force on the global economy. Proponents of the DBCFT are literally ignoring decades of public-choice theory.

Concerns with the World Trade Organization

The World Trade Organization presents another danger. The WTO allows border adjustments on indirect taxes such as VATs. However, it does not allow them on direct taxes, such as income taxes. Since the DBCFT is a hybrid income tax designed to reach towards a consumption base, it is likely to be rejected as is. Allowing for the full and immediate expensing of capital investment may not be enough.

Although Rep. Brady expressed that he is confident the plan will be approved by the WTO, many experts are not so convinced. The danger lies with the post-deliberative ruling on the DBCFT. If the World Trade Organization were to reject the DBCFT as is, all legislators would have to do is drop the deduction of wages and the DBCFT would become a subtraction-method Value-Added Tax.

A Value-Added Tax basically amounts to a sales tax on intermediary production goods, which is then passed onto the consumer — yet in a hidden fashion. It therefore lacks the restraints of a more desirable consumption tax, such as a National Sales Tax, which taxes only final goods and displays the tax right on the receipt for all to see. If taxes rise too high, people simply spend less, resulting in less tax revenue.

Of course, tax-and-spend politicians prefer the VAT, as the tax is deeply concealed in the cost of goods, thereby allowing them to raise taxes with little attention or changes in consumer spending patterns — potentially setting the stage for European-style big government.

Is the Border Adjustment Tax Even Necessary?

Unlike a destination-based territorial system, which is quite complex, a territorial system without a BAT — thereby origin-based — is quite simple: all domestically headquartered firms are subject to a tax on profits earned within the United States, while their profits earned outside the country are not. That’s it. This means we receive all of the positives of the territorial system without the pitfalls of the BAT.

Republicans are concerned that if they implement the plan without the BAT, it will add $1 trillion to the deficit in 10 years. However, such static thinking ignores the dynamic effects of pro-growth tax reform. If we were to implement an origin-based territorial regime while reducing tax rates and allowing the full expensing of capital investment, the subsequent rise in GDP would raise tax receipts significantly.

Economists call this phenomenon the Laffer Curve, or the “Elasticity of Taxable Income.” Put simply, when tax rates rise too far, revenue actually declines despite higher taxes, since work and investment are discouraged and tax shelters are sought out. This slows capital expansion, and thus jobs and tax receipts. The challenge for policymakers is identifying the revenue maximizing point on the curve.

Lastly, since the initial repatriation of profits held by US firms abroad will allow a cool $2.5 trillion in additional capital to flood back into the United States, the US economy will expand yet further — creating even more jobs, and thus taxpayers and federal receipts. Since supply-side growth adjustments can take a few years, the initial deficits could be partially sterilized via baseline spending restraints.

According to the CBO’s latest numbers, if we limited baseline spending increases to one percent annually, we would close the federal deficit by 2022. Two percent annually would get us there by 2025. By 2.63 percent, 10 years. And if we add tax cuts into the equation, even after a “$3 trillion” cut, the budget would still balance in 10 years if we simply limited the growth of federal spending to 1.96 annually.

And that is on a static basis. In other words, letting this dangerous BAT fly certainly isn’t necessary by any means.

It is time for the Republicans to grow a spine and cage this trillion dollar BAT.

Tax Revolution Institute