It\’s important to notice that \”value-added\” is not equal to profits. The \”value-added\” of a firm includes both wages paid to its workers–who are the ones adding value, after all–as well as profits.
- \”Unlike tariffs on imports or subsidies for exports, border adjustments are not trade policy. Instead, they are paired and equal adjustments that create a level tax playing field for domestic and overseas;
- \”Border adjustments do not distort trade, as exchange rates should react immediately to offset the initial impact of these adjustments. As a corollary, border adjustments do not distort the pattern of domestic sales and purchases;
- \”Border adjustments eliminate the incentive to manipulate transfer prices in order to shift profits to lower-tax jurisdictions; and
- \”Border adjustments eliminate the incentive to shift profitable production activities abroad simply to take advantage of lower foreign tax rates.\”
The question that is opened up sounds something like: \”But the US doesn\’t have a value-added tax, and so why does the idea of border adjustment even come up when talking about corporate tax reform?\” The answer to this question is that the proposal from House Republicans for revising the corporate income tax is actually a first-cousin-once-removed of a value-added tax. The proposal is to eliminate the existing corporate profits tax, and then to replace it with what is sometimes called a \”destination-based cash-flow tax.\”
Most countries have both a value-added tax and also a corporate income tax, viewing them as two different creatures. The proposal to install a destination-based cash flow tax as a replacement for the corporate income tax is in some ways a hybrid of the two.
Alan Auerbach provides a readable academic discussion of how this kind of corporate tax can work in \”A Modern Corporate Tax,\” published jointly by the Hamilton Project at the Brookings Institution and the Center for American Progress back in December 2010. He points to a number of advantages from this kind of change.
The new destination-based cash-flow tax would be a form of a consumption tax: that is, it taxes firms based what is consumed (whether through domestic production or imported goods), but would not have a corporate tax on exports. Firms would no longer depreciate equipment over time; instead, it would be treated as an expense the year such investments are made, which should tend to encourage investment. This plan would also stop the corporate gamesmanship of juggling the accounting so that profits seem to occur in low-tax jurisdiction, and should make the US an attractive place for foreign firms to invest. Auerbach writes:
\”Most countries, including the United States, attempt to collect corporate taxes based on where a corporation’s profits are earned. The problems with this approach are that businesses and investments are increasingly internationally mobile and a business’s profits are intrinsically hard to attribute to a particular place; indeed, the fungibility of profits results in a system where a disproportionate share of the profits of multinational companies appear to occur in the world’s least-taxed countries. Current corporate tax systems generate incentives that result in the current environment where countries compete for multinational business activity by lowering their corporate tax rates. To remedy this situation, sales abroad would not be included in corporate revenue nor would purchases or investment abroad be deductible in the second major piece of the proposed corporate tax reform. As a result, the corporate tax would be assessed based on where a corporation’s products are used rather than where the corporation is located or where the goods are produced. Assessing the tax based on where a firm’s products are used eliminates issues of where to locate a business and incentives for U.S.-domiciled businesses to shift profits abroad to reduce U.S. taxes.
\”This plan therefore delivers a host of economic advantages to U.S. businesses and American workers. Promoting domestic corporate activity and encouraging investment would boost productivity, the key driver of increases in wages, employment, and living standards. Indeed, estimates of similar proposals suggest these changes could increase national income by as much as 5 percent over the long run. … This new tax system also would retain or even increase the progressive element of the corporate tax system. The proposal would effectively implement a tax on consumption in the United States that is not financed out of wage and salary income.\”
It\’s worth contrasting the ideas about corporate taxation here with the broader claim that this tax is one way that a Trump administration would \”make Mexico pay for the wall.\” The border adjustment tax would apply to all imports, not just those from Mexico, for the reasons given above. As a consumption tax, it would raise prices to American consumers, who would be the ones paying for the tax. Assuming that it leads to a stronger US dollar, as pretty much all economists who study this subject expect, it won\’t end up affecting the US trade balance: basically, any effect of the border adjustment in reducing imports would be offset by a stronger dollar that will tend to raise imports by a roughly offsetting amount.
For a quick question-and-answer about the destination-based cash flow tax, a useful starting point is the short essay by William Gale on \”Understanding the Republicans’ corporate tax reform proposals,\” (January 10, 2017). I\’ve known Bill Gale more than 30 years, since graduate school days, and lest I be accused of invoking his name in a partisan context, I should note he\’s an interplanetary distance away from being a Trump supporter. He points out a number of potential difficulties with the Trump proposal as it stands: it would raise a lot less revenue than the corporate income tax it is replacing; it may contravene World Trade Organization rules; if it leads to a stronger dollar it will simultaneously reduce the value (in US dollars) of investments that have been made in other currencies; and it could even mean that some large corporate exporters become eligible for big tax refunds. But he also writes: \”The corporate tax is ripe for reform. The DBFCT is an excellent way to kick-start the needed discussion.\”
In short, there\’s also a nubbin of a good idea here about reforming corporate taxes, although it has essentially zero to do with unfair trade, cutting better trade deals, reducing imports, or \”making Mexico pay for the wall.\” If some suitable and substantial adjustments are made–starting with a higher tax rate than is included in the current proposal from the House Republicans–a corporate tax reform along these line is a potentially practical way of addressing many of the counterproductive incentives in the US corporate income tax. For example, US firms are currently holding about $2.5 trillion in cash outside the country, rather than bring it back and have it subject to the existing US corporate income tax. That\’s just one symptom of a deeper dysfunction with the US tax code.
Correction: An earlier version of this post referred to the DBFCT proposal as being from the Trump administration. Although it has been mentioned at times by the adminstration, the proposal itself is actually from Republicans in the House of Representatives. The text has been revised above to reflect this change.