The US Republican party is proposing substantial changes to the US corporate tax system, which President Donald Trump supports with some reservations. The headline change is a slashing of the corporate tax rate from 35 per cent to 20 per cent. There is plenty to say about this, including how it will make Australia’s 30 per cent rate much more uncompetitive.
But the Republican tax plans contain a number of other major parts. This article focusses on two: removing tax deductibility for imports, and providing a tax exemption for exports. These components are together called ‘border adjustment’, and it is this that President Trump is concerned about — although it has some similarities with his proposals for a substantial tax on imports from Mexico.
The overall effect of the tax changes, including border adjustment, would transform the US corporate tax into what is essentially a GST with a credit for wage costs or a GST combined with a cut in payroll tax. Many commentators argue that the plan as a whole (technically called a Destination Based Cash-flow Tax or DBCFT) will reduce tax avoidance by removing the biases towards debt financing, profit shifting and transfer pricing.
However, border adjustment will also create new tax avoidance possibilities, and will undercut many US retail businesses. These harmful effects potentially outweigh the benefits of the tax change.
If Walmart buys a TV from China for US$200, it currently claims this as a tax deduction. If border adjustment is introduced, this deduction would be cancelled. At a 20 per cent tax rate, imports would be about 20 per cent more expensive for American businesses. Unsurprisingly, retailers have complained about this substantial impost. They will need to hike prices by about 20 per cent if margins are to be maintained and the exchange rate does not move.
But the exchange rate will move to offset border adjustment, according to supporters such as Martin Feldstein. They argue the US exchange rate will move to fully offset the tax increase, with a 25 per cent appreciation offsetting a 20 per cent tax on imports (see a worked example here). This appreciation would supposedly mean there was no need for Walmart to change its prices.
But a 25 per cent appreciation of the dollar is implausible. It would cause massive windfall gains for foreigners holding net assets in US dollars and losses for US citizens holding assets overseas or foreigners with debt issued in US dollars. The gains and losses could be several trillion US dollars. (see more calculations here). As noted in a paper for Australia’s Henry Tax Review (see section 9.6.2), anticipation of this effect could cause large capital movements and destabilise the US economy — let alone the rest of the world economy.
Rather than a 25 per cent appreciation, a smaller appreciation is much more likely, with other prices changing to absorb part of the impact of the tax. For example, businesses that get a competitive advantage from border adjustment, such as US manufacturers, might increase their margins, while businesses that lose, such as Walmart, might cut margins or increase prices. Price increases will cause higher inflation and higher interest rates.
But the problems with border adjustment go well beyond exchange rate effects. Another major issue is American consumers buying directly from overseas suppliers.
Walmart will face a 20 per cent tax on TVs it imports from China; a US consumer could buy the TV directly without this impost. And this happens regardless of the exchange rate movement. Whatever the value of the US dollar, Walmart will face a 20 per cent tax that a consumer does not face. If the US exchange rate moves to fully offset border adjustment, then Walmart’s prices may not change but consumers will pay less if they import products directly.
Similarly for services: Netflix US will pay a 20 per cent tax on TV shows it imports from the UK, but a US consumer might be able to buy it directly from the UK without this tax. And again, the exchange rate does not matter.
As a result, US retailers will be forced to absorb part of the tax as lower margins — and won’t be unscathed, despite statements by the supporters of border adjustment. This also supports the argument, stated earlier, that border adjustment won’t be fully offset by movements in the US dollar alone.
If a US business is only a reseller of an imported product, with minimal value added, then their business could be ruined by the 20 per cent tax. This could happen, for example, to a US reseller of imported cloud-based services. Other businesses that do more value-adding on imports will still suffer, but they may not go out of business.
Border adjustment may even encourage US consumers to do a shopping trip to Canada or Mexico to avoid the tax. For example, US citizens might go just across the US-Canada border to buy a new Volkswagen car. Again, this strategy is largely unaffected by the exchange rate, and would be a boon to Mexican and Canadian retailers. Nevertheless, Canadian and Mexican exports to US businesses will be harmed, so the net effect on those two economies is unclear.
The problem of direct imports by consumers has been faced by all Value-Added Taxes (VATs), including Australia’s GST. Australians can buy directly from offshore, avoiding GST on things such as books (think Amazon) and movies (think Netflix). Changes to Australia’s GST, due to start this year, will mean that Australia will attempt to impose GST on these direct imports by consumers.
Could the US also put on a similar tax on imports directly by consumers — either imposing it on the consumer or on the foreign business? This seems doubtful. There are substantial difficulties doing it in Australia’s case: it is almost impossible to detect some digital imports, and difficult to force foreign companies with no Australian presence to pay an Australian tax.
If Apple tries to sell to US consumers via a Singaporean subsidiary, the US government may be able to impose an anti-avoidance tax on Apple, but how could they impose a tax on foreign companies with no US presence? A Chinese business with no US presence could buy iPhones in China and sell them direct to US consumers at a 20 per cent discount to US retailers. Good luck trying to collect any US tax from the Chinese company.
In addition, imposing a consumer tax will be much harder in the US than in Australia. The US does not have the infrastructure to impose a national sales tax or VAT. And given the US opposition to a VAT, such a tax may not pass Congress or escape a Presidential veto.
It is also doubtful that a sales tax only imposed on imports by consumers would be WTO-compliant. Various countries would probably try to stop it through the WTO regardless. This compounds the existing doubts about whether the whole Republican tax plan itself is WTO-compliant.
The problems with border adjustment do not end there.
There would be incentives for businesses to reorganise to avoid tax. For some products, such as software, it would be worthwhile for US businesses to export the product overseas, thus gaining the export tax exemption, then have a foreign affiliate (or an arms-length business) sell the product directly to US consumers. There would effectively be zero US tax on the product.
Border adjustment would mean some exporters would receive large tax credits every year, creating potential problems for tax avoidance, as also noted in the paper for Australia’s Henry Tax Review mentioned earlier. And large ongoing tax refunds may not popular with the public, whether or not they are warranted.
Finally, the tax change may not apply to the smallest non-corporate businesses, so smaller US retailers could avoid the import tax by becoming unincorporated. This might be good for the micro end of retail market, but not for the overall efficiency of the US economy, where Walmart has driven massive productivity improvements.
Despite these problems, border adjustment does help some sectors of the US economy, particularly if its effects are not fully offset by exchange rate changes. US exporters will gain, as will US manufacturers who compete with imports. However, it is not clear that the benefits offset the harmful effect on retailers. There is also a political problem with border adjustment: the losers will complain more than the beneficiaries cheer.
There are other important parts of the Republican plan not considered in this article, particularly the plan to allow immediate write-off (expensing) of asset purchases, making interest expense non-deductible, and the deemed repatriation of funds held overseas. These components are discussed in many other places, including many of the links earlier in this article, as well as in a supportive piece by Laurence Kotlikoff and a critique by Larry Summers. More detailed reviews by the US Tax Foundation and the Oxford University Centre for Business Taxation discuss the concerns raised in this article but strongly suggest they are manageable.
However, the problems with border adjustment discussed here are substantial and largely insurmountable, suggesting that the Republican tax policy will not be implemented in its current form.
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