“Border adjustability, which is equal taxation of all products in the US regardless of where they come from or who produces them— that level playing field at the end of the day— is going to be in tax reform… Let me just tell you… I’ll tell you straight again – at the end of the day we’re not going to have a tax code which favors foreign products over made-in-America products, and we won’t have a tax code that keeps pushing our jobs overseas.” [emphasis added]

-Rep. Kevin Brady, during a CNBC interview with Kelly Evans on February 15, 2017*.

The bolded portion of this quote is true with respect to VAT regimes, but as far as I can tell it is not true with respect to Brady’s proposed Destination-Based Cashflow Tax (a.k.a. “Border Adjustment Tax”). I outlined why in Big Border Tax – Part 1. However, this narrative justifying the proposal is likely to persist, because it sounds compelling and refuting it is difficult for Americans who are completely unfamiliar with how VAT regimes work. What concerns me though is the fervent enthusiasm for the Destination-Based Cashflow Tax (DBCT) in the House of Representatives when the consequences of such a move seem oddly skewed toward a mixture of known and unknown negatives, with what looks to me like only dubious potential benefits. Essentially, the DBCT is the pursuit of free money in an academic vacuum, without regard for the risks of real-world implementation. A lot has been written about this tax plan already, and as I type there remains significant opposition in the Senate. However, today I want to highlight the appeal of the DBCT to explain all the fuss, but then importantly raise a novel consequence which is not currently in the discussion.

First, the free money bit. Wouldn’t it be nice if we could cut taxes and increase revenue to the government without anyone suffering an ill effect? Well, academically-inclined proponents of the DBCT posit that the foreign exchange rate will adjust immediately to offset the plan’s inherent subsidy for exporters and tax on importers. Essentially, the net result of this arithmetic is that the tax burden on importers increases, but the benefit of a stronger USD drives down their import costs by a conveniently symmetrical amount. Importers’ post-tax profitability is equivalent to the boost they would get from a reduced rate without border adjustment, and yet their total tax goes up substantially (in effective rate and in dollars). For exporters, a commensurate reduction in tax burden occurs, again without affecting post-tax profitability. Because the US runs a consistent trade deficit, there are more importers than exporters, so the total tax revenue raised by the government goes up, and post-tax corporate profits go up. Abracadabra! Poof! Free money. We can argue about whether the US consumer or foreign corporations bear the cost of a US corporate income tax reduction, but with a 25% USD appreciation, in theory neither is the wiser.** This plan relies on the FX move to fund the tax cut. It’s clever, but if only it were that simple…

In anything short of the full FX appreciation, there are stark winners and losers. Under a partial adjustment, importer profits are crushed and effective tax rates jump, whereas exporters experience similarly sized effects in the opposite direction. I’d also note that even with full FX appreciation, effective tax rates are still significantly skewed, with importers registering rates significantly above 35%, and exporters owing as little as nothing. (My expectation is for only a partial USD appreciation).

The extent of this differentiation based on business model is well understood now, with import-heavy industries lobbying against the plan, and US-based multinationals advocating for it. By implication, they don’t believe in a full FX adjustment either. However, there is one potential outcome that is not often discussed, but which ought to give pause to those multinationals chomping at the bit to get a tax break. Under the DBCT, foreign multinationals are strongly incentivized to migrate to the United States, even if they do little or no business in the United States. A corporation with 100% offshore revenue and offshore expenses would owe no US corporate income tax, and would still be free to repatriate earnings and pay dividends. The US becomes the go-to jurisdiction for corporate domiciles. This is, of course, extremely undesirable for foreign governments, on top of the displeasure they will experience with the DBCT’s inherent export subsidy and import taxation (which, again, is not the same as trade-neutral border adjustment under a VAT regime). Non-US sovereigns will move to negate these effects and one way to do that would be to specifically target US-domiciled multinational corporations operating within their borders for excess taxation. Such action would be WTO non-compliant as a discriminatory tax, but the WTO may authorize it as retaliation. Or, more likely, the WTO itself could be significantly weakened in influence if a trade war breaks out following a DBCT enactment.

When viewed in totality, the DBCT is an aggressive intervention that would fundamentally alter the nature of trade and cross-border capital flows, especially as other countries impose reciprocal and punitive measures. It distorts terms of trade with unknown consequences in pursuit of something that looks nice only in spreadsheets. The implementation and subsequent reaction would very likely lead to declining trade volumes (in both goods and services), which would be an acute headwind for US and global growth.

* http://video.cnbc.com/gallery/?video=3000593580

**As an aside, in the same theoretical framework justifying border adjustment, our large trade deficit would be maintained, something which has been an anathema to the President, and seemingly to Rep. Brady.