The tone of the policy discourse has shifted, I hope temporarily, away from fiscal stimulus and structural reforms, and toward protectionism and mercantilism. You need look no further than @realDonaldTrump to see this, but beyond the impressively punchy tweets, there is a deeper policy discussion brewing at the intersection of corporate tax reform and US trade policy. As a result, I want to make two points: 1) contrary to the prevailing policy narrative, the systems of Value Added Tax (VAT) used by many of the United States’ trading partners do not disadvantage foreign producers to the benefit of domestic ones – VAT is “trade neutral” and does not need to provoke any “response,” and 2) a Destination-Based Cashflow Tax, a once-buried aspect of the House Republican corporate tax reform plan, is similar in many ways to a VAT but in contrast, its proposed form does appear to create potential trade distortions. Now, if you’re about to stop reading, try to stick with me. These topics are complex, important, and it’s a challenge to explain either in a short discussion. At least humor me to see if I can do it.
Most US trading partners raise a portion of their tax revenue through VAT, which works like a national sales tax, though there is one major difference: sales taxes are, in theory, levied only on final goods and services, whereas VAT is levied at each stage of the production process. The goals are the same – in each system, final consumers bear the burden of the tax, but the VAT regime reduces the challenge faced by a sales tax in identifying only final goods for taxation. In a VAT system, firms pay the VAT rate on the inputs to production, say raw materials, and then receive the VAT rate on the value of the output they produce by the final consumer. Each producer remits to the government only the net of VAT received minus VAT paid, but the total amount received by the government equals the total amount paid by final consumers. In a sales tax regime, the inputs to production are not taxed, and the entirety of the sales tax paid by the final consumer is remitted to the government. If this were the whole story, countries with VAT would disadvantage their domestic producers versus foreign producers, because domestic producers have paid VAT on their inputs – in a sense this is an advance on downstream consumption taxes – whereas foreign producers (potentially) have not.
In order to correct for this, a VAT regime will specify a “border-adjustment” for importers and exporters. In practice, exporters receive a payment at the border (a rebate of VAT paid during production) as goods move out, and importers must pay VAT at the border as they bring goods in. When viewed in total isolation, these border payments smack of exporter subsidy and importer taxation, and often policy debate focuses on the border adjustments without also considering how VAT remittances work. The border adjustments are actually necessary to create a level playing field, from what was otherwise uneven. Under this arrangement as described, for domestic firms and foreign firms who are able to produce identical goods with identical pre-tax efficiency, profit margins and consumption tax burdens embedded in domestic consumer prices will be identical. That is the essence of trade-neutral tax policy, and VAT with border adjustment is WTO-compliant as a result.
What’s not equal are the post-tax earnings to the shareholders of the domestic firm and foreign firm, if their respective home-country corporate income tax rates are different. This effect, rather than create unequal competition for consumers in a given jurisdiction, tends to create unequal competition for business domiciles (i.e. corporate migration toward low-corporate-tax countries). Countries that choose to raise revenue through consumption taxes like VAT, in theory, should have lower tax burdens elsewhere including on corporate income. In practice, VAT countries tend to have a layering of consumption and income taxes throughout the corporate, investment, and personal income landscape, much like the US inclusive of state sales taxes.
Armed with the perception that foreign VAT is harming American firms, and rightfully motivated to dissuade migration of American corporations offshore for (income) tax reasons, the House Republican Blueprint for corporate tax reform introduces a Destination-Based Cashflow Tax (DBCT), with “border adjustment.” In promoting this concept, it has been described as VAT-like, or the American response to VAT regimes abroad. In its simplest form, DBCT taxes corporate cashflow rather than corporate earnings, allowing deductions for domestically-sourced input costs such as labor and raw materials. All foreign revenue is tax free, and all foreign-sourced inputs are not deductible. This differential tax treatment of cashflow and input costs depending on geographic origin is the “border adjustment” feature of the tax plan. As it stands, by my read, this tax proposal benefits exporters and harms importers. A quick example to illustrate: imagine a German car company and an American car company who can each make a car of identical quality and appeal for $15,000 which the American consumer is willing to buy for $20,000, netting each a pre-tax profit of $5,000. When those cars are sold in competition onshore in the United States, the American company can deduct the $15,000 expense, whereas the German company would owe tax on the entire $20,000 sale price. In addition, domestic producers of exportable goods are strongly incentivized to dump inventory abroad. An American-built car sold abroad would accrue zero corporate tax liability, and the deductible domestic input costs would carry forward as corporate losses, all while the company may freely repatriate the cashflow.
Advocates of the DBCT (and most economists) say that the foreign exchange market will immediately adjust via a strengthening of the US Dollar to offset the policy’s benefit to exporters over importers. I have three things to say: 1) I agree the foreign exchange pressure will be real, precisely because DBCT proposal is not trade-neutral (in contrast to VAT), 2) the theoretical adjustment would be enormous – on the order of 25% at the currently proposed tax rate, and 3) if enacted the actual adjustment would probably be partial, because much of the foreign exchange market is officially managed, and if I’m right about the lack of trade neutrality in the DBCT, the WTO may object as well as authorize members to enact retaliatory measures.
So, the nitty-gritty of the DBCT is messy and it gets more intense if you dig deeper. Even a 10%-15% rise in the USD, if abrupt, would be significantly disruptive to financial conditions, never mind a 25% rise or the potential for trade war. As a result, despite good intentions, I do not think it is likely that the DBCT moves forward in its current form, but the narrative shift we are seeing now as the debate heats up will be enough to move markets and temper some of the optimism that sprung up in the post-election honeymoon phase.