A Survey of Potential Border Adjustment Compromises
By Stuart E. Leblang and Amy S. Elliott
As Republicans recover from their failed attempt to repeal and replace Obamacare and turn their attention to overhauling the tax code, one thing should be clear: Fundamental tax reform just got a lot harder.
Strong opposition to the border adjustment feature in House Republicans’ business tax reform proposal means it likely cannot be enacted lock, stock and barrel. Yet some in the Republican Party insist the controversial tax on imports and exemption for exports is a critical component of the proposal, because it raises more than $1 trillion. Money like that is hard to find. (The Koch brothers took a shot at it, and the best they could come up with was a hodgepodge of politically difficult cuts like eliminating the research credit, capping the mortgage interest deduction and reducing the size of the federal workforce by 15 percent.)
Now that the Obamacare taxes that had been targeted for repeal are still in the law, Republicans will have a much harder time passing the kind of tax reform they had in mind. That is in part because the revenue baseline is about $900 billion larger than it would have been had repeal and replace been enacted.
While indications are that Republicans will not try to repeal the Obamacare taxes as part of comprehensive tax reform, if that changes, business groups will be the first to point out that that $900 billion might be better spent lowering the corporate tax rate by about 8 percentage points, from 35 percent to 27 percent. 1
Can fundamental tax reform happen without the border adjustment? Lawmakers might be open to a compromise that makes the border adjustment less radical. A slew of possible solutions have been floated. We outline the pros and cons of a few of them in the table below.
Before discussing options for watering down the border adjustment, remember that it is a common feature of the value-added taxes (VATs) levied by our major trading partners (at rates ranging from 15 percent to 27 percent in the European Union, for example). 2 It is part of a larger effort to implement a destination-based cash flow tax (DBCFT) on all businesses—a novel tax system that economists from both political persuasions acknowledge has many benefits over the traditional corporate income tax.
But the DBCFT also presents a host of potential problems. One of the biggest has to do with the border adjustment feature and uncertainty surrounding the expected appreciation of the dollar. If adoption of the DBCFT does not cause the dollar to appreciate sufficiently to offset the effects of what amounts to a 20 percent tax on imports, then big importers like many retailers and their customers may be harmed.
Another significant problem is that the DBCFT with its border adjustment feature may violate World Trade Organization (WTO) rules. Although this is a serious issue, because the DBCFT would have the same economic effect as a tax system that would withstand WTO scrutiny (a subtraction-method VAT with a separate wage credit), there is a decent possibility that lawmakers can find a way to redesign the tax so that it passes muster.
Before lawmakers decide to throw the baby out with the bath water, we thought it would be useful to provide a survey of some of the compromise solutions that have been advanced thus far to keep some form of a border adjustment in place. We expect solution-minded tax policy experts will come up with even more possibilities.
Although transition rules have also been contemplated, including enlisting the Federal Reserve to take measures to ensure adequate appreciation of the dollar, the following table outlines permanent tax structures that preserve the border-adjusted tax (BAT) but in modified form to make it more palatable. Although we tried to identify the principal options and some of the pros and cons of each compromise, the chart is not meant to be comprehensive.
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#1: Split the Pie
Split the Pie, as coined by Mindy Herzfeld, 3 would provide for a partial implementation of the border adjustment—with 50 percent of import deductions disallowed and 50 percent of export receipts excluded from the base. A partial implementation of a border adjustment (in the context of a phase-in) was contemplated in 2005 by the President’s Advisory Panel on Federal Tax Reform. 4 A 50% destination-based adjustment means there is a 50% origin-based adjustment (taxing exports, deducting imports). At a 20% rate, imports and exports would be taxed at 10% (50% of 20% is 10%).5
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PROS |
-It cuts in half expected appreciation of the dollar, which would be easier to achieve. |
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CONS |
-The DBCFT tax rate will need to be higher to make up for lost revenue. -If the tax rate increased, then the dollar will have to appreciate even more to offset. -It preserves the income-shifting opportunities that our source-based system affords.6 |
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#2: Min-Max Compromise
Providing min and max tax guardrails for the DBCFT is an idea that was under consideration by a prominent economist from the George W. Bush administration. Businesses would pay the DBCFT unless they would owe more than, essentially, the amount of tax they pay under current law (in which case all they would owe is that amount—the max tax) or unless they would owe less than what they would pay if the current law rate was only 10 percent (the min tax). Specifically the min and max taxes would be calculated as follows where DS=domestic sales (U.S. receipts), EX=foreign sales (exports), DC=domestic costs (U.S. expenses), and IM=foreign costs (imports): Min Tax = 10% (DS+EX-DC-IM); Max Tax = 35% (DS+EX-DC-IM); and DBCFT = 20% (DS-DC)
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PROS |
-It provides protection for importers and ensures that the federal government receives some of the windfall from exporters if the currency does not adjust. -Net exporters that benefit from U.S. infrastructure will pay taxes to help cover costs. |
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CONS |
-It applies so broadly that it will significantly impede the expected currency adjustment. -It may raise a lot less revenue than the DBCFT, because it is less tied to the trade deficit. -The max tax is so generous to importers that the dollar will have to appreciate more than 100 percent in some cases before they would be taxed under the DBCFT. -The min tax is so onerous to some exporters with very low profit margins that even small currency adjustments could cause them to go out of business. -It effectively requires administering three different tax calculations indefinitely. |
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#3: Insurance Compromise
The DBCFT with insurance in the form of an alternative (alt) tax—an idea we proposed in Forbes 7 March 9, described in detail in Tax Notes 8 March 6 and sought in Bloomberg 9 February 15—would enable a business whose historic costs are made up of some threshold percentage of imports (for example, 25 percent) to get a tax answer similar to current law until the currency adjusts enough to cause the business to have a better after-tax U.S. operating profit margin under the DBCFT. It also contains a mechanism to curtail transfer pricing abuses.
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PROS |
-It provides insurance for importers and consumers if the currency does not adjust. -Businesses with large dollar-denominated contracts (like oil) would get protection. -It largely preserves the incentive for currency adjustment. -Alt tax firms will pay about as much tax as they pay today, so no large revenue loss. -As the currency adjusts, the alt tax raises more money, not less, all else being equal. -It limits abuse by denying import deductions for related-party profit markup. -Immediate expensing and effective “pure” territoriality may incentivize more businesses to locate production in the United States, spurring domestic growth. -The alt tax is only relevant if the currency does not adjust—it exists to generate support. |
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CONS |
-The profit margin cap in the alt tax may create a lot of theoretical complexity. -It effectively requires administering two different tax calculations. |
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#4: Dollar-Denominated Commodities Compromise
While various transitions have been contemplated that would, among other things, phase the import cost deduction out over a period of time, one of the trickier transition issue involves fixed dollar-denominated contracts, as many U.S. businesses negotiate their contracts in dollars and will not be able to renegotiate them if the currency appreciates. That problem is magnified for oil and wood pulp importers, because those commodities are priced in dollars globally. A stronger dollar may mean an oil importer will pay more for foreign oil plus the 20% tax. Providing a permanent exception from the BAT’s import exemption for commodities priced in dollars would address this concern.
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PROS |
-It would prevent the double hit oil and wood pulp importers could face with the DBCFT. 10 |
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CONS |
-If those importers are also exporters, they will benefit from a windfall. -The permanent exception would breach the integrity of the BAT, undermining the currency adjustment. |
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#5: Sales Factor Apportionment
Bill Parks and the Coalition for a Prosperous America 11 take the positon that Republicans can achieve the same goals as the DBCFT with a partial border adjustment by adopting what they call a subtraction-method destination-based sales factor apportionment (SFA) tax system (used by many states). Rather than policing the base by specifically exempting exports and taxing imports, as in a border adjustment, it would only tax the portion of a business’s global profit that represents its percentage of U.S. sales. In essence, that means that it would only tax the portion of the import cost that represents a profit to the seller. But it would still effectively exclude exports from the tax base.
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PROS |
-Destination-based SFA is likely compliant with the WTO and our tax treaties. 12 -Businesses that compete for U.S. consumption dollars compete on a level playing field. -SFA is an income tax and not a VAT. |
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CONS |
-Without a pure border adjustment, the SFA rate would need to be higher than 20%. |
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#6: Other Forms of Formulary Apportionment
Under formulary apportionment (FA), a business’s tax base would be defined based on location of its economic activity, perhaps including other factors in the formula aside from just sales (SFA includes only sales). One proposal developed by Reuven Avi-Yonah, Kimberly A. Clausing and Michael C. Durst is called the formulary profit split method. 13 Under this method, a business would effectively take its worldwide income minus its worldwide expenses and then use a formula to allocate a portion of that as its base subject to taxation in the United States. While the formula would assign the “residual” based on the portion of sales the business had in the United States, it first takes into account “routine” income where more income is assigned to those jurisdictions where more of the expenses are incurred. The profit split method assumes there is a return to expenses and taxes it, meaning that firms that exclusively produce in the United States and sells their goods abroad will still pay tax. 14 As with the SFA and unlike the DBCFT, there would be no explicit denial of a full deduction for imports.
Avi-Yonah, Clausing and Durst argue reform should ideally be done in coordination with major trading partners like the European Union to prevent trade and tax wars. Like the DBCFT, the SFA and other formulary methods, it would take time to implement in a way that ensures administrative and transition concerns are sufficiently considered and addressed.
Another very similar variant to the profit split method is the residual profit allocation method. It was developed by the same group that refined the DBCFT—Alan Auerbach, Michael Devereux, Michael Keen, Paul Oosterhuis, Wolfgang Schön and John Vella. It, too, has a border adjustment.
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PROS |
-FA would better account for how U.S. policy affects an integrated worldwide economy. |
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CONS |
-It may be unrealistic to think major countries could come to agreement on a formula. |
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#7: Border Adjusted VAT with Payroll Subsidy
Back in August, Lee Sheppard remarked 15 that the DBCFT is economically the same as a border adjusted VAT plus repeal of the employer-level payroll tax and that if lawmakers wanted that, they could simply follow guidance in the EU VAT directive. Although the DBCFT effectively repeals the corporate income tax and replaces it with what is essentially a subtraction-method destination-based VAT with a wage deduction, doing that explicitly is something with which lawmakers are uncomfortable. The most straightforward way to ensure our tax system will withstand a WTO challenge is to replace the corporate income tax with a single-rate, broad VAT and enact a separate credit for wages to address progressivity concerns.
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PROS |
-Designed correctly, it definitely complies with the WTO. |
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CONS |
-Many lawmakers hate VATs and are scared to enact them because Democrats assume they are regressive and Republicans fear they will be used to boost government revenue. -The payroll subsidy would have to be significant, which would present other challenges. |
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#8: Add-On Border Adjusted VAT with Lower Rate
This is the business tax system used by most of our major trading partners. It combines a sourcebased corporate income tax at a low rate with a regressive, border adjusted consumption tax in the form of a VAT. One benefit of such a system is that it represents a “more incremental change” for those who are concerned that “the ‘law of unintended consequences’ and the painful transition to a new tax regime could cause the costs of the DBCFT to far outweigh its benefits.” 16 Introduction of an add-on border adjusted VAT would enable the corporate income tax rate to be greatly reduced.
There are ways to make a credit-invoice VAT, which is effectively levied on consumers at the transaction level, more progressive. For example, Michael Graetz has spent years refining a proposal—the Competitive Tax Plan—that purports to solve the progressivity dilemma. His add-on credit-invoice method VAT proposal would combine a 12.9% VAT with a generous individual income tax exemption of $100,000 for married couples, a payroll tax credit that would further ease the tax burden for low-income workers, and refundable child credits distributed through debit cards. He would reduce the corporate income tax rate to 15% and apply it to some large partnerships. Sen. Benjamin Cardin (D-MD) introduced a reform proposal largely based off of Graetz’s plan. In his Progressive Consumption Tax Act, Cardin proposed a VAT at 10% and a corporate tax at 17%. 17
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PROS |
-It would likely withstand challenge by the WTO and will not gut state taxation norms. -The Graetz plan has been well vetted and refined over the years to ensure that it is both revenue-neutral and will not place added tax burden on low- and middle-income earners. |
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CONS |
-Many lawmakers hate VATs and are scared to enact them because Democrats assume they are regressive and Republicans fear they will be used to boost government revenue. -It preserves the income-shifting opportunities that our source-based system affords. |
[1] Treasury has historically assumed that it would take roughly $100 billion to reduce the corporate rate from 35 percent to 34 percent, and progressively more than $100 billion with each additional percentage point reduction. Many use $110 billion per percentage point as an estimate. It was thought that after the Obamacare repeal and replace legislation got through the Senate, the tax cuts would have resulted in a decrease in federal revenues of about $900 billion over 10 years (as the Congressional Budget Office estimated $999 billion revenue change minus $90 billion for Senate to increase medical care deduction threshold from 5.8 percent to 7.5 percent— https://www.cbo.gov/system/files/115th-congress-2017-2018/costestimate/hr1628.pdf).
[2] See Lincicome, Scott S. and Richard Eglin, January 19, 2017, “Border-Adjustable Taxes under the WTO Agreements,” White & Case LLP (https://www.whitecase.com/publications/alert/border-adjustable-taxes-under-wto-agreements) and the Coalition for a Prosperous America fact sheet “Tax Reform for Trade Competitiveness” (http://www.prosperousamerica.org/tax-reform).
[3] Herzfeld, Mindy, February 20, 2017, “A Better Way on Border Adjustability,” Tax Notes, 2017-2228.
[4] The President’s Advisory Panel on Federal Tax Reform, 2005, Simple, Fair, and Pro-Growth, Proposals to Fix America’s Tax System, U.S. Government Printing Office (http://govinfo.library.unt.edu/taxreformpanel/final-report/TaxPanel_5-7.pdf) p. 173-174.
[5] Alan Auerbach, Michael P. Devereux, Michael Keen and John Vella have contemplated a more intricate adoption of a partial destination base. If a country adopted a cash flow tax at 25% with exports “40% zero-rated for the tax” and imports 40% non-deductible, that would amount to a 10% DBCFT (because 40% of 25% is 10% ) “plus a source-based cash flow tax on production at 15%” (because 25%-10% is 15%). (January 27, 2017, “Destination-Based Cash Flow Taxation,” Oxford University Centre for Business Taxation, Working paper 17/01, page 85.)
[6] Although as pointed out by Victoria P. Summers in her June 3, 1996, special report entitled, “The Border Adjustability of Consumption Taxes, Existing and Proposed” in Tax Notes International (p. 1793), “the U.S. corporate income tax, although a quintessentially direct tax, could be thought of as imposed on an origin basis, in that the imposition of tax is based on the source of the income; exporting goods to another country does not, by itself, result in the imposition of income taxes by the country of import.”
[7] Leblang, Stuart E. and Amy S. Elliott, March 9, 2017, “Insurance For The Border-Adjustment Tax,” Forbes.
[8] Leblang, Stuart E. and Amy S. Elliott, March 6, 2017, “A Slightly Better ‘Better Way’ Plan,” Tax Notes.
[9] Leblang, Stuart E. and Amy S. Elliott, February 15, 2017, “No Need to Fear the Border-Adjustment Tax,” Bloomberg.
[10] Kellar, Karl L., George Korenko and Lori Hellkamp, February 16, 2017, “Border Adjustments in the Destination-Based Cash-Flow Tax: A Bold Proposal with Unanswered Questions,” Bureau of national Affairs Daily Tax Report.
[11] Parks, Bill, March 9, 2017, “Modifying the Republican Tax Proposal to Expand the Economy,” Tax Notes, 2017-1197 and http://www.salesfactor.org/2017/03/border-adjusted-tax-bat-confusion.
[12] Stumo, Michael, Fall 2016, “The Progressive Tax Reform You’ve Never Heard Of” The American Prospect, which notes that Reuven Avi-Yonah and Kimberly Clausing think there is an argument SFA is consistent with tax treaties.
[13] Avi-Yonah, Reuven, Kimberly A. Clausing and Michael C. Durst, 2009, “Allocating Business Profits for Tax Purposes: A Proposal to Adopt a Formulary Profit Split,” Fla. Tax Rev. 9, no. 5 (2009): 497-553.
[14] See https://www.taxpolicycenter.org/sites/default/files/residual-profit-allocation-proposal_1.pdf and http://www.sbs.ox.ac.uk/sites/default/files/Business_Taxation/Docs/Publications/Evidence/t-s-c-tax-policy.pdf
[15] Sheppard, Lee A., August 15, 2016, “Freedom Fries: The House Republicans’ Cash Flow Tax,” Tax Notes, p. 906.
[16] Zlatkin, Lawrence J., March 10, 2017, “The Destination-Based Cash Flow Tax: Tax Reform or Tax Chaos?” Tax Management International Journal, 46 TM International Journal 154.
[17] Another alternative might be to combine a 10% corporate income tax with a wage deduction and a border-adjusted VAT at a 20% rate with a 50% haircut for both the wage deduction and the border adjustment. This would mean that for every dollar of U.S. wages paid, the firm would get a 50 cent deduction, combined with a ‘Split the Pie’ style border adjustment described above. Rather than selling it as an add-on VAT, the combination could be sold as one tax, half of which is destination-based and the other half of which provides for a wage deduction.
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