Prospects for Tax Reform That Includes ‘Infamous’ Border Tax Significantly Underestimated

By Stuart E. Leblang and Amy S. Elliott

House Republicans’ June 2016 tax reform Blueprint entitled “A Better Way” ¹ proposes essentially replacing the corporate income tax with a destination-based cash flow tax (DBCFT) on all businesses. The change could trigger rapid appreciation of the U.S. dollar relative to other currencies, a reaction many economists claim will offset any effects on trade, so imports won’t be harmed and U.S. consumers’ dollars will go as far as they did before. Many are skeptical and have predicted the imminent demise of the border adjustment feature. But it’s critical to the DBCFT, estimated to generate $1 trillion over the next 10 years to pay for lower tax rates.²

As the House fleshes out details of the Blueprint in an ambitious effort to pass legislation by Labor Day, the DBCFT with its border adjustment feature has been misunderstood and misrepresented by many, making it the target of significant criticism. But despite reports to the contrary, it’s not dead. Businesses and investors need to get up to speed on how such a plan would affect particular companies. The winners and losers may seem obvious, but making such a determination is relatively complicated.

Border adjustments are more viable than reports found in the media might suggest because:

• Reform ideas like the DBCFT have a history of support from both economists and tax policy experts across the political spectrum.
• The proposal has special features that make it far more progressive than most consumption taxes and more progressive than the various alternative non-consumption oriented tax reform proposals likely to be considered.
• The border adjustment feature creates a more stable tax base that facilitates tax collection and guards against the type of international tax planning that generally erodes the U.S. tax base. As a result, it clearly eliminates tax incentives under current law to shift manufacturing and other economic activity outside of the United States.
• The DBCFT isn’t designed to favor exports over imports. It makes it harder for companies to use transfer pricing techniques and expatriations associated with import activity to avoid tax.
• The tax meshes with President Trump’s agenda to prevent tax-motivated inversions and the shifting of manufacturing outside the U.S. since it eliminates the tax benefits from offshoring activities resulting in the importing of products and services back to the United States.
• The proposal has less negative budget impact than alternative proposals being considered and it’s much more likely to attract support from legislators concerned about the growing budget deficit.
• The most vocal opposition to the DBCFT is coming from businesses that should theoretically benefit from lower tax rates under the proposal and remain unaffected by the border adjustment feature, assuming exchange rates adjust as expected.³
• The main concern of businesses that are against the proposal is that the exchange rate won’t adjust as expected. If this concern is not addressed, the proposal will have an uphill political battle. However it’s important to note that there’s been a long history of economists and policy experts considering possible transition rules that could induce certain opponents to alter their calculation as to the costs and benefits of the proposal. There are undoubtedly many creative transition proposals that will be developed and carefully considered. The memo below describes some past transition proposals as well as some other potential transition proposals.⁴
• Any transition to a consumption tax base creates complicated transition issues. But almost all of our trading partners in developed countries have been able to create sufficient consensus to shift their tax systems – at least in part – to a consumption tax base.
• The DBCFT has a greater chance for bipartisan support than other likely proposals given the fact that Republicans in the House believe it will promote growth and both parties will view the proposal as potentially maintaining progressivity. This is in addition to the fact that the proposal advances many of the policy objectives of the new administration.
• Although not widely reported, the administration and Congressional leaders have continued to meet daily to discuss the proposal and it remains very much on the table.

Shift to a Consumption Tax

The corporate income tax imposes two levels of tax on corporate earnings and provides interest deductions for debt financing. Moving to a consumption tax model changes that bias against savings, a change House Republicans think will lead to increased investment, higher incomes, and a healthier economy. Rather than taxing money when it’s earned, general consumption taxes (including value-added taxes) tax money when it’s spent. About 85 percent of all countries have enacted a broad-based consumption tax in the last 60 years.⁵

The U.S. already has narrow-based sales taxes levied by the states, so consumption taxation isn’t a completely foreign concept. But compare the U.S.’s mix of taxes on businesses with that found in some of our major trading partners. Europe, for example, has a top corporate income tax rate (averaged across countries and weighted by gross domestic product) of 29.9 percent and that’s on top of an average VAT rate of 22 percent.

Shifting the business tax base from one that taxes income to one that taxes cash flow (cash coming in minus cash going out) isn’t a new idea. In 1977, Treasury issued a report – Blueprints for Basic Tax Reform ⁶ authored primarily by David F. Bradford – proposing a move to a consumption-based tax. Bradford continued to develop the concept of a hybrid system – what he called the X-tax – which combined income taxation on the individual side at a series of graduated rates to ensure progressivity with cash flow taxation on the business side, providing full expensing for investment in things like buildings and equipment and a deduction for all wages paid.

With some changes, the DBCFT is similar to both the X-tax and the Growth and Investment Tax (GIT), which was put forward in 2005 by the President's Advisory Panel on Federal Tax Reform. Over the years these proposals have attracted bipartisan support from tax policy experts and economists.⁷

Forty years later, Treasury is still contemplating the move to a hybrid system, issuing a working paper just this month ⁸ stating that “the combination of a business tax on cash flow and a progressive individual income tax on wages and capital income might prove to be a path forward” to “spur growth and help address increasing income inequality.”

Treasury’s paper challenges the conventional wisdom that a move toward a consumption-based system like the DBCFT would be regressive. Such conventional wisdom is based off of traditional VATs. The tax reform plan containing the DBCFT isn’t technically a VAT. Unlike a classic VAT, the DBCFT contains a progressive income tax base for individuals and a wage deduction for businesses. The cash flow business base means that the only flows effectively subject to the 20 percent DBCFT rate will be what are referred to as supernormal returns from investment.⁹

While the burden of the current corporate income tax falls at least in part on workers, the DBCFT is designed so that the cash flow ultimately bearing tax is limited to the part of the corporate income tax base that falls on owners, not workers. Treasury thinks such a move might actually increase the corporate tax base because it would finally allow the government to tax profits from “excess” returns shifted to low tax jurisdictions by way of “paper transactions.” Treasury affirms that “a move from the current corporate tax to a cash flow tax should be a more progressive way to raise a dollar of government revenue.”

The Border Adjustment Feature

Recent criticism of the DBCFT has largely focused on its border adjustment – something found in all destination-based VATs (nearly all VATs are destination-based). It’s designed to police the tax’s scope. While the current corporate income tax taxes corporate income on a worldwide basis, the DBCFT taxes business cash flow from U.S. consumption. The border adjustment filters out exports and catches imports to make sure all receipts stemming from U.S. consumption end up in the DBCFT tax base.

Some view the border adjustment as a money-grab or a distortive policy, but given that all of America’s major trading partners have one, it might be fairer to say that not having a border adjustment is distortive. VATs can be origin-based (where tax is remitted to the country where the good was produced) or destination-based (where tax is remitted to the country where the good was consumed). All major countries other than the U.S. have a destination-based VAT with border adjustments.

Under the DBCFT, businesses – both foreign and domestic – would pay a flat rate of 20 percent on their cash flow from products and services sold in the U.S. minus the cost of U.S. inputs, including wages of U.S. workers. They would be encouraged to invest by getting a full, immediate deduction for all capital expenses, and they would no longer be taxed on their profits earned outside of the United States.

Two other features distinguish the DBCFT from traditional VATs: Its use of a subtraction method (deductions) instead of the usual credit-invoice method to refine the base; and its deduction for wages, which isn’t a feature of any VAT but is what makes the DBCFT progressive. That change to the base means that the economic cost of the tax may end up falling more on owners of capital than on labor as compared to the traditional corporate income tax base, as acknowledged by Treasury.

Here’s how the DBCFT’s border adjustment works: If a car is made in Mexico but sold in the United States, the Mexican automaker pays U.S. tax on the full amount of revenue from the car. If the car body is made in Mexico but then assembled and sold in the U.S. by a U.S. automaker, then all of the costs associated with making the car in the U.S. (including U.S. wages) can be deducted, although no deduction will be allowed for the Mexican-made car body part.

On the other hand, if the car body is made in America and then sold to an automaker outside the United States, the U.S. car body manufacturer won’t owe any tax on the revenue from selling the part overseas. But because nearly 95 percent of U.S. exports are subject to a VAT in their place of consumption, ¹⁰ the U.S. car body manufacturer will likely pay tax in the other jurisdiction. By adopting a border adjustment tax similar to that of our trading partners, House Republicans argue that the U.S. will remove “the self-imposed unilateral penalty for exports and subsidy for imports that are fundamental flaws in the current U.S. tax system.”

The border adjustment has been described as effectively a tax on imports and a subsidy for exports, fueling concerns that it will alter the U.S.’s trade deficit and result in an increase in exports. Most economists say it won’t. ¹¹ Any benefit to exporters from reduced taxes and any detriment to importers from increased taxes will be offset by a rise in the value of the dollar relative to foreign currencies, resulting in a wash to both businesses and consumers.

Base Broadening and Open Questions

Tax reform is about how best to collect money to fund the government. Today the corporate income tax only makes up about 11 percent of total government revenue ($344 billion out of $3.2 trillion in 2015).¹²Special interest credits and deductions mean that in practice the corporate tax base is fairly narrow.

Today, certain industries (grocery retailers) get squeezed paying an average rate of 34 percent while others (certain sectors of the electronics industry) get away with paying less than 10 percent.¹³The government forgoes an additional $173 billion¹⁴in corporate income tax revenue each year in the way of tax expenditures. Sophisticated firms can find ways to pay as little tax as possible and many companies in recent years have decided to move their tax domicile abroad to benefit from lower top rates and territorial systems of taxation.

Only a few business tax expenditures (some of which are considered part of the tax base by conservatives) would survive in the DBCFT. As mentioned previously, businesses would be allowed immediate expensing for investments in both tangible and intangible assets (although not land). Some form of the research and development tax credit will be preserved. But the deduction for net interest expense would be eliminated and so would nearly all other business deductions and credits, including the domestic production activities deduction and – presumably – other high-ticket corporate tax expenditures including deferral for like-kind exchanges.

Major question marks remain for some aspects of the design, in particular how financial services firms and financial products will be taxed in a cash flow tax base. And while traditional VATs exempt financial flows entirely from the tax base (so that businesses don’t have to include borrowings in their base, for example), the DBCFT doesn’t seem to in all cases. For example, according to the Blueprint, businesses will be allowed to carry forward net interest expense indefinitely to offset future interest income. That implies that any excess interest income in a year will have to be included in the business’s tax base.¹⁵

Another major concern involves the taxation of passthroughs. The Blueprint seems to provide that the earnings of passthrough businesses should flow through to the individual owners and be taxed at their rates, although capped at a maximum of 25 percent, but only for “active business income.”¹⁶

To be clear, if the U.S. enacted the Blueprint tax plan, it would essentially be repealing the corporate income tax, removing itself altogether from the race to the bottom as jurisdictions lower their rates in an attempt to attract businesses shopping for the best tax deal. Although there are many open questions as to how exactly the DBCFT would work, it would drastically simplify business taxation in exchange for an albeit uncertain promise of strong economic growth.

Winners and Losers

Anytime comprehensive tax reform is enacted there are winners and losers. But with the DBCFT, it’s not clear that the winners are limited to those firms that locate production and manufacturing in the United States. It is possible that net importers including many major retailers, oil refiners, and automakers reliant on imported parts could also end up as winners. It is possible that “skeptical winners” can be co-opted with transition rules.

Some businesses that might be reluctant to a change in the business tax system given their mastery of its perceived loopholes are, according to initial indications, coming out in support of the plan. For example, some U.S. pharmaceutical firms view the DBCFT as a win because it will remove transfer pricing from the equation, so that they can better compete with their overseas competitors.

Many retailers, oil refiners, and automakers fear that the border adjustment will amount to a net tax increase that will be passed on to consumers, harming sales. But if the dollar appreciates as expected, that shouldn’t be the effect. ¹⁷ Exports will initially sell for less abroad and imports will sell for more in the U.S., which will in theory increase demand for exports and reduce demand for imports. But the resulting pressures – and even the anticipation of the shift to a DBCFT – will cause the dollar to appreciate, offsetting the trade impacts. It will take more foreign currency to buy exports, reducing demand – with the opposite being true for imports.

Some firms worry that the dollar won’t appreciate to fully offset the trade effects. Others have convinced themselves a strong dollar is bad. Still others are afraid that the World Trade Organization could view the domestic labor deduction component of the DBCFT as an impermissible export subsidy, triggering trade sanctions (a threat arguably avoidable by some reworking of the DBCFT in a way that shouldn’t change the economics for firms or consumers). The question is whether these uncertainties can be managed with smart transition policy.

These concerns are important ones. But it’s also important to remember one of the fundamental attractions of the DBCFT: It would largely eliminate the income shifting, earnings stripping, and transfer pricing games being played by U.S. multinationals and foreign businesses that export to the United States. No other tax reform proposal can make that claim.

The clear losers ¹⁸ under the DBCFT will be inverters, firms that use the transfer pricing rules aggressively to erode the U.S. tax base, and multinational corporations that offshore their intellectual property in tax havens.

Evaluating the Likelihood of Reform

Much of the anxiety surrounding the DBCFT has to do with transition. If lawmakers can craft transition rules that appease the biggest worries of the most important stakeholders, there’s a chance that the Blueprint, despite its relatively radical approach to business taxation, could become law.

Transition is critical because without adequate transition rules, a shift to the DBCFT could cause taxpayers to lose their entire tax basis, all of their deferred tax assets, and could trigger an increase in the dollar of as much as 25 percent. ¹⁹ Transition rules need to be sufficient enough to have a chance of convincing the business community that reform won’t ultimately harm U.S. consumers or distort trade. The after-tax profitability of all U.S. businesses – net importers and net exporters – should remain the same.

The biggest fear is that the currency exchange market won’t react as expected. Other variables could come into play to roil the markets or alter the underlying trade balance, including threats by President Trump to levy actual import tariffs. China, the U.S.’s largest trading partner, could decide to reverse its trend of stockpiling U.S. Treasury bonds and instead unload them in force, causing the U.S. dollar to depreciate.

But there are a lot of smart people in Washington trying to craft transition rules that will address these concerns. Work has already been done in this area. The President's Advisory Panel on Federal Tax Reform from 2005 designed extensive transition rules ²⁰ for the GIT, which is similar to the DBCFT with some relatively minor differences (for example, no deduction for interest expense is allowed even on a netted basis and the top rate for individuals – 30 percent – is the same at the flat rate for businesses).

The panel suggested a phase-out of the interest expense deduction removal for businesses (so that firms could claim a deduction for 80 percent of their interest expense in year one, 60 percent in year two, 40 percent in year three, 20 percent in year four, and then zero going forward), preserving the taxability of interest income in matching proportion only during the transition period.

The panel also provided a phase-in of the border adjustment feature, because, as it explained, “If exchange rates do not adjust as rapidly as economic theory predicts they should, then border tax adjustments would place an undue burden on imports and importers.” Border adjustments would be phased in on a firm-by-firm basis by reference to a base amount (prior two-year average) so that in year one, 90 percent of imports up to the base amount could be deducted (and exporters would pay tax on 90 percent of exports up to the base amount). The proportion would go down to 60 percent in year two and 30 percent in year three, with the border adjustment fully implemented in year four.

Just over a year ago, House Ways and Means Committee member Devin Nunes, R-Calif., introduced the American Business Competitiveness Act (H.R. 4377), called the ABC Act, ²¹ which contains a concept similar to the DBCFT with legislative language for transition rules. Nunes provides a more generous 10-year phase-out of the interest deduction. In addition, businesses wouldn’t lose their basis in assets but could continue taking depreciation deductions for placed-in-service property under the old schedules.

Other possibilities for transition rules could include implementing a floating DBCFT rate that tracks the currency markets, adopting an exchange rate mechanism using a rate based on a basket of currencies; providing rules that would shift the gains from net exporters to net importers for a period of time; or phasing in the DBCFT while phasing out a mirrored origin-based VAT. The provisions would amount to an insurance policy, protecting firms if the currency didn’t adjust as expected. While such transition rules will be complicated and novel, lawmakers may decide that they give the Blueprint plan the best chance of attracting the broad support that is critical to long-term tax system stability.

One other important point: While the Blueprint is sparse on details in some areas, revenue estimators have taken a shot at gauging whether the plan would actually be revenue neutral at the rates proposed. Even with dynamic scoring, the plan comes up short by anywhere from $191 billion to $3 trillion in the first 10 years. That could be fixed with an increase in the rates.²²

The 2005 reform plan with the GIT was revenue neutral without taking into account any revenue from the border adjustments (at the time estimated to bring in $775 billion over ten years), because the drafters were concerned that the border adjustments wouldn’t survive WTO scrutiny. This time around, indications are that House Republicans will have a difficult time making the hard choices required for the Blueprint to be revenue neutral without the border adjustment feature.

Advocates insist the DBCFT is a real solution to a hard problem, noting that it has bipartisan support from people who have been studying the options for decades. But some analysts fear the implementation challenges are too great of a risk. ²³ Regardless House Republicans seem to be moving forward with it, and the DBCFT with its border adjustment feature is shaping up to play a key role in Congressional efforts to rewrite the tax code.

^{[1] Ways and Means Republicans, 2016, A Better Way Forward on Tax Reform Blueprint (https://waysandmeans.house.gov/taxreform/).}

^{[2] Pomerleau, Kyle, 2016, Details and Analysis of the 2016 House Republican Tax Reform Plan, Tax Foundation (http://taxfoundation.org/article/details-and-analysis-2016-house-republican-tax-reform-plan); and James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, Benjamin R. Page, 2016, An Analysis of the House GOP Tax Plan (http://www.taxpolicycenter.org/publications/analysis-house-gop-tax-plan/full). The revenue from the border adjustments is estimated to increase from about $1.2 trillion in the first decade to about $1.7 trillion in the second decade given that the U.S.’s trade deficits are expected to continue well into the future.}

^{[3] Although the most vocal opponents to date of the DBCFT have been focused on the border adjustment, we expect significant opposition from industries that believe it is important to preserve interest deductibility.}

^{[4] Conversely, alternative tax reform proposals that do not include border adjustments but do provide for territoriality could promote inversions and other base eroding activities.}

^{[5] Consumption Tax Trends 2016, 2016, Organisation for Economic Co-operation and Development (http://www.oecd.org/tax/consumption-tax-trends-19990979.htm).}

^{[6] U.S. Department of the Treasury, 1977, Blueprints for Basic Tax Reform (https://www.treasury.gov/resource-center/tax-policy/Documents/Report-Blueprints-1977.pdf).}

^{[7] Jim Carter, staff director of the 2005 panel and a key author of the GIT, was on President Trump’s transition team. If he joins the administration, this could help create a bridge between President Trump and the House Republicans on this type of tax reform. Curtis Dubay of the Heritage Foundation, has been a longtime DBCFT supporter and was also part of the transition team. The Tax Foundation, an organization highly respected by Congressional Republicans, is solidly behind the DBCFT. On January 24, Grover Norquist of Americans for Tax Reform and also influential with House Republicans also expressed his support for the DBCFT as part of comprehensive tax reform. Noted opponents whose views are important to Republicans include Daniel Mitchell of the Cato Institute who is an influential voice to Republicans. Other influential naysayers include Steve Forbes, Larry Kudlow, and the Club for Growth.}

^{[8] Patel, Elena, John McClelland, 2017, What Would a Cash Flow Tax Look Like For U.S. Companies? Lessons from a Historical Panel, U.S. Department of the Treasury Office of Tax Analysis Working Paper 116 (https://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/WP-116.pdf).}

^{[9] There’s broad consensus that the tax on normal returns falls in part on labor and that cash flow taxation ends up taxing super-normal returns.}

^{[10] Nicholson, Michael W., 2010, Value-Added Taxes and U.S. Trade Competitiveness, U.S. Department of Commerce, International Trade Administration, Office of Competition and Economic Analysis (http://www.freit.org/WorkingPapers/Papers/TradePolicyGeneral/FREIT186.pdf).}

^{[11] Auerbach, Alan J., Douglas Holtz-Eakin, 2016, The Role of Border Adjustments in International Taxation (http://eml.berkeley.edu/~auerbach/The%20Role%20of%20Border%20Adjustments%20in%20International%20Taxation%2012-2-16-1.pdf); and Viard, Alan D., 2009, Border Tax Adjustments Won't Stimulate Exports, American Enterprise Institute (https://www.aei.org/publication/border-tax-adjustments-wont-stimulate-exports/).}

^{[12] https://www.cbo.gov/publication/51113}

^{[13] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/taxrate.htm}

^{[14] https://www.jct.gov/publications.html?func=startdown&id=4857}

^{[15] Weisbach, David A., 2017, A Guide to the GOP Tax Plan – The Way to a Better Way, University of Chicago Coase-Sandor Institute for Law & Economics Research Paper No. 788 (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2893224).}

^{[16] Weisbach wrote that by providing for a separate passthrough regime, the Blueprint effectively ex-empts capital income earned through a passthrough (at least to the extent it doesn’t produce a su-pernormal return) from taxation at the individual level. The same income earned by a corporation, while not effectively subject to tax at the corporate level as explained above, would be subject tax at the top individual capital gain rate of 16.5 percent.}

^{[17] Note that the U.S. Government Accountability Office issued a report in 2008 (http://www.gao.gov/products/GAO-08-566) outlining some of the transition issues facing three countries that recently transitioned to a new VAT (although all had preexisting business consumption taxes) . The GAO wrote that as part of the transition, the countries monitored consumer prices to ensure businesses didn’t “artificially inflate prices to take advantage of uncertainty.”}

^{[18] There will be a few sympathetic losers that should get transition relief. Large, dollar-denominated debt holders – including U.S. subsidiaries of multinationals – stand to lose a significant amount of money because they will lose the benefit of their interest expense deductions. One of the many benefits of the DBCFT is that it would change the long-term debt-equity calculus for businesses, removing the incentive for overleverage. But that bias has been in the code for a very long time, and firms who have relied on that bias shouldn’t be penalized in tax reform.}

^{In addition, as Lawrence Summers wrote in the Financial Times January 8, adoption of the DBCFT in the U.S. will “provoke financial crises in some emerging markets.” (https://www.ft.com/content/7e5900ec-d401-11e6-b06b-680c49b4b4c0) While it’s true that emerg-ing market debtors will need to fork up more of their local currency to pay off their dollar-denominated debt, it’s hard to see why their situation should inform the U.S.’s tax system choices.}

^{[19] Experts have estimates that a stronger dollar will mean foreigners holding U.S. assets (both equity and debt, including U.S. Treasuries) could reap significant gains, amounting to a wealth increase in the neighborhood of $7 trillion. At the same time, Americans could lose nearly $5 trillion as the value of their foreign assets decline.}

^{[20] 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).}

^{[21] http://nunes.house.gov/legislation/tax-reform.htm}

^{[22] Treasury acknowledges that if the U.S. were to replace its business income tax system with a VAT, “rough calculations based on national income accounts suggested that a cash flow rate in the neighborhood of 26 to 29 percent might be revenue neutral.” U.S. Department of the Treasury’s Office of Tax Policy, 2017, The Case for Responsible Business Tax Reform, Tax Notes Today, 2017 TNT 13-25.}

^{[23] Avi-Yonah, Reuven S. and Kimberly A. Clausing, 2016, Problems with Destination-Based Corporate Taxes and the Ryan Blueprint (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2884903); David Mericle and Daan Struyven, 2016, US Daily: Corporate Tax Reform: Trading Interest Deductibility for Full Capex Expensing, Goldman Sachs Economics Research (http://static.politico.com/c3/34/c99de58745b29f77b027a0f848d9/goldman-sachs-analysis-of-net-interest-deductibility-and-expensing-provisions-of-tax-reform.pdf); Michael Cembalest, 2016, A mercifully brief note on destination based taxation, J.P. Morgan (https://www.jpmorgan.com/jpmpdf/1320718583962.pdf); and Jeffrey Rosenberg, 2017, Make America grow again, and more of my favorite themes for 2017, Fixed Income Market Strategy, BlackRock (https://www.blackrock.com/es/literature/market-commentary/fixed-income-market-strategy-commentary-en-us.pdf).}