Scott Sumner  

Border tax bleg

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Martin Feldstein had a recent piece in the WSJ that defended the idea of a border tax adjustment, which would be a part of the proposed corporate tax reform. He points out that if imports were no longer deductible, and exports received a subsidy, then the border adjustment would not distort trade. Rather the effect would be exactly offset by a 25% appreciation of the dollar. I certainly understand that this would be true of a perfect across-the-board border tax system. But is that what we will have?

1. Will the subsidy apply to service exports? (Recall that services are a huge strength of the US trade sector.) Let's take Disney World, which makes lots of money exporting services to European, Canadian, Asian and Latin American tourists visiting Orlando. Exactly how will Disney determine the amount of export subsidy it gets? Do they ask each tourist what country they are from, every time they buy a Coke? That seems far fetched---what am I missing? If Disney doesn't get the export subsidy, then the 25% dollar appreciation would hammer them, and indeed the entire US service export sector.

2. What about all those corporate earnings that are supposed to be repatriated? (And future earnings as well.) If the dollar appreciates by 25%, then doesn't this hurt multinationals? Or am I missing something?

Update: It just occurred to me that corporate cash stuffed overseas is probably held in dollars. But future overseas earnings may still be in local currency.

Keep in mind that the prediction of 25% dollar appreciation is from the supporters of the plan, like Martin Feldstein. If you did this sort of adjustment without any dollar appreciation, the impact would be devastating on companies like Walmart. Given the Fed's 2% inflation target, how could they pass along a (effective) 25% tariff on almost everything they sell?

It's clear to me that I am missing something here. Can someone who knows more about the nuts and bolts of border adjustment taxes please explain exactly how this is supposed to work? I'm not saying the border tax is a bad idea--I'm agnostic so far. But unless I get good answers here, I'd recommend they not do it, or perhaps phase it in extremely gradually (like 1%/year for 25 years), and see what sort of side effects occur before going all the way to a 25% dollar appreciation.

Not to mention this violates WTO rules, which the US has previously argued must be adhered to. (Insert Trump sarcasm here.)

PS. Feldstein makes the following claim:

Since a border tax adjustment wouldn't change U.S. national saving or investment, it cannot change the size of the trade deficit. To preserve that original trade balance, the exchange rate of the dollar must adjust to bring the prices of U.S. imports and exports back to the values that would prevail without the border tax adjustment. With a 20% corporate tax rate, that means that the value of the dollar must rise by 25%.

With a 25% rise in the value of the dollar relative to foreign currencies, the $80 net price of U.S. exports would rise in the foreign currency to the equivalent of 1.25 times $80, or $100, and therefore back to the initial price. Similarly, the 25% rise in the value of the dollar would reduce the real import price to the U.S. retail customer back to $125/1.25, or $100, as it is without the border tax adjustment.

Although the combination of the border tax adjustment and the stronger dollar leaves exports and imports unchanged, it has the important advantage of raising substantial tax revenue. Because U.S. imports are about 15% of GDP and exports only about 12%, the border tax adjustment gains revenue equal to 20% of the 3% trade imbalance or 0.6% of GDP, currently about $120 billion a year. At that rate, the border tax adjustment would reduce the national debt by more than $1 trillion over 10 years.

That makes no sense to me. If the tax raises lots of revenue, then why doesn't national saving go up? Isn't government tax revenue a part of national saving? Feldstein is far better at public finance than I am, so I must be missing something here.

Can anyone help me?

Update#2: I forgot about foreign dollar denominated debts. How are they handled if the dollar appreciates by 25%? Tough luck?

COMMENTS (21 to date)
Thaomas writes:

A BACFT is no more inconsistent with WTO rules than a VAT; its the equivalent of a VAT. If Disney exports and invests enough more than it purchases domestically, it gets a rebate. A BACFT could have some pretty horrendous administrative problems (and by all means let's find out what they are) and still be a huge improvement on trying to tax business income. Ideally it could replace the capped wage taxation that finances SS-Medicaid-Medicare.

AntiSchiff writes:

Initially, I oppose this, because I think business income taxes, credits, deductions, etc. should be eliminated. Why take a chance on a policy like this, when we know for sure we can have far less distortionary policy by simply eliminating such taxes?

Scott Sumner writes:

No one can answer my questions?

Miguel Madeira writes:

"A BACFT is no more inconsistent with WTO rules than a VAT; its the equivalent of a VAT."

I think it is not - a company that import goods pays exactly the same VAT that a company that buys the same goods in the domestic market; for the few that I have read about the BACFT, it seems that a company that import goods will pay more than a company that buys the same goods in the domestic market.

Steve K writes:

Miguel - Not that I am in favor of this policy, but the other side would argue that goods will not cost more to import after the USD appreciates.

Hoosier writes:

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John Thacker writes:
Then what's the point if we end up where we started? I thought the goal was to encourage domestic production. If we're just looking to cut corporate taxes, why not just do that.

The point is to assess corporate taxes in a fairer way that has less evasion. It's very easy to avoid the high-rate corporate income tax by not repatriating earnings. By shifting collection to when and where goods are sold, it has the same advantages that a consumption tax does, but for business.

The entire tax is very similar to a VAT, except that the deduction of wages makes it more progressive (combined with the capital expenditure treatment). At the same time, the Republicans want to net cut corporate taxes, but the Left should support it if the rates were higher and the amount of revenue similar.

If you did this sort of adjustment without any dollar appreciation, the impact would be devastating on companies like Walmart. Given the Fed's 2% inflation target, how could they pass along a (effective) 25% tariff on almost everything they sell?

One offsetting advantage for Wal-Mart is that big retailers like Wal-Mart (especially those that import finished products) right now are almost all subject to the enormously high statutory corporate income tax rate because they can't engage in leaving profits overseas. The same goes for US based sellers of services. So they're already hit very hard by the current system.

Not to mention this violates WTO rules, which the US has previously argued must be adhered to.

That part is debatable, and there are ways to structure the tax. Border adjustment per se does not violate WTO rules, as most VATs (and certainly Australia's) are border adjusted. The part that seems to violate WTO rules is deducting the labor costs and so forth that distinguish it from a VAT-- the part that makes it more progressive (and thus more like a progressive income tax or X tax.)

I'd talk to Alan Cole at the Tax Foundation about it.

One thing about the USD-- it's clearly been appreciating significantly already since the election raised the chances of this plan. By your general pro-EFT stance, that should at least increase your belief that at least some currency effects will occur. The Australian experience also suggests that currency offset will occur, though not in the end fully offsetting.

John Thacker writes:

If you consider the tax itself then of course, like all taxes, it will have negative implications. The only fair comparison is to take the tax reform as a whole and consider what is being removed.

A stronger argument of caution comes from Peter Orzag. Much like the Tax Reform of 1986, eliminating distortions could have negative short term effects because of industries and tax shelters that rely on the current (distorted) system. More economically equal tax treatment of debt versus equity could have similar effects to what Trump hated about the 1986 law that eliminated a lot of his real estate tax shelters.

From what I recall Scott, you're a fairly big advocate of moving to a progressive consumption tax. This corporate tax reform is a move precisely along those lines (especially with deducting wages), and would have similar advantages and disadvantages. Certainly you see that any move to a progressive consumption tax would have people similarly screaming about the effects on prices?

bill woolsey writes:

If this link doesn't post, I will send it to you.

It looks to me like an effort to make the corporate income tax more like a VAT. We continue to pretend to tax corporate profit, but we work to manipulate it so that it really isn't aimed at that. That is where I am starting from.

Scott Sumner writes:

John, I already know the information presented in your comments. I'd like to support the proposal (for reasons you state), but cannot do so unless the proponents can answer the questions in my post. No one has done that yet.

Plucky writes:

Accounting for cross-border service transactions seems like an impossible-to-solve accounting nightmare, precisely because the exact location where the service is provided is so hard to pin down. Lets go with a few examples:

Financial Services: A multinational conglomerate listed in London wishes to issue Euro-denominated bonds, and hires an American investment bank to underwrite the issue. The deal team is led by an American-citizen expat based in London, consists of half US citizens and half various others, most of whom are London-based but includes people based in New York and Frankfurt. On the deal itself, team members travel to New York, Dubai, and Singapore to pitch the issue to investors.

Economically, the fees collected by the investment bank are (mostly) a US service export. But how the hell does one do the accounting? Domicile of the company? Citizenship of the labor? Geographic location where the work take place, even if that is pretty nebulous and occurs in numerous locales?

Entertainment: Apple signs a (hypothetical) deal for exclusive rights to stream Seinfeld in the Eurozone to include in its Apple TV product. Technically, the entity that purchases the rights is Apple's Irish subsidiary, but top-level Apple actually writes the checks (like any good nationalist, Steve Bannon wants to be paid in good ol' USD by a company with assets subject to US courts). Apple delivers this product with software developed in the US, hardware developed in the US but manufactured in China, and streams the show from cloud servers spread across Europe, but uses its US-based cloud servers for contingency backup.

Economically, again this is simple: This represents a US export product. But also again, how the hell does one do the accounting?

Travel: The aforementioned deal team flies from London to Dubai in an Airbus operated by a US carrier like Delta or Uni-- BAHAHAHAHAHA that would never happen, we can safely ignore this hypothetical

Natural Resource Development: A developing-country national oil company signs a deal to develop a new oilfield with (Anglo-Dutch-domiciled) Shell. All the engineering & design work is done by Shell's US subsidiary, some of which is outsourced to (US-domiciled) Baker Hughes and (French-domiciled) Schlumberger, with all the engineers being US-based, 2/3 of whom are US citizens and 1/3 of whom are on H-1B visas. The final assembly of the equipment happens in the US, but has an impossibly complex globe-spanning supply chain behind it. The on-site installation is overseen, managed, and done mostly by American citizens, but the deal requires Shell to hire/use 1/3 local labor because said developing country wants to both improve the skills of its labor force and also make sure everyone important's cousin is getting a piece of the action.

Economically, it's obvious there's very much a US-service export component to this deal. Accounting for it? Good luck

Scott Sumner writes:

Plucky, Very good comment. What I want to know is what the proponents of the bill propose. Do they plan to try to subsidize services exports? If so, how? If not, what does 25% dollar appreciation do to our service export sector?

What about EMs with massive dollar denominated debt? What's the plan? Tough luck?

Johannes Becker writes:

As to the dollar appreciation, one should note that all that works as well with an equal one-time inflation. This is admittedly a crazy thought, but a 20 per cent tax rate under a DBCFT could be "swallowed" either via a 25 per cent inflation of the US price level or a dollar appreciation of the same size. You only need to convince the Fed to accept this.

BC writes:

Foreign tourists in Canada can get reimbursed for GST (Goods and Services Tax) after leaving the country by saving receipts and filling out a form. Would something similar work for the Disney case: tourists could get 20% of their purchases refunded from the government?

(From personal experience, I can say that in practice, at least among my fellow travelers to Canada, people often forget to save receipts and/or file the GST rebate form.)

BC writes:

"If you did this sort of adjustment without any dollar appreciation, the impact would be devastating on companies like Walmart."

If Walmart sells a product from an American manufacturer, Walmart gets to deduct the amount that it paid to that manufacturer, but that manufacturer must pay a 20% tax on its profits. The manufacturer can exclude labor costs, but those workers must pay income tax on that labor. If Walmart sells the same product from a foreign producer, Walmart cannot deduct the amount paid to the foreign manufacturer. But, that foreign manufacturer doesn't pay US corporate tax on its profits nor does its labor pay US income tax. So, isn't the only difference between the two cases the difference between the 20% corporate tax rate and the US labor income tax rate? In both cases, tax is paid on labor, manufacturer's profit, and Walmart's profit. I thought that was the point of the border adjustment (regardless of any dollar appreciation) --- to account for the fact that taxes are levied at multiple points in the value chain. Admittedly, I am a newbie in trying to understand these border adjustments.

I thought the dollar appreciation was just the mechanism by which taxes (and subsidies) on imports and exports are made equivalent. Is that not the right way to think about it?

Mike W writes:

Feldstein: "At that rate, the border tax adjustment would reduce the national debt by more than $1 trillion over 10 years."

But, according to Brookings:

"A final concern is that the corporate reform proposals described above, even when coupled with some specified corporate tax revenue-raisers, would reduce federal tax revenue by about $900 billion over the next 10 years on a static basis. Revenues would fall by somewhat less if the changes were dynamically scored, but the proposals would still represent a very large tax cut and would raise the public debt."

Bill Woolsey writes:

The proposal is a modification of the corporate income tax. The cost of imported goods can't be deducted in calculating "profit" but revenues from exported goods can be deducted.

I don't get the impression that sales to foreign tourists will be deductible.

The goal is to shift the tax base from profit earned due to economic activity in the U.S. to profit earned from sales within the U.S.

Now, it would seem that this should be like a tax on imports and a subsidy for exports. Certainly, there is something to that.

But it is an error to ignore the actual tax scheme and think about a tax on imports and a subsidy for exports.

There are other elements of the proposal such as expensing for capital investment and no deduction for interest payments.

So, a tax on capital income (not just profit) earned from sales in the U.S. But the expensing element seems to suggest it is a tax on consumption funded by capital income earned from sales in the U.S.

Because payroll is still deductible, this will not be an added tax on consumption funded by labor income (I guess.)

Also, it only applies to corporate income, so I guess capital income earned from noncorporate sources is free from this tax.

Bill Woolsey writes:

To the degree the proposal shifts the tax base from income to consumption, it should slightly increase U.S. saving and so this would tend to reduce the trade deficit.

The border adjustment part of the proposal will raise tax revenue in the short run because the U.S. has a trade deficit. Corporations' loss of their deduction for imported inputs would not be fully compensated by their ability to deduct revenue from exports. If this was the whole story, this should reduce the budget deficit, increase national saving, and reduce the trade deficit.

However, the reduction in the tax rate especially, and also the expensing of investment will lose revenue, so on net, the effect on the budget deficit, national saving, and the trade deficit is the opposite.

I don't know why those who claim the dollar will rise enough to offset the change in taxes are completely ignoring these effects. They are expressly explaining the dollar adjustment on the correct view that trade deficits reflect the balance of investment and saving. I would mention that these things might change (as I did above) and so impact the trade deficit/surplus.

Michael Potter writes:

1. Tax on tourism
The issue of exports of services based inside a country is faced by every country with a Value Added Tax, including Australia where I am from. So it is nothing particularly new. Disneyland Paris faces this problem for every international tourist, for example. It appears that in Europe, it is just bad luck to Disneyland Paris and service providers to tourists. There is a refund scheme for goods sold to tourists, but not services.
Similar in Australia, we have a refund scheme for goods but not services sold to tourists.

In Australia package travel deals sold to foreigners are exempt from our VAT. And domestic flights that connect to an international flight are similarly VAT exempt.
I don't know whether this also happens in Europe.
If the US provides similar exemptions, I would expect that many foreigners would visit Disneyland US under a package deal.

2. Dollar appreciation and repatriation
Any appreciation will hit repatriation. But there are significant doubts about whether the US dollar will move to exactly offset the border adjustment.
See here:
Any appreciation will mean foreigners investing in the US will get a windfall, and US citizens investing overseas will be hit, see here:
The converse point applies to cross-border debts as you indicate.

Todd James writes:

Just want to make a small point about the Disney example only. Disney has, for a while now, made available RFID bracelets for park guests which, among other features, can be linked to a payment method and then used in most places in the park. In Disney's case, it would be possible to track most, if not all, purchases within their parks attributable to foreign guests, making the follow on accounting gymnastics tractable for them, and simple for their foreign guests if they are due a rebate upon departure.

Jordan writes:

Scott, Ryan's tax plan document from mid 2016 provides some clues.

First off, I don't see any mentions or speculation in the actual document as to what exchange rates may or may not do.

On exported services: "This means that products, services and intangibles that are exported outside the United States will not be subject to U.S. tax regardless of where they are produced."

This doesn't answer the tourism question. Inclined to agree w/ Bill that sales to foreign tourists probably aren't addressed and are therefore lower tourism is an unintended consequence of big dollar strength, at least at this point in the proposal.

On the WTO: "This disparate treatment of different tax systems is what has created
the historic imbalance between the United States, which has relied on an income tax – or direct tax in WTO parlance – for taxing business transactions, and our trading partners, which rely to a significant extent on a VAT – or indirect tax in WTO parlance – for taxing business transactions. Under WTO rules, the United States has been precluded from applying the border adjustments to U.S. exports and imports necessary to balance the treatment applied by our trading partners to their exports and imports. With this Blueprint’s move toward a consumption-based tax approach, in the form of a cash-flow
focused approach for taxing business income, the United States now has the opportunity to incorporate border adjustments in the new tax system consistent with the WTO rules regarding indirect taxes."

Still a lot of unanswered questions of course. The other thing we may want to think about is that a lot of American companies' "imports" or imported inputs aren't necessarily denominated in local currency. Many U.S. multinationals have leverage over supply chains and may have set things up to better align their cost structure in reduce cost and profit volatility from exchange rates. What happens to them?

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