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Border Adjustable Tax Another Way to Grow Government

Summary:
Since President Trump was elected, the stock market has been doing well. Many attribute the performance to optimism about fundamental tax reform, in particular, the destructive corporate income tax system. There are good reasons to be optimistic. You'd be hard-pressed to find anyone who thinks the corporate income tax system doesn't need fundamental changes. Until recently there was a widespread and bipartisan consensus about the need to address the problem. At 35 percent, the U.S. has the highest corporate rate of all wealthy nations. Unlike most of our competitors, we also have a worldwide tax system. This means Uncle Sam taxes income earned by companies overseas, income already subject to tax if they bring it back to the United States. This has created a highly uncompetitive environment for U.S. companies doing business at home and abroad. In the wake of the election, Republicans had a golden opportunity to enact long-cherished reforms. This optimism overlooked the Republicans' incredible tendency to make self-defeating decisions. Rather than being well on their way to passing a tax reform plan that would grow the economy and simplify the tax code, momentum has been dissipated in a counterproductive fight over a "border-adjustable" provision being pushed by House Republicans as part of a new 20 percent tax on businesses.

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Since President Trump was elected, the stock market has been doing well. Many attribute the performance to optimism about fundamental tax reform, in particular, the destructive corporate income tax system.

There are good reasons to be optimistic. You'd be hard-pressed to find anyone who thinks the corporate income tax system doesn't need fundamental changes. Until recently there was a widespread and bipartisan consensus about the need to address the problem.

At 35 percent, the U.S. has the highest corporate rate of all wealthy nations. Unlike most of our competitors, we also have a worldwide tax system. This means Uncle Sam taxes income earned by companies overseas, income already subject to tax if they bring it back to the United States. This has created a highly uncompetitive environment for U.S. companies doing business at home and abroad.

In the wake of the election, Republicans had a golden opportunity to enact long-cherished reforms. This optimism overlooked the Republicans' incredible tendency to make self-defeating decisions.

Rather than being well on their way to passing a tax reform plan that would grow the economy and simplify the tax code, momentum has been dissipated in a counterproductive fight over a "border-adjustable" provision being pushed by House Republicans as part of a new 20 percent tax on businesses.

This provision of the Better Way Plan, which otherwise promotes growth and reduces penalties against work, savings and investment, disallows any deductions for imports (which is the same as levying a tax) and eliminates all taxes on revenue generated by exports.

It feels like export mercantilism because it is another attempt to hammer imports while promoting exports. Its proponents have admitted they hoped it would dissuade the president to impose more punishing tariffs. The immediate result is the dividing of the business community, which surely would be unified in support of a GOP plan absent the border adjustable tax.

The usual beneficiaries of other pro-export corporate welfare policies, like Boeing and GE, are, not surprisingly, cheering the measure. American retailers who rely heavily on imports are lined up against it. A company the size of Walmart might stomach the extra cost but small businesses with razor-sharp profit margins may not survive the change.

There is also the risk of increasing consumer prices to offset the impact of the import tax, although proponents claim the value of the dollar will automatically rise in value and neutralize the impact on trade.

Ways and Means Committee Chair Kevin Brady (R-TX) recently told Politico Pro, "I'm confident that the currency does adjust very efficiently and quickly, which avoids consumer price impacts. Indeed, friction-free economic textbook models predict the dollar will adjust perfectly and immediately to offset the pain of the new tax. In the real world, where different actors react in anticipation of future policies, where adjustments may not be instantaneous, where politicians often mess up the implementation and the management of tax policy, the outcome can be quite different.

Empirical studies done by my colleagues and I have found something less than perfection. As for the final result, no one really knows for sure. This uncertainty is reflected in recent comments by Federal Reserve Chairman Janet Yellen during testimony to Congress. She said, "The problem is there's great uncertainty about how in reality markets would really respond to these changes … A strong set of assumptions is needed to believe that markets would fully offset those changes. … It's very difficult to know just what would happen."

No other country has a border-adjustable corporate income tax, compounding the uncertainty. You wouldn't know it listening to BAT proponents regurgitating misleading soundbites suggesting other countries have border-adjustable taxes. What they are talking about is the Value-Added-Tax (VAT), levies on top of corporate income taxes. Based on their economic performance and the size of their governments, these are not the countries advocates of free markets should try to emulate on tax policy.

The border tax is the brainchild of economist Alan Auerbach, former adviser to former presidential candidate John Kerry. Auerbach first presented the idea in a 1997 paper, The Future of Fundamental Tax Reform. He revisited it for the Center for American Progress/The Hamilton Project in 2010, openly arguing for the end of tax competition and lower tax rates to relieve the pressure on politicians.

Many ideas for making government more efficient emanate from the left, but they are never, ever about making government smaller. Nor do they protect taxpayers from the abuse of Uncle Sam. Some economists are already making the case that this tax is so efficient and distortion-free (as if such a thing exists) that the rate should be much higher than 20 percent. It has been remarkable to see so many conservatives and Republicans fighting hard for this plan.

Also interfering in a perfect currency adjustment is the fact that the World Trade Organization will likely challenge the tax as discriminatory. And indeed it does add some distortions to the current system. The WTO poses another real risk: the possibility that the United States would adopt a dreaded big government VAT. A future Elizabeth Warren administration would only be happy to transform the BAT into a VAT and in a matter of time revive a corporate tax to drop on top of our VAT.

I believe many proponents would not support the BAT proposal if they didn't see it as the way to pay for the other very good aspects of the Republican blueprint. Scores of the plan have shown none of the economic growth comes from the BAT. But it would raise $1.1 trillion to pay for pro-growth features like lower rates, full expensing and a move to a territorial system. That's important to BAT advocates now that Republicans must use the reconciliation process to push tax reform through the Senate. The process requires a deficit neutral proposal in order to make permanent changes.

If we want all the good stuff in the plan, this logic goes, we've got to pass the BAT. That's nonsense. The price is a terribly risky and unfair new tax, which may devolve into a money machine VAT.

Instead, we should first settle for a smaller plan that would improve the system dramatically (lower the rate and move to the territorial system). In a second phase, Congress could implement other reforms. This two phase reform is what Republicans did in the 80s and while it wasn't easy, it worked well. We could also offset the tax cuts with spending cuts. There are plenty of ideas to do that. Alternatively, we could finance the pro-growth tax cuts with a mix of spending cuts and smaller offsetting revenue increases (such as getting rid of the state and local tax deduction or ending the municipal bond interest exemption).

The BAT tax is so complicated lawmakers still have no clue how they will treat services, and financial services in particular, under the plan. As mentioned earlier, it also undermines tax competition, exposing the country to the risk of higher tax rates down the road. And don't get me started on the other misleading arguments used by those supporting the new levy.

There are many more arguments against the BAT. This is a bad idea, seriously putting at risk the possibility of advancing tax reform. And if the Republican leadership doesn't give it up, I predict tax reform will end the same way health care reform did.

Veronique De Rugy
Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University and a nationally syndicated columnist. Her primary research interests include the U.S. economy, the federal budget, homeland security, taxation, tax competition, and financial privacy. Her popular weekly charts, published by the Mercatus Center, address economic issues ranging from lessons on creating sustainable economic growth to the implications of government tax and fiscal policies. She has testified numerous times in front of Congress on the effects of fiscal stimulus, debt and deficits, and regulation on the economy.

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