Border adjustment tax carries unintended consequences

Gary Wolfram

The country’s corporate income tax is in need of change. Taxing corporate profits is inefficient. But the proposed border adjustment tax attempts to insert into the corporate income tax a provision that is a component of a value-added tax. This will lead to uncertainty and unintended consequences, and is likely to create more problems than it solves.

Our corporate income tax rate is the highest in the industrialized world, according to a recently released study by the Congressional Budget Office and the Tax Foundation. In addition, profits earned outside of the United States are taxed at our rate when returned to the U.S. For example, if Apple earns profits in Ireland, it pays Ireland’s corporate income tax rate of 12.5 percent, but then must pay an additional 26 percent tax if it is returned to the U.S. Obviously, this is an incentive to leave profits abroad rather than investing them in the United States. It is estimated that US companies are holding more than $2.5 trillion overseas.

In an attempt to address such problems, the House reform would reduce the top corporate income tax rate to 20 percent. This is a positive. The higher the marginal tax rate the more distortions the tax causes. The proposal has what is known as a deemed repatriation tax that would likely encourage the return of the profits sitting outside the US. It is also beneficial in allowing the expensing rather than the depreciation of the acquisition of machines, buildings, and other goods that are used in the production of other goods, what economists call new capital. Unfortunately, the proposal goes a step too far with its treatment of imports and exports.

The border adjustment tax would not count as revenue sales made outside the U.S. when calculating profit. It would also not count imports as expenses. So suppose a company has $100 in sales and $80 in expenses. If all its sales are in the US it will have $20 in profit to be taxed. If it sold all of its goods in Germany it would have a loss of $80 as it would have no revenue to claim.

Suppose another company, a retailer, had $100 in sales in the US, expenses of $80, and that $40 of these expenses were for items that were purchased from outside the US. Under a Border Adjustment Tax, because it could not expense the $40 of items purchased outside of the US, it would be taxed on a profit of $100-$40, or $60.

It should be obvious that this will create a host of winners and losers. Local retailers that sell mostly in the U.S. and buy inventory from abroad, will find their taxes going up, while companies that export will find their taxes going down. There will be a great deal of uncertainty from this and markets do not like uncertainty.

In addition, because our exports will be cheaper and imports more expensive, there will be a change in the demand for U.S. dollars, likely raising the value of the dollar. Proponents argue that this will offset the increase in the cost of imports. However, it will ultimately create changes in the world-wide economy.

Excluding exports makes sense for the type of tax used by most advanced economies, the consumption based value-added tax. This is because a value-added tax is basically a sales tax. So, just as you pay sales tax on goods based on where you bought them, a value-added tax also levies a tax on where goods are purchased and will exclude exports and tax imports. Arguing that other countries don’t tax exports and tax imports is irrelevant, since they are levying a different type of tax.

Rather than create large amounts of uncertainty in our economic system, we should drop the border adjustment tax, reduce the corporate income tax rate and allow for the repatriating of profits and the expensing of new capital.

Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College.