The House GOP recently released a taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform proposal (click here to see the full details). Among other changes, it would convert the current corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. into what is called a “destination-based cash flow tax.” A key provision of the new business tax is that it would be “border adjusted.” Although this is an important part of the House GOP proposal, it would introduce a new feature to the U.S. tax code. As such, it is important to go over how it would work and how it would impact the economy and federal revenues.
How is the GOP’s business tax different than the current corporate income tax?
The easiest way to understand how the new tax in their plan works is to compare it to the current corporate income tax.
Under current law, corporations are taxed on their profits, which are roughly defined as revenues minus costs, at a marginal rate of 35 percent. Costs are things like state and local taxes, the cost of goods sold, interest payments, and other business inputs. Businesses that purchase capital investments need to depreciate, or write off, the cost of those goods over many years or decades. In addition, U.S. corporations are taxed on profits they earn overseas and bring back to the U.S. minus a credit equal to the taxes they paid overseas on that income.
The GOP’s plan would alter the corporate income tax in five major ways:
- The tax rate would be lowered to 20 percent.
- Businesses would no longer need to depreciate capital investments. Instead, they will be able to fully write off, or expense them, in the year in which they purchased them.
- Businesses would no longer need to pay tax to the IRS on profits they earn overseas.
- Businesses would no longer be able to deduct interest as a business expense.
- The corporate tax would be “border adjusted.”
These changes turn the tax into what is called a “destination-based cash flow tax.”
All of those changes are straightforward, but I am not sure what you mean by “border adjusted.”
The border adjustment is one of the more interesting features in the GOP’s tax reform plan.
Typically, we hear about a border-adjusted tax in the context of a value-added tax. A border-adjusted tax is a tax that is applied to all domestic consumption and excludes any goods or services that are produced here, but consumed elsewhere.
A border adjustment conforms to what is called “destination-based” principle (thus the “destination-based” in the “destination-based cash flow tax”). This principle states that the tax is levied based on where the good ends up (destination), rather than where it was produced (origin).
Most value-added taxes throughout the world follow the destination principle. However, this principle can also apply to retail sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. es, business taxes, and carbon taxA carbon tax is levied on the carbon content of fossil fuels. The term can also refer to taxing other types of greenhouse gas emissions, such as methane. A carbon tax puts a price on those emissions to encourage consumers, businesses, and governments to produce less of them. es. The GOP plan applies this principle to business taxes.
So how does a border-adjusted business tax generally work?
In the context of a value-added tax, a border adjustment works by applying the tax to imports, but exempting exports from the tax. The GOP’s business tax is not a VAT, but the mechanism that makes it border adjustable is similar.
In order to make the corporate tax border adjustable, the revenue from sales to nonresidents would not be taxable, and the cost of goods purchased from nonresidents would not be deductible. So if a business purchases $100 million in goods from a supplier overseas, the cost of those goods would not be deductible against the corporate income tax. Likewise, if a business sells a good to a foreign person, the revenues attributed to that sale would not be added to taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. .
Another way to think about the border adjustment is that the corporate tax would ignore revenues and costs associated with cross-border transactions. The tax would be solely focused on raising revenue from business transactions from sales of goods in the United States.
VATs are usually border adjusted. Does this mean the corporate tax in the GOP’s plan is a VAT?
No. There are provisions in the GOP plan’s business tax that make it similar to a VAT, such as full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. of capital investment, the non-deductibility of interest payments, and the border adjustment. However, it does not have the same tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. as a VAT. Specifically, the tax in the GOP tax plan allows businesses to deduct payroll. A VAT would not.
A tax on imports, but not on exports. This sounds like a tariffTariffs are taxes imposed by one country on goods or services imported from another country. Tariffs are trade barriers that raise prices and reduce available quantities of goods and services for U.S. businesses and consumers. .
A border adjustment is not a tariff, nor would it give the U.S. a trade advantage.
At first glance, a border adjustment sounds like a tariff because it applies to imports, but does not apply to exports. The adoption of a border-adjustable tax is sometimes praised as a cure for the U.S. trade deficit, or promoted as giving the U.S. a competitive edge, or offsetting a competitive edge now enjoyed by foreign producers whose countries use border-adjusted taxes. Such claims are unfounded, and based on a misunderstanding. For instance, Senator Ted Cruz wrongly argued that his plan would benefit exports.
A border-adjusted tax falls equally on domestic and imported goods, in order to tax the amount of income people spend on consumption. A domestically produced good and an imported good will face the same tax. Goods produced in the U.S. and exported abroad are exempt from taxation, but exports are not consumed at home. However, the foreign buyer may be subject to a consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. levied in his home country, but that is not the concern of the U.S. taxing authority.
Of course, U.S. producers may think of this as a subsidy for exports because they would not be taxed on sales overseas. But if businesses were able to reduce the prices of their goods they sell overseas due to the border adjustment, this would trigger a higher demand for dollars in order to purchase those goods. This higher demand for dollars would increase the value of the dollar relative to foreign currencies and offset any perceived trade advantage granted by the border adjustment.
How would a border adjustment impact federal revenues?
In the case of the United States, a border-adjusted tax would raise revenue by broadening the tax base. The United States has a large current account deficit; its imports greatly exceed its exports. Because of that difference, taxing spending on imports instead of taxing sales of exports would raise revenue, roughly $1 trillion or more over a decade.
Of course, the plan also lowers the corporate tax rate and enacts full expensing, so on net the tax changes will likely reduce overall business tax revenue.
Would a border adjustment be complicated?
A system in which cross-border transactions are essentially ignored would actually be simpler than current law.
Businesses have profits and investments all over the world. Properly allocating revenues and costs across borders is quite a complex task and requires businesses to navigate very complex parts of the U.S. tax code.
Moving to a destination-based cash flow tax would eliminate the need for a lot of these complex provisions because the tax would only concern itself with domestic transactions. As Alan Auerbach has pointed out, the need to allocate research and development costs would go away under this proposal.
In addition, because the GOP plan’s corporate tax is a territorial tax—dividends paid by U.S. foreign subsidiaries are not taxable in the U.S.—there would be no need to calculate foreign tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s.
How would the proposed tax impact profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. ?
One of the impacts of the GOP’s proposed cash-flow tax is that profit shifting that occurs under the current corporate income tax would be pretty much eliminated.
Under current law, businesses have the incentive to overstate costs in the United States and overstate profits elsewhere in order to avoid the higher marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. in the United States. This is because the current tax is based on where profits are located, not sales.
With a destination-based tax, this incentive disappears because the very transactions that make profit shifting possible are ignored. For example, if a business understates profits in the U.S. by understating the cost of widgets it sells to a subsidiary in France, it wouldn’t matter because that transaction would be ignored because it is an export. Likewise, if a foreign subsidiary overstates the cost of lumber it imports to the United States, it, again, doesn’t matter because that cost is not deductible against the corporate tax base.
Also, because interest in the GOP’s plan is not deductible, profit shifting through cross-border loans would no longer be possible. IP income would also not be an avenue through which businesses profit shift because royalties paid overseas for goods sold in the United States would not be deductible.
In fact, this system would create an incentive for businesses to shift profits into the United States and companies that hold IP overseas and sell goods throughout the world would have an incentive to relocate that IP to the United States.
What about the World Trade Organization? Would they object to this tax?
The World Trade Organization generally allows and expects consumption-based taxes (called “indirect taxAn indirect tax is imposed on one person or group, like manufacturers, then shifted to a different payer, usually the consumer. Unlike direct taxes, indirect taxes are levied on goods and services, not individual payers, and collected by the retailer or manufacturer. Sales and Value-Added Taxes (VATs) are two examples of indirect taxes. es”) to be border adjusted. However, it objects to income-style taxes (called “direct taxA direct tax is levied on individuals and organizations and cannot be shifted to another payer. Often with a direct tax, such as the personal income tax, tax rates increase as the taxpayer’s ability to pay increases, resulting in what’s called a progressive tax. es”) being border adjusted. So the corporate income tax is considered not eligible for border-adjusted treatment. This is the conventional treatment going back to the 1950s.
However, there is a case for treating this tax as an indirect, consumption-based tax. Once a business tax allows full and immediate expensing of capital investment spending, it takes on the nature and tax base of a consumption-based tax.
Where should I go to read more about this subject?
The Center for American Progress, back in 2011, published a paper highlighting the benefits of a destination-based cash flow tax.Share