Since the release of Senator Ted Cruz’s (R-TX) tax plan, many people have discussed the nature of his “Business Flat TaxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. .” The 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. is best characterized as a subtraction-method value-added tax. This tax is applied to a business’s income and payroll minus investment. It is not the same as a European credit-invoice VAT, but it applies to the same base and would have the same economic impact. We have an excellent primer on the “business tax” in Senator Cruz’s plan if you want to read more about it.
During the Republican primary debate last night, Ted Cruz mentioned another aspect of his “Business Flat Tax,” or value-added tax. He said that the tax is “border adjusted.” He then elaborated by stating that U.S. exports are not taxed, but imports from foreign countries are taxed. Cruz’s characterization made it seem as though his plan gives some sort of special advantage to U.S. based companies while taxing foreign producers.
Border-adjusted value-added taxes are very common. It is the international norm. It is done in order to prevent the double-taxation of goods and ensures that taxation occurs at the point of consumption. It is important to point out that a border adjustment is not a subsidy and it in no way gives an advantage to U.S. exporters over foreign importers and would have no economic impact.
Origin vs. Destination-Based Taxation and Border Adjustment
Generally, there are two principles that value-added taxes can conform to: origin-based and destination-based.
Under an origin-based value-added tax, all value added within a country is taxed by that country, regardless of where the good is finally consumed. This is accomplished by taxing all goods and services produced within a country, while exempting imported goods (imported goods would have been taxed in the exporting country). This does not require any border adjustment.
Destination-based is the opposite: all final consumption in a country, regardless of its source, is taxed within a country. As such, imports are taxed and exports are exempt from taxation. Under this system, a company that sells a good within the United States must collect VAT on the sale. If that same company sells the same product overseas, they do not need to collect VAT, but they still get a rebate for VAT paid on their inputs. Destination-based value-added taxes require a border adjustment.
Ted Cruz’s plan uses a destination-based principle and thus requires a border adjustment.
A border adjusted VAT is the international norm used by most countries. It is sanctioned by the World Trade Organization. It is also consistent with what a destination-based VAT is trying to accomplish: the taxation of domestic consumption. Revenue is collected by the jurisdiction in which the economic activity actually occurred. A border adjusted VAT also has the benefit of putting all companies that operate in the same jurisdiction on an equal footing. Incidentally, this is something Tax Foundation stresses as an important feature of a territorial corporate tax system.
It should be noted that implementing border adjustments are a little more complex under a subtraction-method VAT compared to a typical credit-invoice VAT. Under a credit-invoice VAT, it is much easier to exempt specific products that are sold overseas. This is because the invoice system that tracks specific goods is already in place. A subtraction method VAT that just taxes a business’s total payroll and profits requires more record keeping by businesses engaged in international trade in order to properly administer deductions and income exemptions related to exports and imports.
A Border Adjustment is not a Subsidy
To a casual observer, giving what seems to be special tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. to exporters, could be construed as a subsidy. A business that exports a good does not need to pay any tax on that product while a business that sells the same good within the United States needs to pay tax. One could draw this conclusion from Cruz’s explanation of his tax plan. In fact, many people in the past have called for border-adjusted taxes as a way to encourage exports in order to reduce the nation’s trade deficit. This is the argument that many proponents of a national 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. use.
It is important to stress that border adjustments are not subsidies. They do not give special economic treatment to exporters. Alan Viard of AEI explains:
“In a simple textbook model, a border adjustment would trigger a real increase in the value of the dollar that would raise the cost of U.S. exports and reduce the cost of U.S. imports by an amount that would exactly offset the direct effects of the border adjustment. In that model, the border adjustment would have no economic impact at all.”
In other words, prices adjust in a way that completely offsets the border adjustment.
It was nice to hear a candidate mention a very specific, albeit arcane, part of his tax proposal during a presidential debate. However, the way he talked about it may have confused some observers. The border adjustment in Senator Cruz’s “Business Flat Tax” should not be seen as a subsidy for exporters. It should only be seen as a way to properly define the 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. of the VAT as domestic consumption.
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