On Tuesday night, during his first address to Congress, President Trump reiterated his call for 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. In doing so, he claimed that U.S. goods are at a disadvantage in world markets:
“Currently when we ship products out of America, many other countries make us pay very high 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. s and taxes. But when foreign companies ship their products into America, we charge them nothing or almost nothing.”
It is not entirely clear, but this portion of Trump’s speech seems to be referring to a “border adjustment.” A border adjustment applies a tax to imports and relieves exports of taxation. Border adjustments are usually a component of value-added taxes (VATs) and 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, but can be applied to other taxes. They exist in most countries throughout the world. The House GOP has proposed enacting a border adjustment as part of their tax reform proposal.
What Trump is suggesting is that American products are at a disadvantage in foreign markets because foreign countries apply their VATs to our exports, and that foreign products exported to the United States are at a competitive advantage because they receive a rebate from foreign VATs. So, the argument goes, if the United States were to enact a border adjustment it would put our goods on a level playing field in both foreign markets and at home.
While this is a reason many support a border adjustment, the logic is faulty.
Border adjustments are not a trade policy tool. They do not put American goods in foreign countries at a disadvantage; enacting one in the United States would not balance the playing field for goods produced here; and a border adjustment would not reduce our trade deficit.
Instead, border adjustments are a tax policy tool. They switch a tax’s base from an origin-based tax (a tax on goods and services produced in a country) to a destination-based tax (a tax on goods and services consumed in a country). Border adjustments do not have an impact on trade.
As stated above, border adjustments in foreign countries are part of their broad-based VATs. In principle, a VAT with a border adjustment applies to all goods and services consumed in a country, including those goods and services imported from overseas. The result is that all goods in the same jurisdiction face the same tax. A border adjustment does not provide a benefit to domestic goods over imports.
And if the United States were to enact a border adjustment, it would not give an advantage (or offset a disadvantage) for goods produced here and sold overseas. A border adjustment, such as the one proposed by the House GOP, would trigger an appreciation in the U.S. dollar (or an increase in the overall domestic price level, if you are skeptical) that would offset the additional tax on imports and the 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. on exports, leaving the relative price of imports, exports, and domestic goods unchanged.
If the border adjustment does not boost the competitiveness of U.S. goods and services, as Trump seems to suggest, why do it? There are actually three reasons that a border adjustment as part of tax reform would be an improvement over current law.
1. The border adjustment would eliminate the ability for companies to shift profits to low-tax jurisdictions
Under the current origin-based 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. , which taxes companies on the location of their production, companies have an incentive to shift their profits to low-tax jurisdictions in order to avoid U.S. corporate taxes. This is because under our current tax system, a company can either overstate the costs of goods it imports from foreign subsidiaries or understate the price of goods it exports to foreign subsidiaries.
Under the border-adjusted corporate income tax proposed by the House GOP, the transactions that allow a reduction in tax liability through 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. are eliminated. Since the cost of imports cannot be deducted, it doesn’t matter what a company charges itself on cross-border transactions; it cannot deduct its import costs and thus cannot change its domestic tax liability. Likewise, exports are excluded from 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. , so a company charging itself $1 or $1 billion for an export has no bearing on its U.S. tax liability.
2. The border adjustment would simplify the tax code
The fundamental challenge with an origin-based tax is properly allocating profits based on where goods and services are produced. This is hard in a world with global supply chains that exist in dozens on tax jurisdictions. Properly defining and allocating the location of profits requires a labyrinth of rules to prevent the type of gaming I mentioned above. These rules include “controlled foreign corporation rules.”
Since a border adjustment would eliminate the ability for companies to shift profits as they do under current law, these rules that protect 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. would be unnecessary. This would greatly simplify one of the more complicated portions of the current tax code. Of course, rules would need to be defined to prevent gaming under the border adjustment, but these rules would arguably be much less complex.
3. The border adjustment would broaden the tax base in order to fund pro-growth reforms
Although the border adjustment doesn’t grow the economy, it does raise a significant amount of revenue, which would allow for important reforms that would significantly grow the economy. The $1 trillion the border adjustment raises over the next decade can be used to help pay for a lower corporate income tax rate and 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 investments, which would greatly boost investment in the United States.
It is not clear yet whether Trump supports the border adjustment in the House GOP plan. However, a lot of his rhetoric suggests that he may be open to it and that he sees it as a trade policy that could level the playing field for American products. This is incorrect. A border adjustment would not have an impact on international trade nor would it boost domestic production. Although it wouldn’t have the economic benefits Trump suggests, it would make improvements to the tax code that are worth considering.
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