What Is the “Border Adjustment Tax?”

Corporate tax reform proposals are taking shape, and one of the more complex and controversial proposals is called the “border adjustment” tax or the “destination cash flow tax.” Several variations on this tax are being discussed by Congress. As of yet, none of them have passed. However, if they pass, the effect on corporate tax, and thus corporate operations and profitability will likely be profound in some cases, and therefore have an effect on the stock prices where a corporation is publicly traded and has international operations.

First, the basics. Currently, the U.S. taxes income from corporations based on their worldwide income. Because income earned another country may also be taxed by that country, the potential for double taxing that income exists. This potential is mitigated by allowing a foreign tax credit equal to the lesser of the foreign tax paid or the U.S. income tax on that country’s taxable income. Some countries also use this tax base, but others use a territorial model, where a company is only taxed on its profits made in that particular company. In this system, no foreign tax credit is needed, because the potential for double tax is greatly curtailed.

Other countries have an income tax, and an additional Value Added Tax (VAT). These VATs are generally border-adjusted.  While the U.S. statutory federal income tax is higher than that of most countries, we have no VAT at this time, making our tax system more competitive than it would first appear. A border adjustment tax is essentially a VAT modified to allow for a deduction of wages paid. A VAT is more similar to a sales tax than an income tax. For example, currently, if goods produced in Florida are sold in Georgia, no Florida sales tax is collected. A VAT works similarly.

Critics of the current income tax system point to corporate inversions to low-income-tax countries and the active shifting of profits and activities abroad. They also note that income taxation raises the cost of capital in favor of debt financing.

Under the border adjustment tax systems being discussed, we would keep most of our U.S.  income tax code in place. However, our approach to international transactions would be changed dramatically.

Type of Transaction Current Tax System Border Adjustment Tax Proposal
Sales from U.S. corporations of goods made & sold in U.S. Sales are taxed, Cost of Goods Sold are deductible. Sales are taxed, Cost of Goods Sold are deductible.
Sales from U.S. corporations of exported products Taxed, with foreign tax credit to abate the smaller amount of tax paid to U.S. or other country on foreign income. No taxes on income from exports.
Sales of products imported to the U.S. and sold here Cost of products  sold are deductible as Cost of Goods Sold Imported goods would be taxed, no cost of goods sold would be deducted in arriving at net income.

Critics of this plan believe that the higher tax on imported goods would be passed on to the consumer, meaning that consumer prices and costs to businesses – particularly small businesses – would go up. Proponents of the proposal acknowledge that point. However, they feel that this taxation framework would lead to a stronger demand for exported U.S. goods that could be cheaper since they are not taxed by the U.S. To the extent the exchange was transacted in U.S. dollars, the demand for dollars would go up, strengthening the U.S. dollar. Similarly, there would be a lower demand for foreign goods which cost more, which would strengthen the U.S. dollar. Together, a strengthened U.S. dollar, proponents argue, would then make foreign goods cost less, which could cancel some or the entire rise in prices on imported goods over the long run. As many things affect exchange rates, the measurability of this claim is questionable.

How would the tax on companies be affected? U.S. importers, at least initially, will pay more tax because their sales would be taxed but their cost of goods sold would not be deductible. This would hurt U.S. companies selling imported goods, especially where gross margins (sales minus cost of goods sold) are thin. Let’s take a hypothetical example. Suppose Hypothetical Company and Clone Company are identical low margin retail establishments, except that Clone Company imports all of its cost of goods sold. Also assume a 22% tax rate, which effectively what average corporations currently pay. Assume no major purchases of equipment. Before changes in the value of the U.S. dollar, the difference in tax effects can be daunting.

Hypothetical Clone
Sales $1,000,000 $1,000,000
Cost of Goods Sold -750,000 -750,000
Gross Profit 250,000 250,000
Other Expenses, Mostly Wages -220,000 -220,000
Net Income before Tax 30,000 30,000
Income Tax -6,600 -220,000
Net Income $23,400 ($190,000)

Recall that while a profitable company has just become unprofitable due to the change in the tax structure, this effect is before the change in the value of the U.S. dollar which while unquantified by most proponents, is believed by those proponents to nearly or fully offset the change in tax. There is no firm answer on whether losses generated under this system could be carried over and used either by statute or on a practical basis. Still retailers and auto companies are particularly concerned.

A similar effect would also be expected by proponents to benefit U.S. exporters of goods, relative to those who make good in the U.S. and sell them here. Initially under this scenario, goods would be exported rather than sold here to avoid U.S. tax. The relative shortage of U.S. produced goods would arguably cause a rise in the price of those U.S. produced goods.  Proponents acknowledge while, at this point the price of both foreign and domestic goods have risen, perhaps substantially, the change in the value of the U.S. dollar would offset the lower taxes on U.S. exporters.

Other provisions of the border adjustment tax include replacing our tax system of depreciation with immediate expensing of equipment and eliminating net interest deductions or net tax borrowing deductions. Thus, those companies regularly buying U.S. made equipment would expect their taxable income to fall by the amount of unfinanced purchases.

The taxation of financial services might also change. One proposal is to tax economic rent earned by banks and finance companies. Interest income and expense would continue to be taxable and deductible, respectively, but net borrowing could be included in the tax base and then be deductible when repaid. While this looks like a simple, offsetting timing difference, timing differences matter to borrowing companies – especially start-ups which are often thinly capitalized and unable to raise a great deal of money on capital markets yet. Similarly, emerging-market debtor countries that hold debt in dollars and assets in their own currencies would be hurt in a way that is similar to what happed to Asia in the late 1990s.

Exchange rates are notoriously volatile, and some countries actively try to control their exchange rate. Pre-existing contracts complicate the markets ability to adjust the exchange rate, especially since most U.S. exports and imports are invoiced in dollars. To the extent that proponents are correct that the strength of the U.S. dollar will adjust to the change in prices, effects to the deficit would be neutral. Proponents estimate that the border adjustment tax would raise about $1.1 trillion over 10 years, and that this additional revenue should then lower the tax from a top statutory rate 35% to 20% for corporations.  Pass-through entities like LLCs may have a higher top statutory rate of 25% under some proposed legislation, which will arguably lead to entity arbitrage that will confound natural exchange rate adjustments.  And, since imports are currently greater than exports, the taxable base for the federal government should increase. Other estimates however question whether revenue might fall, and suggest a one-time tax on existing offshore earnings to be revenue neutral.  Recall however that most large corporations do not pay 35%, they pay on average about 14% federally and 8% at state and local levels. The reduction in statutory federal income tax rates is a major motivator for support of this bill among conservatives. However, some conservatives feel that corporate tax breaks in the form of a border adjustment tax and a lower tax rate would be unfair to consumers.

Conservatives are split on whether this system of taxation simplifies the tax code. The change in tax structures arguably provides an incentive for companies to produce goods in the U.S. rather than moving factors overseas.

Investment Portfolios Would Shift

Assuming a  rise in the U.S. dollar, this rise would likely prompt a shifting out of holding foreign assets to U.S. assets by both American and foreign investors. If the exchange rate does not float without friction, low-margin retailers, auto manufacturers, and apparel manufacturers could be less favored investments. This could hurt consumers by restricting their buying power (especially where prices go up but salaries don’t), which in turn puts U.S. further into a recession. Exporters may enjoy larger profits.

The Border Adjustment Tax Could Violate the World Trade Organization Rules

Under WTO rules, border adjustments are allowed under consumption taxes like VAT, but not under all other types of taxes. Since the border adjustment tax is a modified VAT, it is uncertain whether the VAT rules would apply. Direct destination taxes are generally not WTO compliant. And, because the border adjustment tax taxes the whole value of imports but excludes parts of the cost of domestically produced goods, like wages, the WTO may view this tax as non-compliant.

 

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