Unless you are a trade economist, it is unlikely you had heard of – much less given much thought to – a border adjustment tax before House Republicans made it a central feature of their tax reform proposal.
The border adjustment tax keeps cropping up in headlines these days, largely due to its prominent opponents – including Wal-Mart’s CFO, the president of the American International Automobile Dealers Association, and the nation’s secretary of commerce – but occasionally due to its cheerleaders as well. House Speaker Paul Ryan has struggled to secure support for the plan among fellow Republicans, especially those in the Senate. Yet Ryan and others in favor of border adjustment say it is necessary to raise an estimated $1 trillion over the next decade to offset the effects of cutting the corporate tax rate from 35 percent to 20 percent.
Watching the tug-of-war over a border adjustment tax, I come to two conclusions. First, I don’t think the border adjustment plan has any real chance of appearing in the finalized tax reform that we have a good chance of seeing under the current Congress. And, second, that it’s probably a good thing.
In (relatively) simple terms, a border adjustment tax is a “destination-based” tax, levied based on a where goods end up rather than where they were produced. If you make T-shirts or cars (or music boxes), the U.S. government will no longer care where you make them. Instead, it will care where you ultimately sell them. You can see why big U.S. retailers like Wal-Mart are not this idea’s biggest fans.
Border adjustment would mean the cost of imported goods and materials for use or sale in the U.S. would no longer be deductible, while revenue from exported goods and materials would be excluded from taxable income. House Republicans say the idea is to remove the incentives for multinational companies to shuffle production or move their headquarters.
As I have written before, Martians don’t pay taxes. That means the first question to ask when considering a change to a tax system that is supposed to raise $1 trillion is who will pay that impressive sum. In the case of the border adjustment plan, will it be paid by foreigners, who will have to absorb the cost by lowering the price of goods to offset the tax at the border and stay competitive? Or will it be paid principally by American consumers?
Whether you look at the border adjustment tax as a tariff or as a consumption tax – a matter of debate – the end result is likely to be the same. The bulk of it will be paid by American consumers, especially those on the low end of the income scale. Why? Because they spend a larger proportion of their income on generally inexpensive imported goods.
A border adjustment tax would be collected through the corporate income tax, but in practice, it would not be an income tax at all. Under this plan, a store spends money for imported goods but can’t subtract the cost from the store’s revenues – which is how you determine a store’s income.
To see how it works, consider an establishment I’ll call Not-So-Small-Mart. Suppose Not-So-Small-Mart buys an imported T-shirt for $2 and sells it for $4. Retail is generally a low-margin business. When you add in the other costs, such as building and running the store, paying a staff to work there and transporting the T-shirt from the dock to the warehouse to the store itself, say the total cost to the store comes out to $3.80 total. The profit margin ends up at 20 cents, or 5 percent, which is pretty typical for retail.
Now consider how Not-So-Small-Mart will fare under the border adjustment plan. The store will no longer be able to subtract the $2 cost to purchase the shirt. Instead, it will be taxed on a fictional $2.20 profit per shirt. At 20 percent, this comes to 44 cents in taxes – meaning Not-So-Small-Mart will lose 24 cents per T-shirt sale. Not-So-Small-Mart goes broke. Except it won’t, because it will raise the price of the shirt. Thus the border adjustment tax has been successfully passed along to the American consumer.
Those who support the border adjustment plan make this problem disappear through the alchemy of currency exchange rates. In a vacuum, they argue, the scheme will increase demand for U.S. exports. This will increase the value of the American dollar, making foreign goods cheaper in relative terms. Such a change will theoretically offset the import tax for consumers paying in U.S. dollars.
I don’t buy it. Currency exchange is not set in a vacuum. In reality, countless factors affect the dollar’s value, and there is no reason to expect or assume that currency fluctuations will take all the pain out of the adjustment for Americans buying imported goods. Meanwhile wealthier people who tend to invest part of their income instead of spending it, or who spend a lot of it on vacations and services generated wholly inside or outside the country, would bear proportionately less of the burden.
If they jettison the border adjustment, where will lawmakers find the money to offset the cost of reducing corporate tax rates to 20 percent in order to make America’s business taxation competitive with the rest of the developed world? The answer comes in two parts. First, to some extent the mere fact that our business climate has improved should generate additional economic activity, which will offset a part of the cost. Republicans in Congress already assume this will happen when using “dynamic scoring” to calculate the cost of their proposed legislation.
But the rest of the difference, if it will be offset at all, ought to come from reduced spending. If you really want to make government less of a burden on the economy, make it smaller and more efficient. Take $100 billion a year out of the approximately $3.6 trillion the government spends and presto: In 10 years, you will make up the $1 trillion you wanted to recover through border adjustment.
Of course, this is much easier said than done. Of the $3.6 trillion Uncle Sam spends yearly, less than a third is discretionary (that is, spending subject to Congressional appropriation). The rest is governed by formulas, such as those for Social Security and Medicare. Congress can play with these formulas to a degree, but doing so is a politically fraught exercise. Except for some minor tinkering, probably with Medicare, I think it is unlikely such changes will be part of the tax reform bill we will see in this Congress.
So you have to find $100 billion to cut out of the roughly $1.1 trillion in discretionary spending. That’s a cut of about 9 percent. It is going to be noticeable, especially because it will not be distributed equally. Popular items, such as veterans’ benefits, will almost certainly be left alone. That means the cuts will come out of segments such as education, housing or the federal payroll itself.
Or, of course, the cuts could come out of the biggest discretionary piece: military spending. Under a Democratic administration or a Democrat-controlled Congress, that is exactly where such cuts would mainly come from, in fact. But the current regime wants to increase military spending, not cut it, which means this solution is almost certainly off the table.
There are two other options. You could opt not to cut the corporate tax rate by as much, but that would mean sacrificing the worthy goals of tax reform. Or you could give up the idea of making up all the lost revenue, increasing the debt burdens on future generations of taxpayers.
My guess is that the final outcome will be a little of all of the above – except the border adjustment. President Trump has dismissed it as too complicated. That’s probably true. But more importantly, the border adjustment plan is too unfairly targeted at the retail sector and its less-affluent customers. I won’t be sad to see it go.