Is Border-Adjustment the Answer to Broken US Corporate Tax Structure?

The US corporate tax system combined with globalization turns free trade into unfair trade (see last post). Profits domestic companies make overseas are not taxed until they come home; so, naturally, corporations invest these profits abroad and build new factories abroad and favor the output of their foreign factories even if the cost of labor is the same or somewhat better in the US. To add insult to injury, while we are favoring imports with our tax code, most of our trading partners (including all OECD countries except us) favor their exports by rebating value added tax (VAT) when goods leave their country.

If we are going to continue to have the benefits of free trade and globalization, we must make sure free trade is fair to American workers. Sanders and Trump voters are right in saying that these benefits are flowing to the 1% at the expense of American workers. I’m embarrassed not to have thought about this before being hit alongside the head by the strength of these voters’ anger.

One proposal to solve these two problems in the corporate tax code is called a border-adjusted tax. Here’s how The Economist describes it:

“Firms currently pay corporate taxes on their profits. Border-adjustment would change how those profits are calculated. Accountants could no longer deduct imports—say, goods brought in from China—as costs. And their exports would no longer count as revenues. For tax purposes, “profits” would be domestic sales minus domestic costs. Effectively, imports would be taxed, and exports would be subsidized.”

Let’s take a toy which can be purchased by Walmart’s in China for three dollars and which costs twenty cents to bring home. Since the VAT in China is 17%, the refund to Walmart on export to $.51. The net cost is $2.69. Suppose the toy can also be purchased from a factory in the US for three dollars and local transportation is only a nickel. Since there is no refund of corporate taxes in the US like the VAT refund, the cost to Walmart for the US product is $3.05 - $.36 higher than the Chinese toy. Let’s suppose the toy sells for $3.99 at your local Walmart. Under the current system Walmart has a gross taxable profit of $1.30 on the Chinese toy and of $.94 on the US equivalent. Assuming for the sake of example that Walmart pays the effective US corporate tax rate, which is about 26% according to the GAO, the after tax profit on the Chinese product is $.96 and only $.70 on the US product, even though manufacturing costs were the same and transportation from China is more expensive. How do you compete with that?

One answer is border adjustment. Let’s border adjust the example:

This time Walmart is not allowed to deduct the cost of the imported product when calculating its taxable profit, which we’ll assume includes transportation (actually depends on the version of border-adjustment). The full $3.99 sales price is now taxable incremental income to Walmart and the tax due at 26% is $1.03. Walmart will now have an after tax loss of $.07 cents on the Chinese toy as opposed to a gain of $.70 on the US product. Guess who gets the order for the toy – even if the US cost of manufacture is actually somewhat higher.  If, after the tax change, Walmart still wants to make the same after tax profit on the US toy that it used to make on the Chinese toy, it will have to raise the selling price from $3.99 to $4.34. There’s no question that’s an added cost to US consumers (although it might not all be passed through); but all of the cost of the product stays in the US economy.

Walmart is NOT in favor of a border-adjusted tax nor are most other retailers or processors of imported raw materials like refineries. The Koch brothers are against it. See this website for many arguments against.

Suppose the US and China are competing to sell the toy to a third country and transportation is the same and suppose that both factories have a cost of goods and labor of making the product of $2.00. They both sell nominally at $3.00; but the net cost to the buyer of the Chinese toy to the buyer is only $2.49 after the VAT refund. Guess who gets the sale. But, with a border-adjusted tax, the US seller essentially has been forgiven tax on the whole selling price – a savings of $.82 at the effective tax rate of 26%. Now the US manufacturer can afford to drop its price and will win the sale – even if the US price of labor is somewhat higher, the US still gets the sale. The US is more likely to be selling airplanes than toys so add eight zeros to the end of all these numbers.

Boeing is in favor of a border-adjusted tax as are most US manufacturers, drillers, and miners. Farmers are on the fence because of fear of foreign retaliation. This website is sponsored by a who’s who of companies that a border-adjusted tax would benefit.

In a perfect world neither imports or exports would be advantaged. But we don’t live in that world; all of our major trading partners DO advantage their exports. Border-adjustment is one way to enable US workers to compete fairly – even if we pay a little more at Walmart. It’s the best way I’ve seen so far and far better than a set of punitive tariffs – although some countries might challenge it as unfair and we might suffer some retaliation (but they already have VAT refunds). If we had a border-adjusted tax, we could drop a crazy-quilt of tax exemptions whose purpose is to make our products competitive as well as subsidies like the Import-Export Bank.

A border-adjusted corporate tax is part of the tax reform plan Speaker Ryan has been working on for years. It is not clear whether it has enough Republican support to pass nor how much Democrat support to can muster. President Trump is ambiguous on it.

The real shame will be if this important debate gets lost in the noise of hyper-partisanship and the lobbyists keep control of the tax code.