The Proposed Border Adjustment Tax
Incoming and outgoing international trade in San Francisco Bay
Wikimedia Commons / National Oceanic and Atmospheric Administration
Arguments over U.S. tax policies are moving toward a controversial tax proposal around which all other tax discussions are centering. That tax proposal, offered by House Speaker Paul Ryan (R-WI) and House Ways and Means Committee Chairman Kevin Brady (R-TX), is the Border Adjustment Tax (BAT). If this proposal cannot pass Congress, it is quite possible absolutely no tax reform will pass this year, a prospect that would be catastrophic not only for Republicans, but for the country as well.
What the Border Adjustment Tax Is
The border adjustment tax, also called a Destination-Based Cash Flow Tax (DBCFT) at first glance appears to be a tariff, but is actually an adjustment on a company’s income taxes based on its international trade. With this adjustment profits from exports would not be taxable, while the cost of imported goods would no longer be deductible from income taxes. Corporate income taxes would have a 20% levy on the cost of imports. Clearly, this would have the effect of encouraging American exports and discouraging imports, making the tax a mercantilist measure. Even more to the point, the Tax Foundation, a Washington think-tank, estimates the Republican proposal would raise about $1 trillion over a decade’s time. This is important since it is just about the only politically palatable way to keep the whole tax plan, including large corporate and middle class tax cuts, revenue neutral. Why this in turn is important is explained in an Atlantic.com post entitled Who’s Afraid of a Big BAT Tax?.
It’s a question of Senate math. To pass with a simple majority (and avoid a filibuster by Democrats), the GOP’s plan must go through under the procedure known as reconciliation. But to qualify for reconciliation, the package–which slashes both corporate and upper-bracket taxes–cannot blow a hole in the long-term budget. Without the $1 trillion in revenues from BAT, say advocates, there’s no way that hole can be plugged.
“This is the only way at these rates and keeping things revenue neutral,” insisted a senior Republican aide. There is no other viable option. Period. End of story.
Therefore, to pass any tax reform at all that cuts the total tax burden for all companies plus the middle class, either the BAT or some other tax must must be raised to keep total revenues approximately the same. Otherwise, the Senate rules for reconciliation with the budget resolution would not be met and debate would not be limited to 20 hours. Without something like the BAT in a tax reform bill, the Democrats could filibuster the bill to death.
Below is a video from Youtube produced by the Wall Street Journal explaining some of the intricacies of a BAT.
Arguments Over the Border Adjustment Tax
Republican opposition to the BAT in Congress has been vociferous. Some Republican senators such as Sen. Tom Cotton (R-AR), Sen. David Perdue (R-GA), and Sen. Orrin Hatch (R-UT) have been reported as seriously questioning the soundness of a BAT bill or openly opposed to it. Tom Cotton is reported to have said concerning BAT,
Some ideas are so stupid only an intellectual could believe them. This is a theory wrapped in speculation inside a guess. Nobody knows for sure what will happen.
One of the major purposes of foreign trade is to provide Americans with goods at lower cost, and it should be obvious that an increase in importing companies’ costs with BAT might negate that advantage with higher corporate taxes on imports at least partially passed on to customers. That is, much of the cost savings is siphoned away from consumers and corporations via a BAT and then handed to the federal government. That is enough to get any neoliberal (i.e. conservative) Republican exercised.
Other arguments against the BAT cite the tax’s inherent complexity, and the fact that firms who import foreign goods, or use them as intermediate inputs to finished goods, or retail them are all punished to favor exporters. In this way the federal government distorts markets, and choses exporters as winners over importers. This seems as great a market distortion as any Keynesian stimulus.
In the BAT’s defense, Dr. Martin Feldstein, professor of economics at Harvard and chairman of the Council of Economic Advisors in the Reagan administration, wrote in the Wall Street Journal that the extra cost of the border adjustment to importers would not really occur. This is “because the dollar’s international value would automatically rise by enough to eliminate the increased cost of imports and the reduced price of exports.” He explains further,
Here’s why. If the exchange rate remained unchanged, the higher price of U.S. imports would reduce the U.S. demand for imports and the lower dollar price of U.S. exports would raise the foreign demand for American exports. That combination would reduce the existing U.S. trade deficit.
But as every student of economics learns, a country’s trade deficit depends only on the difference between total investment in the country and the saving done by its households, businesses and government. This textbook rule that “imports minus exports equals investment minus savings” is not a theory or a statistical regularity but a basic national income accounting identity that holds for every country in every year. That holds because a rise in a country’s investment without an equal rise in saving means that it must import more or export less.
Since a border tax adjustment wouldn’t change U.S. national saving or investment, it cannot change the size of the trade deficit. To preserve that original trade balance, the exchange rate of the dollar must adjust to bring the prices of U.S. imports and exports back to the values that would prevail without the border tax adjustment. With a 20% corporate tax rate, that means that the value of the dollar must rise by 25%.
With a 25% rise in the value of the dollar relative to foreign currencies, the $80 net price of U.S. exports would rise in the foreign currency to the equivalent of 1.25 times $80, or $100, and therefore back to the initial price. Similarly, the 25% rise in the value of the dollar would reduce the real import price to the U.S. retail customer back to $125/1.25, or $100, as it is without the border tax adjustment.
He goes on to argue that although the original trade balance is unchanged due to revaluations of international currencies, the border adjustment tax will still raise a lot of money to replace what was lost through tax cuts. He estimates tax adjustments will yield about $120 billion per year in new revenues and over a trillion dollars over ten years.
Even better, this $120 billion per year revenue gain by the federal government will not be borne by U.S. consumers or companies, but by foreign consumers and companies. The stronger dollar means fewer dollars are required to buy foreign goods, with the increased U.S. dollar savings captured for the federal government by the border adjustment tax.
In addition, although U.S. prices of foreign goods, will remain unchanged due to currency adjustments, American corporations that export will still be encouraged to increase their exports since the BAT exempts export profits from taxation. This result will be good for increased employment for exporting companies, helping to erase increases in unemployment due to import substitution.
Most Important Aspects of the Argument
The most potent counterargument by Paul Ryan, Kevin Brady, and other proponents of BAT might be simply to ask the critics what their alternative is. If the Republicans are to succeed in restarting the American economy, the cutting of high corporate marginal taxes and middle class income taxes is an absolute necessity. Merely cutting onerous economic regulations, although necessary and useful, will not be sufficient because they will not make American companies competitive with foreign companies paying lesser taxes. Other methods of offsetting corporate and middle class tax cuts, such as a Value Added Tax or VAT, would almost certainly garner even more strenuous opposition.
Yet, to attempt to cut high corporate marginal taxes and middle class income taxes without some revenue offsets to replace them achieves nothing but immediate failure. If Republicans try to pass tax reform without offsets, the reform bill cannot enjoy the status of a reconciliation bill, and the Democrats will merely filibuster it to death.
That is probably the single most important argument about the prospect of border adjustment taxes: Without them or an equivalent in terms of offsetting the tax cuts, the absolutely essential tax reform we need will just not happen, and the American economy will continue to sputter.
If opponents of BAT can not find an alternative to it, I would recommend they consider the following point. All taxes are destructive of economic activity and freedom to some degree. Almost by definition they take away the use of economic assets from the private-sector. Yet they are a necessary evil because we do need some government services to survive as a free and prosperous nation. The only question left is which kinds of taxes do the least amount of damage. In an environment where the country has suffered an almost continuous negative balance of trade for decades, a little mercantilism might be acceptable for a short period of time. Nevertheless the ultimate aim should be for completely balanced trade, with imports equaling exports averaged over some small time period. For now, however, especially since the passage of all the rest of tax reform depends on it, voting for border adjustment taxes may be the least evil of all the choices.
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