International tax policy for a vibrant American economy
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Controversy has emerged over “border adjustment,” a key provision in the House Republican tax reform blueprint. This is unfortunate, as the underlying policy has an important goal: to level the tax-based playing field in international competition.

Today, a business producing goods in the United States and selling them overseas faces the corporate income tax on those exports. The House proposal would rebate its 20 percent cash flow tax on exports and would impose the tax on imports. Together, these provisions ensure that the tax puts domestic and foreign production on an even footing that depends on destination. This means that products used in the U.S. are taxed in the U.S., and products not used in the U.S. are not taxed here, regardless of where they are made.

For some, this raises the specter of a tax collector in every port, but that’s far from reality. The House provision is implemented in an easy, transparent and elegant manner. As each firm prepares its year-end tax return, it would exclude from the tax base all cross-border transactions. Specifically, it would not report overseas sales revenue—effectively exempting it from the U.S. tax—or costs of imports into the U.S., thereby including the cost of imported intermediates in the 20 percent tax.

For others, the focus on borders and taxes means that the goal is to reduce imports and expand exports. In other words, they view the proposal as trade intervention in disguise. Again, this is off the mark.

Unlike tariffs on imports or subsidies for exports, a border-adjusted tax code is not trade policy. Instead, the paired and equal adjustments on the import and export sides create a level tax playing field for domestic and overseas producers. More importantly, border adjustments do not distort trade, as exchange rates should react immediately to offset the initial impact of these adjustments.

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To see this, note that relieving U.S. exports of the tax immediately makes those goods more competitive in global markets and increases the demand for dollars to buy them. Similarly, the U.S. tax on imports would reduce demand for them and lessen the demand for foreign currencies.

Together, these provisions should cause the dollar to appreciate immediately, until the incipient increase in export demand and decrease in import demand are eliminated. In the case of imports, what used to be an import cost of $1 will change into $0.80 of purchases and $0.20 in tax liability, while the reverse would be true for exports.

Because the move to a border-adjusted tax system changes the composition of the cost structure, but not overall costs and prices, the system does not distort trade. Production, export, import and purchase decisions continue to be driven by the fundamentals. As a corollary, border adjustments also do not distort the pattern of domestic sales and purchases.

These “do no harm” neutrality provisions may be appealing to economists, but they don’t answer the basic question: why do this at all? There are three important reasons.

First, the tax code is much simpler. A U.S. multinational firm engages in three types of transactions: between its foreign affiliates and others abroad, between the domestic company and its foreign affiliates, and between the domestic company and others in the U.S. To compute their tax under the House proposal, firms operating in the U.S. would need only report transactions of the last type—domestic transactions. This limited focus also makes it easier to verify that firms are complying with the tax code.

Second, there should be less pressure on compliance to begin with. Because the tax base is unaffected by the value of exports or the cost of imports, border adjustment eliminates any incentive to “game” the tax system. Currently, there are incentives to manipulate “transfer prices” between domestic and overseas operations in order to overstate import costs and understate export sales. The result is that reported profits are lower in the U.S. and shifted overseas to lower-tax jurisdictions.

Since cross-border transactions don’t enter the tax base under the new system, transfer prices can’t lower U.S. tax liability. The incentives to misstate sales and costs are gone. It is a simple, straightforward alternative to messy, unending attempts at formulating “base erosion rules” as a way to maintain the integrity of the tax base.

Finally, border adjustment does more than just keep firms in line on paper transactions. Most important, it removes incentives for domestic firms to relocate production offshore. Because they will owe taxes on U.S. sales whether production takes place in the U.S. or elsewhere, and owe no U.S. taxes on non-U.S. sales, they will gain no tax benefit from shifting operations abroad. And with foreign countries still taxing production occurring there, shifting operations abroad will be a losing proposition.

Border adjustment isn’t mercantilism in disguise. It needn’t even be applied at the border. It is a tax policy that levels the competitive playing field and has a neutral impact on trade flows. Most importantly, it preserves the integrity of the tax base and the incentives for companies to hire, expand and grow in the United States.

Douglas Holtz-Eakin is president of the American Action Forum. He served as director of the Congressional Budget Office under President George W. Bush from 2003 to 2005. Alan Auerbach is a professor of economics at the University of California in Berkeley and director of the Robert Burch Center for Tax Policy and Public Finance. He served as deputy chief of staff of the U.S. Joint Committee on Taxation in 1992.


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