President Donald Trump and his allies in Congress have big plans for tax reform, and thereâ€™s something to be said for ambition. But the way theyâ€™re promoting their ideas suggests they donâ€™t quite understand their consequences — and that raises larger questions about whether the plan could work at all.
House Republicans have long proposed cutting the corporate tax rate from the current 35 percent to 20 percent. But with Trump, theyâ€™ve added a twist: the so-called border adjustment.
Under the current corporate tax system — gross oversimplification alert! — firms tally their revenues, deduct their costs, and pay a tax on the difference. With a border adjustment, all this changes. Firms wouldnâ€™t be able to count revenue from exports, nor would they be able to deduct the cost of imports. This would make the corporate tax work something like a value-added tax, which most other countries rely on for a substantial share of their revenues. In effect,
the change would turn the US corporate tax into a tax on domestic consumption.
The plan is not without appeal. Because multinational firms would pay taxes on domestic revenue no matter what, they would have no incentive (as they do now) to shift profits to overseas subsidiaries in low-tax jurisdictions. And because it would end the deductibility of imports — and the U.S. imports more than it exports — the plan would raise additional revenue, as much as $100 billion a year.
Isnâ€™t this barely disguised protectionism? Not really. True, the new tax would force up the price of imports in much the same way as a tariff, but in due course the dollar would appreciate. That would make imports cheaper and exports dearer, in the end leaving prices to consumers as before. Even after this adjustment had happened, the US would retain the fiscal benefits: extra revenue (which would allow other taxes to be cut), and no more profit-shifting.
The problem is what happens next. How would the administration respond to the substantial strengthening of the dollar that the reform would induce — and in fact would have to induce in order to work well? Presumably, the administration would denounce this as “currency manipulation” on the part of US trading partners, and see it as providing grounds for an outright protectionist response.
There are other drawbacks. In principle, border adjustment on corporate taxes should be no more objectionable to advocates of liberal trade than border adjustment under a valued-added tax. The World Trade Organizationâ€™s current rules, though, take a different view, and the Republicansâ€™ plan would likely give rise to legal objections and possible retaliation.
Thatâ€™s not all. Though a stronger dollar would boost US real incomes, some groups would lose. For instance, a stronger dollar would cause a big shift of wealth from US holders of foreign assets to foreign holders of US assets. Some countries with heavy dollar-denominated debts might struggle to meet their obligations, and the resulting financial strain could easily rebound on the US.
No question, the US corporate tax needs reform. The current rate is far too high and the incentive to park earnings abroad much too strong. A broader, simpler base with lower rates would be a big step forward all by itself, and a relatively easy undertaking. Radical reform, guided by policy makers who donâ€™t always seem to know what theyâ€™re doing, is too much of a gamble.