Border Adjusted Tax: Implications for Importers and Exporters
Much of the discussion surrounding tax reform in the first months of the Trump Administration has centered on the implementation of border-adjusted tax. But what exactly is a border adjusted tax, and how does it work?
While the Administration has talked about the imposition of “border taxes,” most of the ideas floated have been more akin to tariffs designed to punish U.S. companies that import goods into the country. In contrast, House Republicans, led by House Speaker Paul Ryan, have put forth a proposal that is designed to include a border adjustment component in a far more sweeping reform of the corporate tax system.
Destination-Based Cash Flow Tax with Border Adjustment
Currently, the U.S. imposes a true net corporate income tax, a direct tax imposed on the net income of corporations after allowances for costs of goods sold and other expenses such as wages, depreciation, interest income and administrative costs.
The GOP proposal would implement a border tax (technically, a “destination-based cash flow tax” or “DBCFT”) under which tax jurisdiction would follow the location of consumption rather than the location of production. The border tax would include an immediate allowance for all asset purchases (as opposed to the current depreciation rules) and a border adjustment that would disallow the deduction of imported parts or finished goods and would exclude revenue from exports from taxable income. The border tax would be imposed at a rate of 20%, as opposed to the current 35% corporate income tax rate.
To illustrate the difference, assume that MyCo has $100,000 in annual revenue, and it spent $50,000 producing its inventory, $10,000 on wages, $20,000 on other administrative costs and $10,000 on new machinery. Under the current tax regime, MyCo would deduct $82,000 ($50,000 in production costs, $10,000 in wages, $20,000 in administrative costs and hypothetical annual depreciation of $2,000 on the machinery purchase), resulting in net taxable income of $18,000 and a tax of $6,300 ($18,000 x 35%). However, if a DBCFT were imposed, MyCo would be allowed to deduct the full amount of all the expenses listed above, including the total cost of the machinery, which would result in a tax base of $10,000 and, at the 20% rate of tax under the GOP proposal, a tax of $2,000.
In the absence of a border adjustment, revenues would plummet under the GOP proposal. In theory, the border adjustment is designed to alleviate these concerns, primarily through the disallowance of any deductions for parts and finished goods imported from outside the U.S. For example, a company with $1 million in total revenue that has inventory costs of $500,000, $400,000 of which were incurred in importing inventory from other countries, would only be allowed to deduct $100,000 for the cost of inventory, thereby dramatically increasing its tax base. In contrast, companies that export products would be permitted to deduct the full amount of their export sales from their total revenue. Accordingly, a company with $1 million in total revenue, $700,000 of which is derived from exports, would deduct the full $700,000 amount from their tax base prior to any other adjustments for wages, asset purchases or administrative costs. In such an example, the company is likely to pay no tax, or even generate a tax loss, despite being profitable.
One primary argument in favor of the border tax and its border adjustments is that it will encourage U.S. companies to stay home as opposed to seeking tax havens outside the country. Given that the plan would shift the basis of taxation from where companies produce to where they sell, it likely would lessen current incentives to move outside the U.S. or to employ mechanisms like transfer pricing or corporate inversions.
Perhaps the most important aspect of the plan is that, because U.S. companies sell more in the U.S. than they produce in the U.S., the border adjustment will generate sufficient revenue to help pay for the reduction in the tax rate from 35% to 20%. The Tax Foundation has estimated that the border adjustment, as applied in the context of the GOP proposal, will raise $1.1 trillion over 10 years.
So who wins, importers or exporters?
Naturally, partisan groups on either side of the argument contend that the GOP proposal creates winners and losers. The National Retail Federation, for example, contends that the plan will force retailers to increase the cost charged to consumers for imported merchandise by at least 15%. Automakers and oil companies, which are each reliant in some way on imports, also could stand to lose. In contrast, purely domestic corporations would automatically gain through the reduced tax rate, and companies like Boeing, which are engaged largely in exporting domestically produced goods, would also benefit.
At first blush, the border tax seems to benefit exporters and harm importers, but economists believe that the plan would eventually be trade neutral because it will create higher demand for U.S. goods. This increase is projected to lead to a stronger U.S. dollar, making it less expensive to import goods, which will offset the higher tax on imports imposed by the border adjustment.
Similarly, while exporters would pay lower taxes under the plan, a stronger dollar would make exporters’ products more expensive to purchase in foreign markets, thereby offsetting the lower tax rate. Of course, it is impossible to predict with certainty exactly how currency markets would adjust to the plan, particularly in the short term, but the Tax Foundation notes that there is historical evidence, particularly related to the U.K.’s increases in its border adjusted value-added tax (“VAT”) over the past 40 years, that markets do adjust quickly to such changes.
There have been recent indications that the Trump Administration plans to advance its own tax reform plan without a border adjustment tax, further complicating the landscape.