Most countries around the world and all high-income countries other than the United States have ”border adjustments” in their tax code.
However, a key point to recognize is that border adjustments are typically part of a value-added tax–not the corporate income tax.
A value-added tax is essentially similar to a national sales tax in its economic effects. However, instead of being collected at the time of purchase, like the sales taxes with which Americans are familiar, a value-added tax is collected from firms throughout their production process. For example, the common ”credit invoice” VAT works like this: As a starting point, the firm calculates what the value-added tax would be if applied to all of its sales. However, every time a firm buys a good or service from an outside supplier, it receives an invoice, and on that invoice is recorded the VAT previously paid by the supplier. The firm starts with what it would need to pay if the VAT rate was applied to all of its sales, but then subtracts out the value-added tax that was already paid by its suppliers at an earlier stage of production. Through this ”credit invoice” method, the value-added tax is only applied to the ”value-added” that the firm itself has created. Also, as a matter of enforcement, every time a firm buys inputs it has an incentive to make sure that the previous firm paid the value-added tax that was due at that earlier stage of production.
It’s important to notice that”value-added” is not equal to profits. The ”value-added” of a firm includes both wages paid to its workers–who are the ones adding value, after all–as well as profits.
To understand how the ”border adjustment” comes into play, consider the situation across US states when different states have different sales tax levels: say state A has a sales tax of 5% and state B has no sales tax. If a firm based in state B makes a sale in state A, state A will charge sales tax on the product ”imported” across the state border. But if a firm from state A sells in state B, then no sales tax is charged on the product ”exported” to the other state. Similarly, imagine two countries with different rates of value-added tax. When imported goods arrive across international borders into a country with a value-added tax, they need to pay a border adjustment. The purpose is not to put imports at a disadvantage, but only to avoid giving imports a special advantage of being able to avoid the value-added tax.
Alan Auerbach and Douglas Holz-Eakin provide a longer discussion in ”The Role of Border Adjustments in International Taxation,” written for the American Action Forum (November 30, 2016). As they write:
”Unlike tariffs on imports or subsidies for exports, border adjustments are not trade policy. Instead, they are paired and equal adjustments that create a level tax playing field for domestic and overseas;
”Border adjustments do not distort trade, as exchange rates should react immediately to offset the initial impact of these adjustments. As a corollary, border adjustments do not distort the pattern of domestic sales and purchases;
”Border adjustments eliminate the incentive to manipulate transfer prices in order to shift profits to lower-tax jurisdictions; and
”Border adjustments eliminate the incentive to shift profitable production activities abroad simply to take advantage of lower foreign tax rates.”
To this point, the explanation answers one question, but opens up several others. The question that (I hope) is answered is why a tariff that places a tax on imports is different from a border adjustment. The typical border adjustment is not about the disadvantageous imports relative to domestic production: it’s just making sure that imports pay the same value-added tax as is paid by all other products in the country.
The question that is opened up sounds something like: ”But the US doesn’t have a value-added tax, and so why does the idea of border adjustment even come up when talking about corporate tax reform?” The answer to this question is that the proposal from House Republicans for revising the corporate income tax is actually a first-cousin-once-removed of a value-added tax. The proposal is to eliminate the existing corporate profits tax, and then to replace it with what is sometimes called a ”destination-based cash-flow tax.”
The ”destination-based” language means that US corporations would be taxed based on the destination of where their goods are sold, not based on where they are produced. The ”cash-flow tax” language means that the tax would look a lot like a value-added tax, except that firms would not need to pay the tax either on inputs purchased from other firms, and also not on wages paid to workers (as occurs in a standard value-added tax).
Most countries have both a value-added tax and also a corporate income tax, viewing them as two different creatures. The proposal to install a destination-based cash flow tax as a replacement for the corporate income tax is in some ways a hybrid of the two.
Alan Auerbach provides a readable academic discussion of how this kind of corporate tax can work in ”A Modern Corporate Tax,” published jointly by the Hamilton Project at the Brookings Institution and the Center for American Progress back in December 2010. He points to a number of advantages from this kind of change.
The new destination-based cash-flow tax would be a form of a consumption tax: that is, it taxes firms based on what is consumed (whether through domestic production or imported goods), but would not have a corporate tax on exports. Firms would no longer depreciate equipment over time; instead, it would be treated as an expense the year such investments are made, which should tend to encourage investment. This plan would also stop the corporate gamesmanship of juggling the accounting so that profits seem to occur in low-tax jurisdiction, and should make the US an attractive place for foreign firms to invest. Auerbach writes:
”Most countries, including the United States, attempt to collect corporate taxes based on where a corporation’s profits are earned. The problems with this approach are that businesses and investments are increasingly internationally mobile and a business’s profits are intrinsically hard to attribute to a particular place; indeed, the fungibility of profits results in a system where a disproportionate share of the profits of multinational companies appear to occur in the world’s least-taxed countries. Current corporate tax systems generate incentives that result in the current environment where countries compete for multinational business activity by lowering their corporate tax rates. To remedy this situation, sales abroad would not be included in corporate revenue nor would purchases or investment abroad be deductible in the second major piece of the proposed corporate tax reform. As a result, the corporate tax would be assessed based on where a corporation’s products are used rather than where the corporation is located or where the goods are produced. Assessing the tax based on where a firm’s products are used eliminates issues of where to locate a business and incentives for U.S.-domiciled businesses to shift profits abroad to reduce U.S. taxes.
”This plan therefore delivers a host of economic advantages to U.S. businesses and American workers. Promoting domestic corporate activity and encouraging investment would boost productivity, the key driver of increases in wages, employment, and living standards. Indeed, estimates of similar proposals suggest these changes could increase national income by as much as 5 percent over the long run. … This new tax system also would retain or even increase the progressive element of the corporate tax system. The proposal would effectively implement a tax on consumption in the United States that is not financed out of wage and salary income.”
It's worth contrasting the ideas about corporate taxation here with the broader claim that this tax is one way that the previous Trump administration wanted to ”make Mexico pay for the wall.” The border adjustment tax would apply to all imports, not just those from Mexico, for the reasons given above. As a consumption tax, it would raise prices to American consumers, who would be the ones paying for the tax. Assuming that it leads to a stronger US dollar, as pretty much all economists who study this subject expect, it won’t end up affecting the US trade balance: basically, any effect of the border adjustment in reducing imports would be offset by a stronger dollar that will tend to raise imports by a roughly offsetting amount.
For a quick question-and-answer about the destination-based cash flow tax, a useful starting point is the short essay by William Gale on ”Understanding the Republicans’ corporate tax reform proposals,” ”The corporate tax is ripe for reform. The DBFCT is an excellent way to kick-start the needed discussion.”
In short, there’s also a nubbin of a good idea here about reforming corporate taxes, although it has essentially zero to do with unfair trade, cutting better trade deals, reducing imports, or ”making Mexico pay for the wall.” If some suitable and substantial adjustments are made–starting with a higher tax rate than is included in the current proposal from the House Republicans–a corporate tax reform along these lines is a potentially practical way of addressing many of the counterproductive incentives in the US corporate income tax. For example, US firms are currently holding about $2.5 trillion in cash outside the country, rather than bring it back and have it subject to the existing US corporate income tax. That’s just one symptom of a deeper dysfunction with the US tax code.
Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.