Stuart E. Leblang was Treasury associate international tax counsel from 1995 to 1997. Amy S. Elliott was formerly a contributing editor with Tax Notes magazine.
In this article, Leblang and Elliott argue that Congress may want to consider an alternative tax for importers that would replace the border-adjusted tax until the cost of imports decreases sufficiently to put them into a better after-tax profit position.
Copyright 2017 Stuart E. Leblang and
Amy S. Elliott.
All rights reserved.
Powerful interests, including major retailers, automobile dealers, and the Koch brothers, have spent the last few weeks railing against the border-adjusted tax in the hopes that they could sway President Trump to reject what is a central component of the business tax reform plan -- called "A Better Way" -- championed by House Speaker Paul D. Ryan, R-Wis., and Ways and Means Committee Chair Kevin Brady, R-Texas.
The plan would effectively replace the corporate income tax with what is called a destination-based cash flow tax. Brady has indicated that he doesn't intend to implement it overnight but may use transition rules to ensure that the currency adjustment magic (that he claims will prevent net importers from taking a hit and will protect consumers from price increases) will actually come to pass. Those assurances haven't won over the critics who see the border-adjusted tax as simply a 20 percent tax on all imports that will most likely be passed on to consumers.
Because of this growing opposition, it may be prudent for Congress to consider a special backstop -- an alternative tax -- for certain importers if the currency adjustment integral to the Ryan-Brady plan doesn't come to pass right away, causing their after-tax profits to decline.
A subset of businesses (including many retailers, some oil refiners, and others whose historic costs are made up of some threshold percentage of imports -- for example, 25 percent) could be allowed to use an alternative tax calculation that is more favorable than the Ryan-Brady plan in limited circumstances. This would not carve out any businesses or industries from the Ryan-Brady plan, because the alternative tax result generally would only be more favorable than the result under the Ryan-Brady plan if the dollar does not sufficiently appreciate.
Businesses eligible for the alternative tax calculation would generally be allowed to deduct nearly all of their import costs from a tax base otherwise like the Ryan-Brady plan (allowing for full expensing, for example), and then would apply a tax rate similar to the top rate under current law, for example 35 percent.
Businesses using the alternative tax would get a tax answer similar to current law. The alternative tax calculation contains a design feature (described in detail below) that would ensure that the only way for a business to end up with a better after-tax profit than what it has today would be for the currency to appreciate or its import costs to otherwise decrease and for it to be taxed under the Ryan-Brady plan.
The alternative tax is insurance for importers that fear they'll be faced with taxes that are increasing but costs that aren't decreasing. Without it, the skepticism about currency exchange rate adjustments may prove to be insurmountable.
Other alternative solutions -- including relief tied to currency adjustment failures, trade distortions, or price levels -- are unworkable because they are almost impossible to measure. Transition to the border-adjusted tax by way of a four-year, across-the-board phaseout of the import deduction and phase-in of the export exemption should also be rejected. It provides insufficient relief for importers if the currency doesn't adjust -- and if the currency adjusts more quickly in anticipation of the phase-in, exporters would be harmed.
The alternative tax proposed here is designed to help reassure those businesses that are afraid they will be worse off under the Ryan-Brady plan. If the dollar gets stronger relative to other currencies -- something it has done by 25 percent over a recent 30-month period without deleterious effect -- importers will be better off not using the alternative tax calculation.
The Alternative Tax Calculation
We expect that the alternative tax would be available only to a limited subset of businesses with relatively high import costs (for example, those with historic import costs of 25 percent compared with total costs, although this could be refined to remove the cliff effect).
The alternative tax calculation is like current law in that eligible businesses will be allowed to deduct most of their import costs. We expect the alternative tax will have a rate similar to the top corporate income tax rate under current law (somewhere around 35 percent). However, the alternative tax base will generally be smaller than it is under current law for retailers. With the exception of the import deduction, we expect it will look more like the base in the Ryan-Brady plan.
While most import costs will be deductible under the alternative tax, there will be a limitation. Import costs attributable to related-party profit markup will be disallowed. This limitation is necessary to ensure that inverted companies and multinationals won't be able to use transfer pricing manipulations to shield a portion of their profits from U.S. tax.
All unrelated-party import costs are deductible in the alternative tax calculation. However, related-party import costs can only be deducted as long as they're traceable to real expenditures such as costs paid for parts and labor. If a related party marks up an import purely for profit, that profit element cannot be deducted in the alternative tax calculation. (Because this is a backstop, eligible businesses will be held to higher documentation standards for substantiating cost allocations to prevent abuse.)
The other caveat to the alternative tax is that it will be adjusted in cases in which it causes the business to achieve an after-tax U.S. operating profit margin that is greater than that business's historic average (which could be calculated by averaging the business's top three annual after-tax U.S. operating profit margins out of the last five years). A similar firm-by-firm baseline was contemplated in 2005 by the President's Advisory Panel on Federal Tax Reform as part of a transition to the growth and investment tax, which is like the destination-based cash flow tax.
To understand how it would work, imagine that Congress enacted the Ryan-Brady plan with an alternative tax available for certain import-oriented businesses. A business with high import costs (RetailCo) calculates what its tax would be under Ryan-Brady and doesn't like what it sees. Ryan-Brady may cause RetailCo's after-tax U.S. operating profit margin to drop sharply or go negative (for examples with numbers, see the appendix).
Instead, RetailCo pays the alternative tax, which generally gives it a better after-tax U.S. operating profit answer than the Ryan-Brady plan and a similar tax answer (unless it has a lot of related-party import profit markup) to what it has under current law.
If at any time -- and this will generally happen when the currency adjusts and RetailCo's import costs go down -- the alternative tax calculation would cause the business to have a better after-tax U.S. operating profit margin than its historic average, then the tax due is increased (or if it is designed as a credit, the credit is decreased) to prevent such a result. According to our estimates, in many cases well before the dollar has appreciated by 25 percent (for whatever reason), the business will find that it is better off being taxed under the Ryan-Brady plan.
The alternative tax isn't simple or perfect. Several complications will have to be taken into account. The use of a U.S. operating profit margin cap raises various accounting considerations, and rules will need to be established to provide uniformity and prevent manipulation. Economic factors like a recession could also affect the calculation, complicating the transition away from the alternative tax.
However, if a solution like this could actually be designed to work, it could have a significant impact on the debate because it would substantially address many of the arguments levied against the Ryan-Brady plan.
Insuring Against Currency Adjustment
Although the alternative tax will act as insurance for importers if the currency doesn't adjust, it doesn't remove the incentive for currency adjustment. The alternative tax is designed so that if the currency fully adjusts, businesses will always be better off being taxed under the Ryan-Brady plan, all else being equal. Because of this feature, we think it shouldn't significantly impede the currency adjustment but should help feed into all of the many market factors that will fuel the change.
As the dollar appreciates, the import cost deductions built into the alternative tax calculation become less and less valuable. At some point -- in many cases well before the currency has appreciated the full 25 percent anticipated under the border-adjusted tax -- businesses will want to be taxed under a system that doesn't cap their after-tax U.S. operating profits and that offers a low 20 percent rate even though they'll lose their import deductions.
The revenue impact of the alternative tax will depend on the alternative tax rate (we use 35 percent, but that is just to help show how the numbers might work) and base and which businesses will be eligible.
However, we think those parameters can be designed to ensure that on day 1, assuming no currency adjustment, the government would get approximately the same amount of revenue from alternative tax businesses as it receives from them now under current law. Note that if the currency doesn't adjust over time, that presumably would alter the trade balance, encouraging exports and potentially resulting in a boost to the economy.
Although this alternative tax approach could raise its own unique issues under the WTO's anti-discrimination rules, we think it could be designed so that it is less problematic to implement than some alternatives.
Threatening the Closed System
If the perfect world that economists envision comes to pass and the Ryan-Brady plan causes the dollar to appreciate enough to offset the border-adjusted tax, few if any businesses will use the alternative tax calculation because they generally will have higher after-tax profits under Ryan-Brady. If the dollar takes time to appreciate, then as that happens -- no matter how long that takes and no matter why it is happening -- the alternative tax gives businesses more manageable after-tax U.S. operating profit margins in the meantime, reducing the chances that consumer prices will rise.
We know some economists will be adverse to the idea of an alternative tax. They will argue that it threatens the integrity of the Ryan-Brady plan. They will say that any special rules for a limited group of businesses will upset the balance of the border adjustments and will undermine the appreciation of the dollar. The alternative tax is simply a political tool to generate support for the Ryan-Brady plan. If the Ryan-Brady plan can't get through Congress, whether the currency will adjust in a perfect system won't even matter.
This is not an absolute carveout. Businesses that pay the alternative tax would have to pay taxes determined in part by a calculation that uses a much higher tax rate than what is in the Ryan-Brady plan. And currency adjustments are still relevant to the calculation. It is a limited carveout that could get the Ryan-Brady plan to the finish line and is worth considering.
Americans who called for corporations to pay their fair share should support the Ryan-Brady plan with the alternative tax. It would help stop businesses from being able to achieve single-digit effective tax rates by putting their valuable intellectual property in tax havens and playing games with what their right hand is charging their left hand to minimize the amount of income that is taxed in the United States.
Retailers have some of the highest effective tax rates (averaging close to the top rate of 35 percent) and some of the lowest profit margins. There is a perceived threat that the Ryan-Brady plan gone wrong could harm retailers. Americans are concerned that the border-adjusted tax could shrink their wallets. In politics, those concerns are hard to ignore.
The alternative tax helps to address these problems. Under the alternative tax, businesses will effectively get to deduct more of their import costs so there won't be as much pressure to raise prices.
If the dollar does strengthen even a little relative to other currencies, retailers will end up paying less for their imports, which will still figure into the alternative tax calculation, and their after-tax U.S. operating profits will rise up to the cap. As the dollar continues to strengthen, the low 20 percent rate looks more appealing, and the freedom from the after-tax U.S. operating profit margin cap will make more and more businesses want to be taxed under the Ryan-Brady plan.
The alternative tax makes the Ryan-Brady plan more likely to be a win-win. It acts as insurance to help prevent the kinds of catastrophic outcomes feared by importers and consumers. A reform plan that helps level the playing field for U.S. businesses and helps end the transfer pricing games played by inverted companies and some multinationals is worth saving.
Appendix. Taxing Importers Under the Alternative Tax
This table shows how the alternative tax would work for a variety of
businesses. For a business to get a higher profit margin than its historic
average, import costs must go down enough for the business to want to be taxed
under the Ryan-Brady plan. This happens at different levels of appreciation
(15 percent in Example 1, 8 percent in Example 2, 0 percent in Example 3) de-
pending on the specific profit margin and import cost profile of the business.
Example 1 also shows why the profit margin cap is needed.
Example 1: High profit margin (20.3 percent), high import cost (93 percent)
$125 U.S. receipts, $5 U.S. costs, $80 real import costs, $1 related-
party import profit (import costs go down to $74.07 and 93 cents at 8 percent
appreciation and $69.57 and 87 cents at 15 percent appreciation)
Assuming no decrease in import costs Current law 20.3%
Alternative tax 20.0%
Assuming 8 percent appreciation Ryan-Brady 16.8%
Alternative tax 23.1%*
Assuming 15 percent appreciation Ryan-Brady 20.4%
Example 2: High profit margin (22.9 percent), medium import cost
(61.7 percent) business
$125 U.S. receipts, $30 U.S. costs, $50 real import costs, $1 related-party
import profit (import costs go down to $46.30 and 93 cents at 8 percent
Assuming no decrease in import costs Current law 22.9%
Alternative tax 22.6%
Assuming 8 percent appreciation Ryan-Brady 23.0%
Example 3: High profit margin (20.3 percent), low import cost (26.7
$125 U.S. receipts, $62 U.S. costs, $23 real import costs, $1 related-party
Assuming no decrease in import costs Current law 20.3%
Example 4: Medium profit margin (11.4 percent), high import cost
(89.3 percent) business
$125 U.S. receipts, $10 U.S. costs, $92 real import costs, $1 related-party
import profit (import costs go down to $76.67 and 83 cents at 20 percent
Assuming no decrease in import costs Current law 11.4%
Alternative tax 11.2%
Assuming 20 percent appreciation Ryan-Brady 11.6%
Example 5: Medium profit margin (10.4 percent), medium import cost (64.8
$125 U.S. receipts, $36 U.S. costs, $68 real import costs, $1 related-party
import profit (import costs go down to $57.14 and 84 cents at 19 percent
Assuming no decrease in import costs Current law 10.4%
Alternative tax 10.1%
Assuming 19 percent appreciation Ryan-Brady 10.6%
Example 6: Medium profit margin (9.9 percent), low import cost (26.4
$125 U.S. receipts, $77 U.S. costs, $28 real import costs, $1 related-party
import profit (import costs go down to $25 and 89 cents at 12 percent
Assuming no decrease in import costs Current law 9.9%
Alternative tax 9.6%
Assuming 12 percent appreciation Ryan-Brady 10.0%
Example 7: Low profit margin (3.6 percent), high import cost (95.8 percent)
$125 U.S. receipts, $4 U.S. costs, $113 real import costs, $1 related-party
import profit (import costs go down to $91.13 and 81 cents at 24 percent
Assuming no decrease in import costs Current law 3.6%
Alternative tax 3.4%
Assuming 24 percent appreciation Ryan-Brady 3.9%
Example 8: Low profit margin (4.7 percent), medium import cost (62.1
$125 U.S. receipts, $43 U.S. costs, $72 real import costs, $1 related-party
import profit (import costs go down to $58.54 and 81 cents at 23 percent
Assuming no decrease in import costs Current law 4.7%
Alternative tax 4.4%
Assuming 23 percent appreciation Ryan-Brady 5.0%
Example 9: Low profit margin (4.7 percent), low import cost (25.9 percent)
$125 U.S. receipts, $85 U.S. costs, $30 real import costs, $1 related-party
import profit (import costs go down to $25.21 and 84 cents at 19 percent
Assuming no decrease in import costs Current law 4.7%
Alternative tax 4.4%
Assuming 19 percent appreciation Ryan-Brady 4.8%
* The profit margin cap is necessary because as import costs go down, the
alternative tax calculation could result in a higher after-tax U.S.
operating profit margin (profit margin) than the Ryan-Brady plan. The cap
increases the business's tax bill (but not its profit margin) to ensure that
the only way such cost reductions will give the business a better profit
margin is when the business can achieve it by way of the Ryan-Brady plan. In
Example 1 above, the business will not have a profit margin of 23.1 percent
assuming 8 percent appreciation but will have to pay extra tax so that it
will only have a profit margin of 20.3 percent.
The calculations for Example 1 are below. Note that we assumed only a small
amount ($1) of related-party import profit in all of the examples. Businesses
will get worse answers from the alternative tax if they have larger amounts of
this type of import cost as it can be inflated to avoid tax under current law:
Current-law profit margin = $125 receipts - $5 U.S. costs - $80
real import costs - $1 related-party import profit = $39 tax base x 35
percent tax rate = $13.65 tax; $39 pretax profit - $13.65 tax = $25.35
after-tax profit; and $25.35 after-tax profit / $125 receipts = 20.3
percent profit margin.
Ryan-Brady profit margin = $125 receipts - $5 U.S. costs = $120
tax base x 20 percent tax rate = $24 tax; $125 receipts - $5 U.S. costs -
$80 real import costs - $1 related-party import profit = $39 pretax
profit; $39 pretax profit - $24 tax = $15 after-tax profits; and $15
after-tax profits / $125 receipts = 12 percent profit margin.
Alternative tax profit margin = $125 receipts - $5 U.S. costs -
$80 real import costs = $40 tax base x 35 percent = $14 tax; $39 pretax
profit - $14 tax = $25 after-tax profit; and $25 after-tax profit / $125
receipts = 20 percent profit margin.
To calculate how much tax is owed when the cap is triggered (when there
has only been 8 percent appreciation, for example), start with current-
law profit margin. On $125 of receipts, a 20.3 percent profit margin
means having an after-tax profit of $25.35. For the tax due, subtract
$25.35 from the pretax profit at 8 percent appreciation ($125 receipts -
$5 U.S. costs - $74.07 real import costs - 93 cents related-party import
profit = $45 pretax profit; and $45 pretax profit - $25.35 = $19.65 tax
Note that whether a business has receipts from exports is irrelevant, because
under the Ryan-Brady base, receipts from non-U.S. consumption aren't taxed.
These examples do not show the benefits of using a Ryan-Brady base, including
any benefit from immediate expensing. However, if a business using the
alternative tax calculation benefits from that, the benefit will always be
capped if it results in a higher profit margin than its historic average until
it moves to being taxed under Ryan-Brady.
1 The optimistic views and simplistic thinking in this article are their own.
END OF FOOTNOTE