Some mysteries are better left unresolved. Did FDR know in advance about Pearl Harbor? Did Lee Harvey Oswald act alone? Was Tony Soprano bumped off in that Jersey diner? We’ll never know.
The tax community is fixated on a mystery of its own, and it’s a genuine cliffhanger. The future direction of U.S. tax policy hangs on a solitary issue: If Congress enacts the GOP House blueprint – including the hotly debated border-adjusted tax -- will currency exchange rates adjust? It’s literally a trillion-dollar question, and it’s dominating economic discussions at the highest levels of government from Washington to Brussels to Beijing.
Scads of other nations have border-adjusted taxes that hit imports and relieve exports, as would the one in the House blueprint. But they’re part of VAT regimes, and the proposed destination-based cash flow tax is a slightly different creature. No other country has adopted this particular kind of tax system. It ought to work brilliantly, in theory, but at some level it feels like we’re conducting a social science experiment with the world’s largest economy.
Thinking Things Through
Let’s assume the tax in the House blueprint was imposed at a rate of 20 percent, as proposed by the plan’s drafter.
If it were a simple tariff, you’d expect the tax to be passed on to consumers in the form of higher retail prices. But the border-adjusted tax isn’t a tariff, despite the superficial similarities. Economic theory tells us that currency exchange rates should adjust by a quantifiable amount. If that happens, our nation’s importers have little to fear from tax reform. Ditto for the broader U.S. economy.
Under that scenario, the dollar would be worth significantly more relative to all other currencies -- or at least those currencies that float on the FX market. (Note: Some currencies are pegged to external targets, including to the dollar itself, so it’s possible that tax reform might cause the dollar to appreciate against some foreign currencies but not others.) Computationally, a full adjustment of exchange rates would require a 25 percent appreciation of the dollar. Anything less and there’s pain involved. By the way, that much currency appreciation is ginormous.
How quickly would exchange rates respond? Are we talking months, weeks, or days? By way of reference, the dollar has recently appreciated significantly against other leading currencies, but that rise was stretched out over a 30-month period. This might be very different. The Tax Foundation has produced a useful analysis that you can see here.
According to some experts, the swing will occur abruptly. At a recent Urban Institute event in Washington, professor Alan Auerbach of the University of California at Berkeley (one of the principal innovators of the destination-based cash flow tax) postulated that currencies would adjust in “negative time.” He’s saying the FX market is so remarkably efficient it will anticipate changes before they actually occur. Does that mean rates would adjust before the effective date of tax reform legislation? Nobody knows for sure.
If exchange rates fully adjust, as predicted, it follows that domestic retail prices for foreign-made goods would be the same as they are now -- other things being equal. That’s crucial if your firm’s business model relies on the price stability of things like Saudi Arabian crude oil, Swiss watches, Japanese computer components, or just about anything Wal-Mart stocks on its shelves.
Those retail prices should not increase because the global demand for dollars would increase in direct proportion to the newly imposed export subsidy – which exactly matches the tax on imports. In short, the export subsidy perfectly offsets the import penalty, so price equilibrium is maintained. (So is the U.S. balance of trade, which is measured in terms of dollars rather than units transferred.)
Therein lies the subtle beauty of the cash flow tax. Its design elements are rather elegant, assuming the darn thing works as advertised.
Would there be any unwanted side effects of currency appreciation? Yes, and they involve implicit wealth transfers. Foreign investors who hold dollar-denominated assets would be in for a nice windfall. Their assets would suddenly be worth 25 percent more in terms of relative value. (For example, the Chinese government holds a crazy amount of U.S. debt, which is denominated in dollars. If exchange rates adjust, China gets richer. The face value of its portfolio won’t change, but the dollar would be worth more relative to the yuan.)
The opposite is true if you’re a U.S. investor who holds assets denominated in a foreign currency. The relative value of those holdings would correspondingly drop by 25 percent. (For example, President Trump owns an impressive golf resort in Scotland that’s valued at around 35 million euros. If exchange rates adjust, he’d be worse off by roughly €8.75 million. The golf course would not have changed at all, but euros would be less valuable relative to dollars.)
Economically speaking, that’s the equivalent of the latter group of investors transferring a quarter of their equity to the former. Obviously, many investors hold both categories of assets, so the identity of winners and losers isn’t so clear cut. A hypothetical investor who held equal pools of dollar and non-dollar assets would experience a wash and presumably be indifferent to the swings of the FX market.
The Tax Burden
Tax reform can’t ignore issues of fundamental fairness. We live in an era of populism, after all. Key stakeholders are sensitive to notions of income inequality, and rightly so. Do adjusting exchange rates influence the distributional attributes of the cash flow tax? This issue has been underreported amid all the chatter about how the plan affects retailers.
As it turns out, movement in exchange rates has significant implications on the incidence of the tax burden. If rates adjust, the burden would fall largely on corporate profits -- particularly a nuanced category of corporate earnings referred to as extraordinary profits. That means the tax is mostly affecting capital income. In other words, the cash flow tax would be no more regressive than the current corporate income tax.
What if exchange rates don’t adjust? Then everything we’ve discussed above changes. In that case, the burden of the cash flow tax falls mostly on domestic consumers in the form of higher prices, rather than on extraordinary profits (i.e., capital income). That would likely make the tax about as regressive as any other consumption tax.
Also, if retail prices surge higher (which would happen without full adjustment), it’s likely that American consumers will feel the pinch and spend less freely. That could have a detrimental effect on aggregate demand, which threatens economic growth. One of the main purposes of tax reform is to boost GDP, so why bother if it hurts the overall economy?
Where There’s Risk …
By now you get the big picture. All the things that make the proposed cash flow tax an exciting and worthy endeavor are contingent on the workings of the FX market, which is something we don’t control. Personally, I tend to believe economists when they insist that exchange rates will adjust, assuming some underlying conditions apply. I’m just a tad uncertain about whether those assumptions will actually hold true.
What do clever people do when confronted with a business proposition that’s highly appealing but subject to a clear downside risk? They insure against the adverse outcome. Is it possible to reap the considerable benefits of tax reform based on the cash flow tax, but hedge against the possibility that exchange rates don’t fully adjust? My knee-jerk reaction says no, but not everyone agrees.
Stuart Leblang and Amy Elliott of Akin Gump Strauss Hauer & Feld LLP recently published an article in Tax Notes that offers a novel approach to tweaking the House blueprint. They describe an alternate tax calculation that, on its face, seems to mitigate the aforementioned risk. If their idea has legs, it could help quiet opponents of the plan.
Like other alternate taxes (i.e., the AMT), this one is complicated. Rather than attempt a full explanation here, I will refer readers to the Tax Notes article -- which includes a detailed description of the calculation and an appendix with nine illustrations of how it applies to specific fact patterns.
The key attributes of the alternate calculation are as follows:
• First, it redefines the tax base of the cash flow tax by allowing a deduction for imports. The applicable rate would be the same as current law, 35 percent. Combining these two features, the calculation offers a higher rate coupled with a narrower base (because it allows deductions that would be denied under the House blueprint).
• Second, the mathematics are such that taxpayers will always be better off under the cash flow tax if exchange rates fully adjust. The alternate calculation is designed to offer relief only where rates don’t fully adjust. In that sense, it’s not a giveaway to taxpayers – more of a shield than a sword.
• Third, it would not be available to all U.S. businesses, only those that satisfy a numerical threshold (however gauged) of reliance on imports. Leblang and Elliott suggest limiting the alternate calculation to firms for which imports account for at least 25 percent of overall commercial inputs.
• Fourth, it could be subject to manipulation by means of related-party transactions. Multinationals might be tempted to squeeze the profits of foreign affiliates into the U.S.-borne cost of imports, effectively sheltering those profits from taxation. The shadow of transfer pricing looms large here.
Leblang and Elliott concede the alternate calculation isn’t perfect. They seem aware of its pitfalls and suggest tweaking its design to disallow import costs attributable to related-party profit markup. They also suggest eligible businesses be held to higher documentation standards when substantiating cost allocations.
That we’d need to invent a new batch of related-party antiabuse measures to safeguard the integrity of the alternate calculation is a bit concerning. Cynics will smell yet another profit-shifting opportunity. Other than that, the proposal seems like a useful approach to reviving congressional interest in the border-adjusted tax.