Tax Analysts Blog

Oh Cupid, Why No Love for Tax Reform?

Posted on Feb 17, 2017

Valentine’s day notwithstanding, this week was short on any love for tax reform. It began with visitors from the Great White North. Canadian Prime Minister Justin Trudeau had a sit down with President Trump at the White House. The two leaders talked about cross-border trade and Trump’s desire to “tweak” NAFTA. They didn’t specifically discuss tax reform, but members of Trudeau’s cabinet held meetings with their U.S. counterparts and voiced displeasure with the House GOP tax reform blueprint, specifically the border adjustment. Not a surprise considering much of Canada’s economy depends on trade with the United States.

Rather than blast the border adjustment as an outright nightmare for his country’s export sector, Finance Minister Bill Morneau displayed remarkable restraint, telling CNBC "our sense is that a border adjustment tax wouldn't necessarily enhance our trading relationship." Foreign Affairs Minister Chrystia Freeland acknowledged the whole issue might go away because the viability of the border adjustment is clearly in doubt. “This is very much in the early stages and there is a very broad diversity of opinion in the United States around that.” Canadians are nothing if not understated.

A day after Trudeau’s meeting with Trump, the C.D. Howe Institute, a leading Canadian think-tank, released a report estimating the economic damage that might result if the Blueprint were enacted. The paper, “Aftershocks: Quantifying the Economic Impacts of a US Border Adjustment Tax,” argues that Canada is particularly “exposed” to harm due to its close economic ties with the U.S. The paper forecasts that border adjustment would cost Canada a full percentage point of GDP each year. Surprisingly, the authors, Dan Ciuriak and Jingliang Xiao, predict the Blueprint would be even more harmful to the U.S. economy, costing us 1.3 percentage points of GDP per year. Their analysis will be sobering news to advocates who pitch tax reform as a way to unlock our economic engine. As you will recall, the primary rationale for slashing the corporate tax rate is not to bestow gratuitous benefits upon capital income, but to elevate the overall economy. Dwindling GDP isn’t exactly what House Speaker Paul Ryan had in mind.

It’s not unreasonable to ask how a country with a VAT – or as Canada calls it, a GST – can complain when a trade partner implements a border adjustment. After all, Canada’s GST is also a destination-based tax with its own border adjustment. Canadian exporters benefit from a full GST rebate when goods are shipped abroad, while imports into Canada get taxed at the local GST rate (which varies among provinces). That’s not a trade barrier, per se, it’s merely a way of taxing all domestic consumption on a level playing field, regardless of where the good or service originated from. The same thing occurs in every country with a VAT or GST. 

So how, then, can Canada complain about the border adjustment that would occur under the destination-based cash-flow tax (DBCFT)? As would-be tax reformers are quickly discovering, the answer lies in the wage allowance. Not all border adjustments are created equal. VAT doesn’t include a wage allowance, and WTO trade rules effectively preclude it by limiting export subsidies to the realm of indirect taxes.

And speaking of the WTO, EU trade officials announced this week that they wouldn’t hesitate to formally challenge the DBCFT if it were enacted. European Commissioner Jyrki Katainen told the Financial Times that the 28-nation bloc wanted to avoid a trans-Atlantic trade war, but if provoked would take the necessary steps to “respect the global rule base when it comes to trade.” If that dialogue seems  familiar  it’s because  the U.S. Trade Representative has lost almost identical WTO disputes raised by the EU on three prior occasions. If you’re keeping score, those would be: (1) the domestic international sales company regime (1976); (2) the foreign sales corporation regime (1999); and (3) the extra-territorial income exclusion regime (2002).

As big as those trade disputes were, they’d be dwarfed by a case involving DBCFT. According to Chad Bown, with the Peterson Institute for International Economics, an adverse WTO decision on the DBCFT would result in punitive sanctions of roughly $385 billion. By contrast, the ETI case resulted in trade sanctions of $4 billion.

The U.S. probably should have learned its lesson about delivering an export-contingent tax subsidy through a direct tax system. One assumes the architects of the House Blueprint were aware of this relevant history, but assumed their cash-flow concoction was different enough from an income tax that it would pass muster. As things stand now, they appear to be the only people around who see things that way.

A degree of fatalism is settling in regarding WTO compliance. I detect a gradual realization that we’ve been asking ourselves the wrong questions. It’s not a matter of how different a cash-flow tax is from an income tax, or how similar DBCFT is to a VAT. Those inquiries offer false comfort; they are beside the point. The critical determination, judging from a careful study of WTO jurisprudence, is slightly different. It was best articulated by Professor Jennifer Hillman of Georgetown University Law Center. In addition to being a former commissioner to the U.S. International Trade Commission, Hillman served on the WTO Appellate Body. She should know how the WTO is most likely to evaluate DBCFT, and she offered the following observation at a policy forum earlier this month:

“If you put a tax on an import that is even one penny more than the tax that is on the domestically produced product, that is an unequivocal violation of our WTO obligations, and the tax proposal that is pending before the Congress would do exactly that. It would tax imports without allowing a deduction for wages so the tax on imports would cover the entire value whereas the domestic tax would allow a deduction for that portion that is attributable to wages so there would an absolute, unequivocal, no-doubt-about-it violation of our WTO obligations on the import side.”   

The analysis on the export side is more straightforward. Again, it’s the wage allowance: VATs don’t rebate wage costs, but DBCFT would. Those seeking more detail would do well to consult a paper by Professor Wolfgang Schoen of the Max Planck Institute (“Destination-Based Income Taxation and WTO Law: A Note”), or the analysis of Wei Cui of the University of British Columbia that appeared in Tax Notes last fall (“Destination Based Taxation in the House Republican Blueprint.”). A contrary view on WTO compliance is offered by economists Alan Auerbach of the University of California at Berkeley, and Douglas Holtz-Eakin of the American Action Forum (“The Role of Border Adjustments in International Taxation“).

Rejection at the hands of the WTO might not be a slam-dunk. But why should members of Congress move mountains to get the Blueprint passed if there’s a substantial likelihood that it’s not going to stick?. True, it could take a handful of years before the WTO process runs its course … but is that worth the hassle?

 

 

Read Comments (1)

Edmund DantesFeb 17, 2017

Very helpful summary, thanks. I agree that the DBCFT should be dropped. Too complicated, even if it didn't violate so many treaties.

Better to just drop the corporate tax rate to 20%, including on foreign earnings, and call it a tax reform.

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