Tax Analysts Blog

Reciprocal Taxes and Parallel Universes

Posted on Mar 6, 2017

Another week gone by and we’re still no closer to knowing whether President Trump will throw his support behind the tax reform blueprint offered by House Republicans. Trump’s address to a joint session of Congress failed to shed any new light on the matter. Likewise, Treasury Secretary Steven Mnuchin didn’t clarify things when the topic came up during a recent television interview. When asked about the controversial border adjusted tax, Mnuchin acknowledged the obvious: “There are certain aspects that the president likes about the concept of a border adjusted tax, and there are certain aspects that he’s very concerned about.”

We can surmise what he was referring to. Trump likes how the border adjusted tax targets imports; it appeals to his sense of economic nationalism. Let’s punish those darn foreign companies that think they can steal our jobs and sell their goods back into our domestic market. America first, and all that.

What Trump doesn’t like about the border adjusted tax is that its economic burden falls on customers in American shops. The conundrum is that you can’t have one without the other. Tax all the imports you want, but Wal-Mart shoppers will suffer.

Trump wants a tax that hits foreign production without throwing American consumers under the bus. But it’s not clear that such a thing exists, and if it does, a consumption tax certainly isn’t it.

The desire to transfer your tax burden onto the backs of people or businesses that reside somewhere else is not new. Trump is not the first politician to think along these lines. Depending on one’s outlook, it may warm the heart to think we can smack Chinese manufacturers with a heavy tax when they ship their cheap exports over here -- and that they alone will absorb the burden of the tax. Good luck with that. It might work out that way in some parallel universe. But in our universe, consumers pay consumption taxes. Ditto for tariffs.  

Speaking of parallel universes, what really caught my attention was when Mnuchin floated the concept of a “reciprocal tax” to create greater trade parity with other countries. Addressing trade parity is fine, but the thought that a reciprocal tax will get us there is nitwittery.

For starters, we have to guess as to what Mnuchin is talking about because no country in the world has reciprocal taxes. Presumably he’s talking about a bizarre variation on a border adjusted tax -- a distant cousin of the one included in the House GOP blueprint. The difference is that the tax rate applied to imported goods would not be fixed, as it is under the House blueprint (a uniform 20 percent). Instead, a reciprocal tax would apply rates that vary among countries and product categories.

So if Japan taxed our steel exports at 7 percent, that’s the rate at which we would tax their steel imports upon entering our country. And if South Korea taxed our electronics at 5 percent, that’s how much we’d tax their electronics. And so on.

That’s basically an origin-based VAT. Let me be blunt: It’s a rotten idea. Not because it’s a VAT, but because the rate is being determined by the origin basis. There are more than 160 VAT regimes in operation around the world, and none of them operate on the origin basis. All VATs are destination-based, and for good reason.

The destination basis preserves production efficiency while the origin basis preserves consumption efficiency, and the former is vastly more important to national economic outcomes than the latter. Also, the origin basis lends itself to transfer pricing abuses that have proven highly problematic with corporate income taxes. We should also note that an origin-based VAT violates WTO trade rules (as does the House blueprint, but that’s a different kettle of fish).

I’m tempted to describe reciprocal taxation as a solution in search of a problem, but that would falsely imply it’s capable of actually solving something -- and that’s not the case. That the Treasury secretary fails to grasp this strongly suggests that he’s not a tax guy – not even close – and that his department desperately needs a Treasury assistant secretary for tax policy (position currently vacant) who can set his superiors straight.

Why the hate on origin-based consumption taxes?

Consider this analogy. American audiences are generally confused by VAT, so let’s focus on something we understand reasonably well: the retail sales taxes (RSTs) imposed by most U.S. states.

Let’s say I wander into the grocery store in Washington and fill my shopping cart with a range of items from various parts of the country. (To keep the analysis simple, let’s ignore imports from foreign countries.)

When I appear at the checkout, how much sales tax should the clerk charge me? The answer is 5.75 percent, because that’s the RST rate in the District of Columbia. The identical rate applies to an avocado (California), a tangerine (Florida), a bag of cherries (Michigan), and a carton of potatoes (Idaho).

This is a classic illustration of destination-based taxation at work. The place of a product’s origin is irrelevant in determining the consumption tax rate. In terms of design elements, that’s a very good idea. This method of taxation is simple and predictable. The system is easy for tax officials to administer and for the business community to comply with.

Now imagine the outcome under an origin-based RST system. The sales clerk wouldn’t charge me the local tax rate unless the item in question was produced locally – which in the case of D.C. isn’t likely. Going through my groceries, he’d be required to deduce the applicable tax rate by first determining where each product came from. Twenty different items could result in 20 different tax rates. The words “gross inefficiency” should come to mind.

How that model helps D.C. and hurts other states is not at all clear. You’ve done nothing to address a trade balance, which theoretically is the root of the economic grievance. Ultimately, all you’re really doing is creating a tax system that is a nightmare in terms of administration, compliance, and enforcement. Oddly, you’ve also transferred discretion over local tax burdens to another jurisdiction’s tax authorities. That’s not only bad economics, it’s just weird from a governance perspective.

Let’s get back to Mnuchin. Why mention reciprocal taxation in the first place? There must be something about it that appeals to his boss’s instincts. (In fairness to the president, I will forgive him for not being up to date on consensus views among tax wonks; he has other things to worry about.) But what’s the appeal? What problem does he think this will solve?

We got a glimpse of the answer recently when Trump spoke to state governors the day before his address to Congress. He told them his administration plans to “make taxes between countries much more fair.” OK, what about the current state of play is unfair?

His explanation is something we’ve heard before, dating back to last summer. Trump is critical of the fact that foreign companies can sell into the U.S. market and face no border adjusted tax, while U.S. exports are subject to border adjusted tax when they enter foreign markets.

That’s factually correct, but only because the United States is a global outlier in not having a VAT. If the goal is to mimic what all our major trade partners are doing, the answer is clear: Get a VAT of our own. You want parity, there it is – all the border adjusted tax you could ever want.

In speaking to the governors, Trump added: “I want fair trade, and if we’re going to be taxed, they should be taxed at the same amount, the other countries. And one of two things is going to happen: We’re going to make a lot of money, or the other country is going to get rid of its tax.”

News flash: Other countries are not going to eliminate their VAT regimes simply because the border adjusted tax (or more accurately, the lack of a U.S. equivalent) offends Trump’s sense of economic justice. In fact, those countries are not going to eliminate VAT, period. They can’t; VAT pays the bills.

For the last 20 years, the dominant trend in international taxation has been for governments to gradually heighten their fiscal reliance on VAT revenue – often in lieu of revenue from taxes on capital income. Ironically, that’s the whole point of the House blueprint. Its authors are fairly open about their desire to switch to a consumption tax base.

Contrary to what Trump has repeatedly asserted, VAT is not a trade barrier. VAT is trade neutral. Remember, VAT is destination-based just like our state-level RSTs. It does not punish the consumption of imported goods relative to locally manufactured goods. A BMW sold in Munich gets hit with the same German VAT rate as a Ford made in Detroit. VAT is blind to a product’s country of origin.

At least there’s one thing Trump got right. He seems to understand that border adjusted taxes, however they are designed and implemented, are significant revenue raisers. His comment about making “a lot of money” is spot on. The catch is that he still needs to think about where that money is coming from. It’s not some foreign scapegoat. As stated previously, there’s no escaping the conclusion that consumption taxes are paid by consumers – the very people Trump says he’s looking out for.

Who knew tax reform was this difficult?

Read Comments (1)

Mike55Mar 9, 2017

Enhancing retaliatory border taxes doesn't strike me as outlandish. Every country (including the U.S.) applies customs duties and excises on an origin basis, often in retaliation for trade practices deemed unfair. The rates can apply by country/product, and can be huge (e.g., the 500% excise on Chinese steel). Sure we usually don't call these "reciprocal taxes" as Trump does, but that's indeed what they are.

Big picture I think Trump is correct when he claims trade policy generally, and increased "reciprocal taxes" specifically, can be used to promote rust belt manufacturing jobs. Past administrations used trade/import policy to achieve a broad swath of goals, so there is room to reprioritize in the manner Trump suggests. So the real question isn't whether the benefit Trump claims is possible, but instead whether we're willing to accept the costs associated with deprioritizing equally valid trade policy goals (e.g., security, environment, cheap fuel, etc.).

Personally I'm not at all convinced manufacturing jobs narrowly, or even labor participation rates more broadly, is the appropriate metric for trade success. If U.S. productivity growth continues to slump it will be 100% irrelevant how many new jobs are created building Harley Davidsons for export, or even what percentage of people are working overall. This isn't to say manufacturing jobs/labor participation rates don't matter, but instead that it doesn't make sense to view economic well being that narrowly.

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