With the defeat of the ACA repeal bill last month, Republican House leadership has started to turn its attention toward tax reform, in what could be its biggest agenda item of the term.

One particularly contentious proposal concerns how corporations’ tax liabilities are calculated, moving from the corporate income tax to something called a destination-based cash flow tax, or less precisely, a border adjustment tax. Depending on how the economy reacts to the change, the tax may favor some companies over others, and some experts say it may disproportionately burden the poor.

To see how this tax works, imagine two fictional companies: The exporter makes its products in the United States and sells them abroad, while the importer makes its products abroad and sells them in the United States.

Companies under the current law are treated the same

Two hypothetical U.S.-based

companies:

EXPORTER

$100

$200

costs

sales

IMPORTER

$200

$100

sales

costs

Two hypothetical U.S.-based companies:

EXPORTER

IMPORTER

$100

$200

$200

$100

sales

costs

costs

sales

In this simplified scenario, each business sells $200 of products and encounters $100 of costs. We assume they’re not using loopholes or other deductions, for simplicity’s sake. And throughout this example, we assume the overall corporate tax rate remains constant, though Republican House leadership has indicated that they intend to lower it, and that the government will issue tax refunds to companies with losses, which may not be politically viable.

Under the current corporate tax system, those sales and costs are treated the same regardless of where in the world they occur. Therefore, both of the businesses have $100 of taxable income, equal to their profits.

EXPORTER

$200

sales

$100

costs

$100

taxable income

IMPORTER

$200

sales

$100

costs

$100

taxable income

EXPORTER

IMPORTER

$200

$200

sales

sales

$100

$100

costs

costs

$100

$100

taxable income

taxable income

So when these companies face the 35 percent federal corporate tax rate (assuming they’re not using loopholes or other deductions, for simplicity’s sake), they both pay the same $35 tax and make the same $65 after-tax profit.

EXPORTER

$200

sales

$100

costs

$35

tax

$65

profit

IMPORTER

$200

sales

$100

costs

$35

tax

$65

profit

EXPORTER

IMPORTER

$200

$200

sales

sales

$100

$100

costs

costs

$35

$35

tax

tax

$65

$65

profit

profit

Under the proposed tax structure, however, the two corporations would be treated differently.

How things may change under the proposed tax

Only U.S.-based revenue and expenses count toward a company’s taxable income, so the importer would be liable for its full $200 of sales and would not be able to deduct its $100 of expenses abroad. The exporter, by contrast, has no domestic revenue, so it would face no tax liability.

If we assume the economy doesn’t react at all to this change — which experts say is unrealistic — this would mean that the exporter ends up with a $100 profit, and the importer only ends up with $30.

EXPORTER

$100

$200

costs

sales

$0

U.S. sales

$100

U.S. costs

$100

taxable income

$200

sales

$100

costs

$35

tax refund

$135

profit

IMPORTER

$200

$100

sales

costs

$200

U.S. sales

$0

U.S. costs

$200

taxable income

$200

sales

$100

costs

$70

tax

$30

profit

EXPORTER

IMPORTER

$100

$200

$200

$100

sales

costs

sales

costs

$0

$200

U.S. sales

U.S. sales

$100

$0

U.S. costs

U.S. costs

$100

$200

taxable income

taxable income

$200

$200

sales

sales

$100

$100

costs

costs

$35

$70

tax refund

tax

$135

$30

profit

profit

Changes under the proposed tax, with currency adjustment

In all likelihood, though, the economy will react. Namely, the value of the dollar will rise. Currencies, like other goods and services, are traded on the international market and, in theory, operate by the same supply and demand forces. For instance, if more Europeans wanted to buy U.S. goods, the demand for dollars in Europe would rise, causing the value of the dollar in euros to increase.

In that vein, the proposed tax would pressure more U.S. goods to be exported. The number of dollars foreigners need to buy those goods would increase, raising the value of the dollar. (A similar argument can be made given that the tax would decrease imports — fewer Americans would buy those items, so the supply of dollars abroad would be lower.)

When the value of the dollar rises, U.S. goods will become relatively more expensive, pushing down the number of exports and increasing the number of imports. That’s to say, if the dollar fully adjusts, as economic theory says it will, companies’ profits, as well as the quantity of goods imported and exported, will remain unchanged.

Here you can see that if the dollar fully adjusts — increasing in value by 35 percent, the same amount as the tax — both corporations end up with the same profit they had under the original scenario.

EXPORTER

$100

$130

costs

sales

$0

U.S. sales

$100

U.S. costs

$100

taxable income

$130

sales

$100

costs

$35

tax refund

$65

profit

IMPORTER

$200

$65

sales

costs

$200

U.S. sales

$0

U.S. costs

$200

taxable income

$200

sales

$65

costs

$70

tax

$65

profit

EXPORTER

IMPORTER

$100

$130

$200

$65

sales

costs

costs

sales

$0

$200

U.S. sales

U.S. sales

$100

$0

U.S. costs

U.S. costs

$100

$200

taxable income

taxable income

$130

$200

sales

sales

$100

$65

costs

costs

$35

$70

tax refund

tax

$65

$65

profit

profit

But just how realistic is that? Although full adjustment would occur in theory, economists are split over whether it would occur in reality, according to Bill Gale, a fellow at the Brookings Institution and a co-director of the Urban-Brookings Tax Policy Center.

The dollar, many say, will end up somewhere between these two scenarios: It will adjust part of the way, but not all the way. If that occurs, the tax could have a serious effect on businesses — helping exporters and hurting importers and consumers — essentially acting as a consumption tax on imported goods. Because lower-income Americans disproportionately spend their income on imports, they would be hit the hardest, according to Gale.

Regardless of the currency adjustment, the tax would probably make it more difficult for companies to tax shelter their profits abroad, according to Eric Toder, an Urban Institute fellow and co-director of the Urban-Brookings Tax Policy Center. An iPhone bought in New York, for instance, would be taxed at its sale value regardless of whether Apple transferred that money to its Irish subsidiary. That means the tax would increase government revenue, allowing Republicans to cut tax rates without increasing the deficit.

With a months-long tax reform fight ahead, the proposal is already on shaky ground. Right-leaning organizations such as the Club for Growth and Americans for Prosperity, along with a handful of lawmakers, have already announced opposition to the change. Import-focused organizations such as the National Retail Federation are opposed as well.

Although these tax changes can go through the budget reconciliation process, requiring only 50 votes to pass the Senate, they’d still require a level of Republican Party unity that may not exist.

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