If President Trump was surprised by how complicated health care could be, he’ll be in for a real shock when he gets around to business tax reform.
Everyone agrees that the way the United States taxes business profits needs an overhaul. The current tax regime encourages companies to move operations, assets and even corporate citizenship overseas, while raising less and less money every year as companies come up with ever more ingenious and ethically questionable ways to avoid it. For most big companies, the official 35 percent corporate tax rate is irrelevant.
The average rate actually paid is about 24 percent, with some companies routinely paying no tax at all.
So why have three presidents and countless Congresses been unable to fix it? The answer is that despite all the bellyaching by business leaders about our uncompetitive tax system, it is the business lobby itself that has stood in the way of reform. The reason is simple: To restructure the tax code while still raising the same amount of revenue, all those companies paying less than the average effective rate would have to pay more so those paying uncompetitive rates could pay less. And the low-tax companies have made it their business to prevent that from happening.
Now, House Speaker Paul D. Ryan (R-Wis.) and his Ways and Means chairman, Rep. Kevin Brady (R-Tex.), are determined to try again, proposing to replace the existing business profits tax with a “destination-based cash flow tax. ”
The wonky-sounding idea — long championed by economist Alan Auerbach of the University of California at Berkeley — has been kicking around in tax policy circles for more than 20 years, winning plaudits from think tanks on the right and left. Despite what you may have read, it is not part of a Republican conspiracy to eliminate taxes on capital. It is not a disguised tariff, or sales tax or value-added tax, although it would mimic their economic impact in some respects. It would not raise the price of imports by anywhere near 20 percent, nor would it bring millions of manufacturing jobs back to the United States.
So what is it?
Let’s start with the “cash flow” part, which has received too little attention. What that means is that companies would deduct the full value of any investments they make in the year they make them, rather than spreading them out — or depreciating them — over many years, as now required by tax and accounting rules. It also means that interest payments used to finance those investments could no longer be deducted as a business expense.
This switch from a profits tax to a cash-flow tax makes things simpler, encourages investment and eliminates the incentive for businesses to borrow rather than raise capital from investors. This is the part of the Ryan-Brady plan that economists love and most businesses support because of the way it simplifies business taxation and removes taxes as a factor in business investment decisions. In the short run, it also reduces the amount of profits that are subject to tax.
More controversial is the “destination” part of “destination-based tax flow tax.” What that means is that companies will be taxed only on profits from sales made in the United States. Consider four different scenarios.
The first is an American company producing goods or services at home and selling them to American customers. That’s a big chunk of the economy, and the tax structure for those companies would remain largely unchanged.
Then there are sales from overseas divisions of American companies to customers who are also overseas. Right now, profits from these transactions are not subject to U.S. tax as long as they are left overseas. A destination tax would ignore them as well.
Then there are sales of goods and services produced in America but sold to customers overseas — think Boeing. Under the destination tax, the overseas sales would not be counted as revenue, but the expense of producing them would still be deducted as a business expense in calculating the company’s taxable profit. That’s the tax equivalent of all gain, no pain.
And the opposite would be true of a company that imports products, or parts of products, for sale in America — think Walmart or Nike. In that case, the revenue will be counted, but the cost of the imported goods or services will not. All pain, no gain.
By lowering taxes for exporters and raising them for importers, this “border adjustment” is meant to remove the current incentive for companies to locate production and intellectual property, or realize profits, in tax havens such as Ireland or the Bahamas. As a result — and this is what gets President Trump all excited — jobs would come back, tax revenue would increase and the trade deficit would disappear.
Or not. For if those good things actually happen, or even look like they are about to happen, then something else might also happen — namely, that the value of the dollar would rise sharply against other currencies, which for Americans will lower the price of imports and makes exports seem more expensive to buyers overseas. Economic theory, in fact, predicts that the dollar would rise just enough to offset the new tax advantage that would flow to exporters as a result of a border adjustment, and offset the tax hit to importers and their customers. What the new tax code giveth in terms of higher or lower taxes, the currency exchange market would taketh away in the form of lower or higher prices.
If economic theory is right, in other words, the only lasting economic impact of border adjustment impact might be a nasty global financial crisis as some foreign countries and companies that borrowed cheap dollars would find themselves unable to repay more expensive ones. In addition, as the dollar rises, the value of foreign investments held by Americans would fall, while foreigners’ appetite for investing in the United States would wane, potentially depressing stock prices and pushing up interest rates.
While economists are fairly united in predicting that border adjustment will lead to an equal and opposite currency adjustment, business executives aren’t so sure. That’s why importers have mounted a furious effort to kill the Ryan-Brady plan, while exporters are pushing it with the urgent conviction of new converts at a tent revival. Officials in the Trump administration are said to be similarly divided.
There is good reason to be skeptical that global markets are so efficient that the dollar will rise to offset the economic impact of the border tax. If markets were that efficient, currency adjustments would have prevented the United States from running large and persistent trade deficits all these years. The reason that didn’t happen was because the flow of investment capital across borders is even greater than the flow of goods and services, with an opposite effect on the dollar exchange rate. The same dynamic could limit the rise of the dollar in response to a border-adjustment tax.
Whatever happens with the dollar, border adjustment will put an end to ridiculous and costly shell games played by virtually every global corporation to shift activity and profits overseas, where nearly $2 trillion sits idle in the bank accounts of foreign subsidiaries of U.S. companies. Other countries will almost certainly mount legal challenges to border adjustment, claiming that it violates global and bilateral tax treaties. But there is also a possibility that other countries could realize what a good idea it is and copy it. That would neutralize some of the economic benefits to the U.S. economy.
There is debate about whether the Ryan-Brady proposal would shift the burden of the corporate tax from shareholders and employees to consumers, which would make it less progressive. Liberal economists such as Jared Bernstein think so, but Kyle Pomerleau at the conservative Tax Foundation thinks not. In the end, it would depend on how much the dollar adjusts and whether importers would be able to pass tax increases on to consumers rather than to their shareholders and employees. In other words, it’s anyone’s guess — although either way, the effect will probably be modest.
For me, the problem with the Republican business tax plan is not so much the structure of the tax, but the fact that the proposed 20 percent rate is too low.
As Howard Gleckman of the Tax Policy Center has written, if border adjustment increases exports and discourages imports to the degree promised by some proponents, then the 20 percent tax rate will not raise anything close to what the corporate tax raises now.
Edward Kleinbard, a tax expert at the University of Southern California law school, figures a rate of 25 percent would be needed for the plan to be revenue neutral. William Gale of the Brookings Institution thinks it would be 30 percent.
“The 20 percent rate is not economically driven,” Kleinbard said. “It’s purely a political number.”
The House plan also retains the current tax advantage enjoyed by small businesses, partnerships, proprietorships, investment trusts and limited liability corporations — enterprises that, as a result of this tax advantage, account for half of all business profits.
Such enterprises — some of which are very large and very profitable — are not subject to either the corporate tax or to the additional 20 percent tax on dividends and capital gains that corporate shareholders pay. Instead, they are taxed only once at the personal income tax rate of the owners. The House proposal would expand this boondoggle by creating a special new tax rate of 25 percent for these “pass-throughs” — a rate that is not only undeservedly low but will create a whole new tax scam, as highly paid employees rush to turn themselves into independent contractors to take advantage of it.
Because of these and myriad other problems, the Ryan and Brady proposal needs lots more study and debate — it shouldn’t be rushed through to meet artificial political deadlines. But by the same token, it deserves serious consideration.
“I’m very intrigued by it, particularly the economic benefits,” said Martin Sullivan, the respected columnist and chief economist at Tax Notes. “There are concerns with it, no question. But the reason we are still talking about it is that there is no obvious alternative.”
Pearlstein is a Post economics and business columnist. He is also Robinson Professor of Public Affairs at George Mason University.