Republican tax-reform plans face many hurdles, including Donald Trump
Mr Trump will soon have to confront his economic policies’ internal contradictions
Jan 21st 2017
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AMONG other things, the start of Donald Trump’s presidency this week heralds a collision between campaigning rhetoric and legislative and economic reality. What follows will be a learning experience for all, it is fair to say. Though not perhaps the most consequential of the looming reality checks, the outcome of a brewing debate over a proposed border-adjusted tax plan could prove a taste of things to come. As Mr Trump and his Congress work to make policy, there are many ways for things to go awry.
Both Mr Trump and congressional Republicans are keen to cut taxes on corporations. America’s inefficient corporate-tax system has remarkably high rates but leaks like a sieve, yielding a pitiful tax take (see chart). As a solution, Mr Trump favours a large cut in the corporate-tax rate, from 35% to 15%, and a chance for companies to repatriate foreign profits at a tax rate of 10%. Paul Ryan, Speaker of the House of Representatives and chief Republican policy wonk, has something very different in mind.
At present American firms are assessed for tax on their global income. This encourages multinationals either to use clever accounting to book profits in foreign subsidiaries, or to “invert”: to relocate their headquarters, at least on paper, to countries with more favourable tax regimes. Mr Ryan’s radical solution is to scrap the tax on corporate income and replace it with a modified value-added tax (VAT). The new tax, assessed at a rate of 20%, would apply to all domestic sales while exempting foreign ones. This “destination-based” system would reduce the incentive to move profits or operations abroad. As is common in VAT systems, the plan includes a border adjustment: imports would be subject to the tax while firms would receive a credit for their exports. And that is where things get tricky.
Many suppose that a VAT, because of the adjustment, provides the countries which use it with an export advantage. Some Republicans have argued in favour of their reform plan on just those grounds. Imposing a 20% VAT means adding 20% to the price of imports while rebating domestic firms 20% of the value of their exports. The combination of import tax and export subsidy certainly sounds like a boon to exporting firms. Yet economists are practically unanimous in their view that it is not.
To see why, imagine that Congress were to impose a universal sales tax on all coffee mugs sold in America, regardless of origin. The tax would have no effect on the price of American coffee mugs sold abroad and therefore would not give a boost to exporting American mugmakers. Suppose the tax were then extended to include foreign sales of American mugs. The American tax would then come on top of whatever sales taxes were in place in foreign markets, leaving the American mugs at a significant disadvantage relative to competitors. The rebate paid to exporters is the way the government prevents what is essentially a national sales tax from penalising domestic firms seeking to compete in foreign markets. A value-added tax with border adjustments has no effect on export competitiveness whatsoever. Sad!
That is not quite the end of the story. Republican leaders do not consider their plan to be a VAT. That is partly because labelling it as such might discomfit rank-and-file Republicans accustomed to seeing VAT as a money-generating machine, fit to support a European-style welfare state. More substantively, Mr Ryan’s reform also exempts labour costs: a practice common in corporate income-tax regimes but not VATs.
Exempting firms’ wage bills would add an additional subsidy to exporters’ rebates, which might cause the plan to run afoul of the rules of the World Trade Organisation (or at least to attract a challenge from other countries). Still, the effect of the wage exemption is similar to that of a cut in payroll tax. It can hardly be taken as a ham-fisted attempt to sock it to foreign competitors. Perhaps this should come as no surprise. Mr Ryan unveiled his plan in June of last year, long before election day, in a distant past when Republicans were less supportive of trade restrictions. It is tempting to suspect congressional leaders of trying to slip a non-protectionist tax plan past Mr Trump under the cover of “border adjustment” language.
If so, Mr Trump is on to them. In a recent interview with the Wall Street Journal he criticised the complexity of the plan, adding: “Anytime I hear ‘border adjustment’, I don’t love it.” A more straightforwardly mercantilist policy such as import tariffs might not please him any better, even if he could wring one out of Congress. In a world of flexible exchange rates, policies which reduce demand for foreign goods—and, correspondingly, for foreign currency—generate exchange-rate shifts which offset much of the competitiveness effect.
We’ve had enough of exports
Indeed, plans for tariffs could generate a speedy rise in the dollar, squeezing goods exporters before tariffs take effect (and hurting exporters of services who could not expect much help from tariffs in the first place). American exporters would suffer in the short run, and a rising dollar could exacerbate global financial stress. Mr Trump seems to be aware of that threat as well. In the same interview he suggested the time was right for a dollar decline, as the currency’s strength, as he put it, is “killing us”. In this area, as in others, the need to make real-world policy decisions will reveal to Mr Trump previously unappreciated inconsistencies in his policy preferences.
In practice, the impact that competing Republican tax plans have on exports will be a sideshow. Centre stage will be occupied by other issues: the impact of tax changes on inequality, for example; and separate policy debates such as over the repeal of Obamacare. Overshadowing it all will be the unceasing, stomach-churning drama to be expected in the presidency of Mr Trump. But the tax-policy battle will reveal how well he and Congress can manipulate each other. And it will give a taste of how
the president reacts when economies fail to do as they are told.
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