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BAT rhymes with VAT

Importers object to congressional tax proposal aimed at helping domestic manufacturers

By: Eric Kulisch
 | 
Photo: DRogatnev/Shutterstock
   There is broad support in the business community for Republican plans to reform policy on corporate taxes – with one significant exception.
   A plank in the “Better Way Forward” plan released last June by House Speaker Paul Ryan calls for a quasi “value-added tax” (VAT) to be applied to imports. It got little attention until Donald Trump won the presidential election and Republicans held onto power in both chambers of Congress in the November election – clearing the way for potential passage of a major tax overhaul bill. The Ryan plan also would lower the corporate income tax from 35 percent to 20 percent.
   Many private sector entities are still trying to figure out how the so-called border adjustment tax would work if crafted into legislation, but importers that studied it have reacted negatively.
   “The proposed border tax adjustment will distort the market, increase consumer prices and create an uneven playing field for companies and consumers alike,” Koch Industries said in a statement. “Our tax system should encourage, not destroy, free exchange and trade resulting in robust commerce and lower, not higher, prices for consumers.”
   Koch Industries, an industrial conglomerate, is the second largest privately-owned company in the United States. CEO Charles Koch, and his brother David, are billionaire libertarians who have used their fortune to finance the Tea Party, the Cato Institute think tank and a huge political donor network that steers millions of dollars to Republican candidates.    
   The border adjustment tax (BAT) has no connection to Donald Trump's campaign threats to impose punitive tariffs of up to 35 percent on certain countries or industries in an effort to gain trade concessions or reverse outsourcing by some companies. In fact, in an interview with the Wall Street Journal published Tuesday, Trump criticized the BAT as too complicated.
  The motivation behind the consumption-based border adjustment tax (BAT) is to increase U.S. exports and help keep the overall tax reform plan revenue neutral. The conservative-leaning Tax Policy Institute estimates it will generate $1.2 trillion over 10 years, making it one of the largest revenue raisers to pay for the plan. Without the BAT, it is unclear where Congress would find the money to offset revenue reductions from tax cuts.
   Lawmakers are also trying to offset corporate and individual tax cuts by eliminating many deductions and credits, including the interest deduction, and by factoring in extra tax revenue generated by economic growth to pay for the reforms.
   The “Better Way” blueprint says the current system acts to subsidize imports and penalize exports. Countries with VATs rebate the tax when a product is exported and impose it on imported products. The effects of those costs tend to offset when trade occurs between countries with VAT systems. Moving to a cash-flow, or net revenue approach, rather than an income one, will level the playing field, according to the plan.
  “We have made a strong case that for America to compete and win again, we need to change the way we tax,” Kevin Brady, chairman of the House Ways and Means Committee and an architect of the “Better Way,” said on C-SPAN’s “Newsmaker” program last month. “And right now all of our competitors border adjust their taxes. They take their taxes off the goods and services coming our direction. So, that gives them the price advantage over us here in America. We don’t, sending out products around the world. So today we lose both here in America and around the world. That can’t stand.”    “Companies that rely on global supply chains would face huge business challenges caused by increased taxes and increased cost of goods, which would in turn likely result in reductions in employment, reduced capital investments and higher prices for consumers,” a coalition of more than 80 trade associations said in a Dec. 13 letter to Rep. Brady.
   One of the groups that signed the letter is the National Retail Federation. 
   “I have one retailer that tells me last year their profits were $50 million and if the border adjustment tax went through, the cost would be $250 million, or five times their profit,” Rachelle B. Bernstein, the NRF’s tax counsel, said in an interview with the Adam Smith Project. “So, obviously, this could drive this particular retailer out of business.”
   The company sells apparel and 97 percent of its merchandise is sourced from overseas. With few domestic sources of shoes and clothing available, the BAT would be an unfair burden, she said.

I have one retailer that tells me last year their profits were $50 million and if it went through the border adjustment tax, the cost would be $250 million, or five times their profit.

   More broadly, many product categories, such as bananas and coffee beans, have no domestic substitute that importers could use to avoid the BAT.
   The petroleum industry would be most affected by the border tax because the United States remains a net importer of crude oil, according to a recent whitepaper by economists at the Brattle Group and commodities expert Philip Verleger. The authors calculated that the BAT would lead to a 13 percent increase (or 30 cents per gallon) in the domestic retail price of gasoline and an 11 percent increase (or 27 cents per gallon) for diesel fuel, assuming a $50 per barrel price for crude oil. And if the world price of crude oil rises to levels forecast by the U.S. Energy Administration ($90 per barrel), the BAT would cause a 55 cent per gallon hike in fuel costs.
   The report also said imports of electronics and automobiles would be among the chief commodities affected by the proposed tax. 
   Bernstein and others said the border tax would force retailers to raise prices on consumers, or be left trying to source domestic goods.
   In the example of the shoe retailer, an importer that seeks to maintain its $32 after-tax profit will need to capture more revenue to cover the $12 difference between the existing and proposed tax schemes. The most competitive companies would probably find ways to offset the tax burden and keep prices relatively flat, but the market is set by the least efficient suppliers, who have to raise prices in order to stay in business.
   NRF is in the middle of producing an economic study intended to quantify how the BAT would impact a sample basket of products, Bernstein said.
   The revenue-based tax would decrease Home Depot's net income from $7.8 billion to $5.2 billion, or 34 percent, according to a research paper by RBC Capital equity analyst Scot Ciccarelli. The home improvement chain would need to increase total revenue 3.5 percent, or source 77 percent of its goods domestically, to offset the BAT's effects, it said.
   But Home Depot, because of its sourcing patterns and other factors, gets off easy compared to other big retailers. Companies such as Williams-Sonoma, Dick's Sporting Goods, Best Buy, Costco, Dollar Tree and Walmart all would essentially incur tax bills that exceed their operating profit, RBC estimated.
 
Export incentive. Experts said the BAT would even hike the price of goods made in the United States. 
  The border tax would serve as a huge incentive to sell everything abroad because companies could keep more money from the transaction in their pocket. Domestic buyers would have to pay more -- enough to equal or exceed the tax advantage enjoyed by the manufacturer and make it worthwhile to sell to them. A domestic retailer that previously paid $100 to a manufacturer for the pair of U.S.-made hiking boots, would have to pay at least $125 under the House blueprint to overcome the supplier's export benefit. Those costs would be passed onto consumers, who likely won't see wages keep pace, a government affairs official (who spoke on condition of anonymity because his company is trying to keep a low profile as it lobbies Congress on the measure) told the Adam Smith Project
  “The proposed border adjustment tax would create a windfall for domestic oil producers. A company in the Permian Basin of Texas producing light crude oil would receive the world price of oil less any transportation costs free and clear of any taxes if the crude oil were sold to a buyer in China or any other foreign country,” the Brattle paper said. “Taxes, though, would have to be paid if the crude oil were sold to a domestic producer. Under these circumstances, the Permian Basin company would insist on receiving a higher price for domestic sales. The price received would likely be close to $62.50 per barrel if global prices were $50. In effect, a 25 percent wedge between domestic and foreign prices would be imposed.”
   The economists estimated that a BAT imposed solely on the petroleum industry would lead to a 0.3 percent cut in consumer expenditures on other goods, and possibly a 0.4 percent reduction in U.S. GDP. A 55 cent per gallon increase “could have very serious economic consequences,” they declared. 
   “We worry that the border-adjusted tax provision proposed in the House Republican blueprint would adversely impact American consumers by forcing them to pay higher prices on products produced in and goods imported to the U.S. that they use every single day," Koch Industries said in its news release. "While companies like Koch who manufacture and produce many products domestically would greatly benefit in the short-term, the long-term consequences to the economy and the American consumer could be devastating. As leaders in Congress continue to explore ways to bring much needed reform to a broken tax code, we encourage lawmakers to pursue cuts to excess spending and eliminate existing corporate welfare provisions, including those where Koch benefits.”

Deep impact on imports. Opponents say the BAT would result in a steep decline in imports and boost exports.
   “This is just very destructive of trade," FedEx Corp. CEO Fred Smith said in a recent earnings call with analysts. "It’s not the proper solution to the problem.”
   Officials said the integrated logistics provider is still trying to figure out how the destination-based tax would directly affect the company, as well as its customers.
   Economists and foreign exchange advisers say the BAT would likely cause the value of the dollar to appreciate, helping to alleviate some of its impact by giving importers more buying power relative to foreign goods. In a November paper analyzing border adjustment on international taxes, Douglas Holtz-Eakin, a former director of the Congressional Budget Office and founder of a conservative free-market think-tank, and Alan Auerbach, an economics professor at the University of California, present a case for the BAT. They argue that dollar appreciation would cancel out the BAT's impact, that it would not distort trade or the pattern of domestic sales, and that it would eliminate incentives for firms to engage in transfer pricing to shift profits to lower-tax jurisdictions or shift production overseas to take advantage of lower foreign tax rates.
  Others note, however, that Federal Reserve action on interest rates might blunt the expected rise in the U.S. dollar.
  At the NRF's annual convention in New York on Tuesday, Federal Reserve Bank of New York President William Dudley expressed concern about about the potential negative impact of a border adjustment tax.
  “I think that it will probably lead to a lot of changes in the value of the dollar, the prices of imported goods in the U.S. I’m not sure that that would all happen very smoothly and I also think there could be lots of unintended consequences,” he said, according to an NRF readout. “I’m not of the view that import prices would go up 10 percent and the dollar would appreciate by exactly 10 percent so that the value that retailers pay for the imported goods would be exactly the same in dollar terms.”
   The destination-based tax appears illegal as an export subsidy under World Trade Organization rules, but according to the House tax plan, border adjustments are permitted for consumption-based taxes. Direct taxes on income are prohibited, the plan said.
   “Under WTO rules, the United States has been precluded from applying the border adjustments to U.S. exports and imports necessary to balance the treatment applied by our trading partners to their exports and imports. With this Blueprint’s move toward a consumption-based tax approach, in the form of a cash-flow focused approach for taxing business income, the United States now has the opportunity to incorporate border adjustments in the new tax system consistent with the WTO rules regarding indirect taxes,” the document says.

The destination-based tax appears illegal as an export subsidy under World Trade Organization rules, but according to the House tax plan, border adjustments are permitted for consumption-based taxes. Direct taxes on income are prohibited, the plan said.

   
Pro-Business Tax Changes. While a large segment of the business community strongly opposes the border adjustment tax, there is wider consensus in favor of the House Republicans’ plan to lower the corporate tax rate from 35 percent to 20 percent, move to a territorial system for taxing the earnings of American companies with overseas operations, allow for an immediate write-off of capital expenditures, eliminate the deduction for net business interest expense, and eliminate most tax preferences.
   Trump advisers have even talked about a 15 percent corporate tax rate.
   The United States has the highest corporate income tax rate in the developed world, creating an incentive for companies to invest in other countries.
   Another disadvantage, many experts and business leaders argue, is that the United States is virtually unique in using a worldwide tax system that taxes the earnings of American companies when those earnings are brought back home, minus a credit for any foreign taxes paid on those earnings. America’s major trading partners generally do not tax business income earned overseas by companies headquartered in their country.
   The tax penalty for repatriating earnings – essentially a form of double taxation -- has resulted in American companies currently holding more than $2 trillion in capital overseas, according to the “Better Way” blueprint. In recent years, many corporations have also acquired smaller foreign companies and then relocated their headquarters outside the United States, a process known as “inversion.”
   Lowering the corporate tax and ending double taxation is designed to encourage companies to bring home a significant portion of their overseas income, much of which is expected to be invested in capital projects and jobs. It will also bring additional revenue to the federal government.
   On a one-time basis, the Ryan plan would tax accumulated foreign earnings held in cash at 8.75 percent and otherwise at 3.5 percent.
   “I think if they lowered the tax rate and went to territorial it would accomplish 95 percent of all of the benefits they are looking for and ignite a significant investment boom in the United States,” FedEx’s Smith said. 
   “We are very supportive of tax reform that creates a competitive global rate, establishes a territorial international system and provides certainty for businesses,” Whitney VanMeter, communications director at UPS, said in an e-mail response. “We will analyze all tax proposals in their entirety. We cannot make an assessment on the proposed border adjustment tax until we have more technical details. We look forward to weighing in with Congress and the Administration as the tax reform debate continues and we have a better understanding of how the new tax affects our services and our customers.”