Sunday, January 15, 2017

An Argument that the Border Adjustment Tax is an Illegal Export Subsidy

As has been widely publicized, there are serious questions about whether the BAT constitutes an illegal "subsidy" for exports under the WTO General Agreement on Tariffs and Trade (GATT).

A quick clarification on terminology:  A "direct" tax is a tax on the income or profits of the person who pays the tax.  An "indirect" tax is a tax on goods or services.  For those of you who want more, lots more, here is the WTO Primer on its tax rules.

GATT permits a border adjustment tax for indirect taxes (taxes on goods or services) if the tax does not exceed that assessed against similar domestic goods and services. [Weisbach, page 35]  In the case of VAT, this means that a border adjustment on an imported good will equal the tax that would be paid on a domestically produced competitor.  In my example from a couple days ago, the border adjustment on an imported item is the same as for a domestic item, thus the burden is the same.

GATT, however, does not allow border adjustments for direct taxes. [Weisbach, page 36] Remember, a direct tax is a tax on the income or profits of the party that pays the tax.  In this case, the Brady Plan allows the deduction of payroll from the calculation of the tax imposed on domestic companies.  By shifting the tax burden partially from domestic manufacturers to their employees, exporters in effect get a subsidy over importers. 

Another way to look at this is that the Brady plan is neither a consumption tax nor a true income tax. It is an odd amalgam of the two, and the distortions caused by the cutting-and-pasting shifts tax burden to importers and away from exporters in a manner than disfavors domestic importers and consequently, prejudices foreign manufacturers. The playing field for international trade becomes tilted, not level anymore. Japan, China, Germany and the like may object to this. 

In a real, not bastardized, VAT system, the VAT would apply up and down the chain based on the sale and resale of imported and domestically produced goods (and services), with the tax burden falling on the last guy in the chain.  If there is no "last guy in the chain", as in export situations, the entire tax stream is removed.  I already covered this.  The VAT would be a substitute for an income tax on individuals, but to achieve a progressive, rather than regressive, tax system, some form of personal income tax may remain to shift burden from the lower strata of earners to the higher ones.  Also covered previously.  Thus the distortion which is objectionable under GATT does NOT occur in a VAT regime.  VAT calculations have nothing to do with wages.  

But the BAT has a deduction for wages, meaning that a border adjustment is charged in full but down the chain, there are deductions shifting the burden away from the manufacturers to wage earners. This distorts trade and is banned under GATT.  The U.S. enjoys the protection of these rules as do all other members of the WTO.  In addition, it adds up to a big, and illegal, subsidy on exports.

In each of the scenarios, I posit a threes-step distribution chain resulting ultimately in the sale of $100.  The total economic profit in the chain is $17.50 in each scenario, and the expected all-in income tax at 25% should therefore be $4.38.  If the BAT were really a consumption tax, we would also expect to see consumption taxes of $25 (on $100 of value creation) for either domestic or imported goods. The $25 would be rebated if an export occurred under those circumstances. Thus, one would expect to see $29.38 in taxes for sales made in the U.S. and $4.38 for export sales.

I have produced a spreadsheet to show what results the BAT actually produces..  There are five scenarios illustrated:

Scenario 1:  VAT and Income Tax Model (EU/China).  This is the example I explained previously. This illustration uses a 20% VAT rate which is pretty typical, and results in $20 in VAT and $4.63 in income taxes as expected. [I chose the 20% rate for this scenario because I used in a previous example.] Please see that VAT in this example totals $20.  in the event that the last sale is an export sale, C would get back $10, and every party in the chain, including the government, would end up back where they started (zero).  The total corporate tax is the expected $4.38.

Scenario 2:  BAT Model (U.S. Consumption of U.S.-made Goods).  This is how the BAT would affect domestic manufacturers selling in the U.S.  Other than the reduction of tax rate, in this example, everything is the same as today's tax regime.  Tax on the last guy is also $2.50 on a profit of $10.  The total income tax paid in this chain is $4.38.  The expected BAT charge of $25 is missing.  This illustrates why domestic items will enjoy a HUGE pricing advantage under this law.

Scenario 3:  BAT Model (Final Export of U.S.-made Goods).  In this scenario, the total tax paid in this chain of transactions is ($20.63).  This is equal to $4.38 in income tax on the actual economic profit of $17.50, less $25 of BAT on the $100 sale.  The "rebate" of the BAT is nothing more than an export subsidy because we know that $25 was not previously charged.

So far, the BAT looks sort of like a VAT/Income tax combo but with odd outcomes.  The treatment of importers is odder still.

Scenario 4:  BAT Model (U.S. Consumption of Imported Goods).  This is what happens to imported goods in the same circumstances as Scenario 2 (domestic goods).  As you will see, the taxes paid on imported goods are higher than on domestic goods.  This is a subsidy for those goods under the BAT, a subsidy that is NOT present in a VAT and is likely to prompt retaliation by foreign countries.  The total tax paid here is $8.13, which equals the income tax of $4.28, plus 25% of the imported value of $15 in this case.  The $25 BAT is largely missing but the importer pays a portion that the domestic manufacturer won't.

Scenario 5:  BAT Model (Final Export of Imported Goods).  This is what happens when an importer (like our company) exports a previously imported good.  The analogous scenario for domestic goods is Scenario 3.  Again, this chain of commerce results in more taxes being paid by the importer than the domestic manufacturer. The total tax here is ($16.88), which is equal to the income tax of $4.38 less 25% times the difference between the imported price of $15 and export value of $100 (25% of $85).  Please note that the entire $25 in BAT is NOT rebated in the case of re-export of imported goods.

Thus, in this example, the domestic manufacturer gets a subsidy of 25% times the difference between export and import prices.  In the case of domestic consumption, the importer pays an extra tax of 25% of the imported value.

In sum, taxes are always higher on imported goods, whether consumed domestically or exported, and domestic producers enjoy a permanent tax advantage that subsidizes their production over foreign tax systems comprised by a combination of VAT and income tax.  

The implications and mathematics of this tax design may be obscure and glossed over the House Republicans pushing this plan.  While that may work for awhile, the plan will be easily understood by taxing authorities elsewhere in the world, who will not sit idly by while the U.S. distorts trade with this policy.  The politicians are apparently speculating as to whether anyone will present this issue to the WTO, and whether the U.S. get away with it.  I believe it is certain that other countries will make the case, and will not simply rely on the plodding WTO process to protect their economic interests.  They will retaliate.  

Do we really need this tax plan so badly as to risk a worldwide trade war?  Is this the only way to improve our system of taxation?

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