Statement of Richard Woldenberg on Border Adjustment Tax
Submitted to the Subcommittee on Tax Policy
of the House Committee on Ways and Means
The United States House of Representatives
May 23, 2017
My name is Richard Woldenberg, and I am CEO of Learning Resources, Inc. located in Vernon Hills, Illinois. I am submitting this testimony on behalf of our company. Our company is a family business which develops and markets educational products and educational toys in the United States and dozens of other countries. We outsource the manufacturing of our products overseas, and as a result, we are a significant importer (of our own products) into the United States.
We have grave concerns about the Border Adjustment tax proposal being considered by the House Ways and Means Committee as originally described in the “A Better Way” plan. The proposal is rife with risk and unintended consequences. I fear that the future of our company, and the jobs we provide, are at stake. We are a small business under the Federal government definition and believe that the problems we will face under the Border Adjustment tax proposal will be experienced by thousands of other small business importers in the United States.
Learning Resources, Inc. (LR) was founded in 1984 and is located in Vernon Hills, Illinois and has about 150 employees in the U.S. and U.K. The company is part of our family business group which turned 100 years old in 2016; I am in the third generation of my family to run this business, and we were proud to welcome the first member of the fourth generation into our business this year. LR develops and markets proprietary educational toys and materials in Vernon Hills but manufactures its 1400 products overseas. Jobs at our company pay well, turnover is low and we are an important part of our community, injecting many millions of salary and benefit dollars into the local economy annually. In 2013 and again in 2016, LR tried and failed to find U.S. molders interested in making our products here. In other words, we know from recent experience that we have no realistic option to make our products in the U.S., with or without the incentive of a reconceived Federal tax regime.
The Issues Created by Border Adjustment Tax (BAT):
1. We will become the involuntary subject of an historic exchange rate experiment. The BAT plan is unprecedented in U.S. history and its effects are unknown and unknowable. The plan is premised on a surging dollar that erases import costs. Betting the U.S. economy on a rising dollar is irresponsible – we shouldn’t confuse being “bold” with being reckless. Tax policy based on presumed changes in the value of the U.S. dollar is simply gambling. We cannot afford tax policy based on hunches, regardless of the resumes of those who pound the table promising dollar nirvanas.
Economists Auerbach and Holtz-Eakin assert that U.S. dollar appreciation after implementation of the BAT will reduce importers’ Cost of Goods Sold (COGS) enough to pay the new Federal tax bill. This is the basis of the contention that the plan simply “levels the playing field” without affecting cash flows. The economists offer little more than bland assurances, however.
The plan’s flaws are manifest:
- Congress can’t accurately predict the course and direction of financial markets and hence can’t be certain of future exchange rates. What if the predictions of massive U.S. dollar appreciation are wrong? What if the changes are smaller or larger than expected, or arrive later, or fade over time? After all, foreign exchange markets are massive, and dominated by large pools of capital not tied to trade. Tax policy is hardly the only factor which drives exchange rates. Interestingly, economists have given a name to the inability to predict exchange rates: The Exchange Rate Disconnect Puzzle. See
https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwjt1LSc4YLUAhXL5YMKHZrnArkQFggtMAE&url=https%3A%2F%2Fwww.dallasfed.org%2Fassets%2Fdocuments%2Fresearch%2Feclett%2F2008%2Fel0806.pdf&usg=AFQjCNGGj0SNFH-Q5SRwd2vcQBn-SrkTEA&sig2=LiFrN9xlIWK6Mr-MqLxR6A It is an accepted fact that movement in exchange rates cannot be foretold.
- The cost of imported goods will always include foreign content. For instance, foreign-made clothing often includes U.S. cotton or U.S. thread. Toys made in China often use imported plastics, paper or wood. Oil and gasoline are also foreign inputs. Foreign inputs rise in cost as the dollar rises, while only local content falls in cost. Our factories estimate 30-65% of our product cost is foreign-sourced. This means that our factories’ overall costs will likely RISE when the dollar rises. The economists’ assertion of cost savings is illusory.
- Dollar-denominated costs are the norm for U.S. importers. As the dollar rises, dollar-based costs don’t decline – they are fixed by contract. Realizing savings will require a line-by-line renegotiation of our entire business, essentially a zero-sum game with our factories. Factories may well refuse to cooperate with any effort to ratchet down dollar-based costs. In any event, cost reductions required to balance out the BAT will be epic and FAR beyond any cost reduction achievement in our company history. To fund the BAT, we will need to lower costs by as much as 19% which is frankly absurd. This cost savings is presumed by supporters of the BAT, but it’s entirely unrealistic.
- We believe there are other risks to the exchange rate scheme, including resistance by other countries (in the form of currency manipulation or interest rate changes). There is no guarantee that the dollar will move equally in all markets, for any number of reasons, so there is likewise no guarantee that costs will actually decline. We also believe we will be subject to significant changes in the terms of our bank line of credit owing to novel currency risks imposed by the BAT. Instability in bank financing could be devastating for many companies.
Unlike the 1986 Reagan tax plan, the BAT has no fallback position. If the Reagan plan didn’t work, the Federal government had the option to raise tax rates and no company would have been damaged. Under the BAT, corporate restructuring for many businesses seems inevitable and significant job losses likely. If the theory behind the BAT doesn’t hold, Congress will not be able to resurrect the companies killed by the BAT. Humpty-Dumpty can’t be put together again. Policy makers should not take such risks with American livelihoods.
2. The BAT will likely trigger a highly-regressive inflationary firestorm. When it becomes clear that importers will have no realistic way to capture sufficient cost savings to pay the enormous increase in taxes caused by the BAT, there will be no choice but to pass the costs along to consumers. And of course, consumers always bear the cost and consequences of tax increases like the BAT. We estimate that costs will ultimately rise as much as 20% under the BAT.
The mechanism for the price hike is being demonstrated in the U.K. right now. The collapse in the value of the British Pound from $1.50 (on the evening of the Brexit vote) to a recent low of $1.21 mimics the inflationary pressures likely created by BAT-induced dollar appreciation. Sharply rising U.K. consumer prices from import cost inflation strongly suggests that consumer inflation will naturally occur here under the BAT. Like a value-added tax, this rise in consumer costs will be regressive in nature and strike hardest the most vulnerable in our economy. A large population of defenseless constituents will find their standard of living slipping into decline post-BAT.
For example, see these news reports of U.K. price hikes:
https://www.wsj.com/articles/brexit-comes-with-price-shock-at-checkout-1489512547 (Brexit price shocks hits consumer products)
https://www.theguardian.com/business/2016/dec/14/lego-to-raise-its-prices-in-uk-from-january-sterling (LEGO raises prices due to British Pound weakness)
http://www.toynews-online.biz/news/read/lego-reportedly-raising-prices-in-the-uk-by-5/047893 (LEGO letter explaining price increase)
http://toyworldmag.co.uk/blog/the-end-of-days-its-the-friday-blog/ (Battle between retailers and suppliers over cost of the British Pound decline)
http://www.independent.co.uk/news/business/news/brexit-microsoft-prices-rise-pound-slump-value-software-impact-a7378181.html (Microsoft hikes prices 22% over British Pound decline)
http://www.independent.co.uk/news/business/news/brexit-pound-value-christmas-pudding-prices-rise-a7445476.html (Supply chain costs cause 21% rise in cost of Christmas pudding)
http://www.cyclingweekly.co.uk/news/latest-news/brexit-will-be-the-cause-of-possible-brompton-cost-increase-in-uk-298369 (UK bike manufacturer may raise prices because of currency-related supply chain cost increases)
http://europe.autonews.com/article/20161006/ANE/161009940/ford-vauxhall-nissan-raise-uk-car-prices-after-brexit (Ford, et. al., raises car prices because of component costs in locally-made cars).
https://www.thesun.co.uk/news/2517213/marks-spencer-to-increase-prices-by-up-to-15-despite-making-post-brexit-promise-to-protect-shoppers-from-devaluing-pound/ (Marks & Spencer reverses course and increases prices 15% because of the Pound).
3. The BAT will almost certainly spark trade wars. Economists supporting the BAT confidently predict an “immediate” 25% appreciation in the U.S. dollar after the BAT is implemented (based on a 20% Federal tax rate for “C” Corps). Simple math indicates that this translates into a British Pound at parity (the lowest exchange rate ever), the Euro at $.80 (near its all-time low of $.70 in 1985), and almost certainly a broken peg for the Hong Kong Dollar and other key currencies tied to the dollar. Such sharp U.S. dollar appreciation can be expected to devastate U.S. exports. The theory that the BAT will stimulate export sales seems dubious in light of a skyrocketing dollar, and therefore the value of the BAT tax holiday on export sales is of limited value.
The likely financial impact of this Congress-induced currency manipulation certainly seems calamitous. It seems delusional to believe that other countries will simply sit idly by and let the United States inflict this kind of harm on their economies. Consider Canada as an example. Canada was the third largest exporter to the U.S. in 2016, with total exports of $278 Billion. The BAT on that flow will be approximately $56 Billion, half the projected annual “take” under the BAT. Some estimates indicate that 75% of Canadians live within 100 miles of the U.S. border. Consider the impact of that tax on the Canadian economy and the population living near the U.S. Will Canada elect to just “take it”? No chance. Add to this the fact that Canada also imported $266 Billion from the U.S. The BAT will give American exporters a significant edge in competing with Canadian suppliers by eliminating income tax. Canada will get it coming and going under the BAT. I am sure Canadian legislators will quickly find inspiration to give the Americans a taste of their own medicine.
It is implausible that these effects will be ignored. To seriously entertain the notion that other countries won’t find ways to retaliate is to engage in happy talk.
4. Preventing inversions but opening up other gaping tax loopholes at the expense of our jobs and our company is unacceptable. Eliminating the inequity of companies implementing tax gambits like inversions would make the U.S. tax system fairer, certainly. We feel the pain because we pay a far higher tax rate (43.6%) on our worldwide pretax income as an Illinois-based “S” Corp. We do not shop internationally for low tax rate jurisdictions. We believe we are typical of American small businesses. While it may be galling that some taxpayers pay much less, unjust enrichment of others does not actually make us poorer. It is even MORE galling, however, to know that we are being asked to sacrifice our businesses so large highly-profitable mega-corporations can be excused from paying any tax under the BAT. That’s even more unfair than the current situation and will outrage ordinary taxpayers once they realize what has happened. We would be much better off if Congress did nothing.
5. We are a Small Business job creator but our job creation engine will be eviscerated by the BAT. Our products were developed by Americans in the United States, our intellectual property is owned in this country, and we created about 150 jobs by developing a market for our educational products. We are not ashamed of our decades-long record of helping American kids learn and American families improve their standard of living with products that we make offshore. If we must nevertheless reorganize to fund the BAT, however, we will be incentivized to eliminate as many high paying jobs as possible – we will recapture 75 cents for each dollar of expense eliminated at the new tax rate. Investments in automation will become much more attractive – and will be immediately deductible under “A Better Way” plan. How does the BAT create enough jobs to compensate for job losses like these all over the country?
Notably, 97% of U.S. importers are Small Businesses, according U.S. Census data from 2014. The average import value per annum per congressional district is about $1.5 billion from Small Business alone, meaning that each district will pay $300 million in extra taxes under the BAT. The annual import value (2015) for the U.S. Small Business community - $631 billion (https://www.census.gov/foreign-trade/Press-Release/edb/2015/exh1d.pdf) – would fully fund the projected $1.2 trillion ten-year revenue raised by the BAT. In other words, the BAT is a Small Business tax. According to the U.S. Census Bureau, there were more than 191,000 small business importers in 2015 in the United States. That’s a lot of small business jobs at risk under this proposal.
6. Long-promised lower Federal corporate tax rates will not translate into lower tax bills under the BAT. Despite the expected 25% rate for “S” Corps under “A Better Way”, our company’s Federal tax bill is expected to increase by 4-5x. Based on our actual 2016 results, we project paying a 165% tax bill at the 25% rate for “S” Corps. The negative impact of BAT math intensifies as Cost of Goods Sold (COGS) grows as a percentage of sales. In other words, the tax is regressive in the corporate community, by pinching the lowest margin companies most deeply.
Notably, importers will face giant tax bills even in years when they are losing money. This is simple math – importers might have no GAAP earnings but high imported COGS, and thereby will generate a huge Federal tax bill with no money to pay it. Does the House Committee on Ways and Means want such companies to die quickly? We believe that companies facing financial difficulties or going through a turnaround will shed jobs in droves post-BAT just to survive, or simply go out of business. The BAT will lead to death by Federal taxes.
7. The shift of tax base from GAAP earnings will create great risk for companies and unpredictable tax outcomes. We finance our business based on predicted cash flows. Taxes under American law have always been a fraction of earnings, which facilitates planning and certainty. As an importer under the BAT plan, our Federal tax bill will greatly exceed our GAAP earnings, and our ability to pay will depend on various factors largely out of our control. Planning and certainty are no longer possible. If we fail to capture savings from dollar appreciation for any reason (meaning that we must sharply reduce our product costs, bring the inventory in, sell it at unprecedented profit margins and collect the cash, all in time to fund a quadrupled tax bill) we will either incur losses to pay taxes or have to restructure our business to survive. We don’t know what our business looks like under these conditions.
8. Foreign VAT systems do not put American products at a disadvantage. The BAT purportedly addresses a longstanding disadvantage created by foreign value-add tax systems (VAT). This is an urban myth. In fact, VAT is a tax paid by consumers in lieu of personal income tax. The BAT is a corporate income tax, not a personal income tax substitute. This is apples-and-oranges. VAT is paid in full by the last buyer in the chain of commerce, the consumer. No one pays anything in the chain other than the consumer by definition under a VAT. Foreign corporations pay tax on their earnings just as we do in this country (corporate income tax). U.S. tax treaties ensure that no corporate profit dollar is taxed twice. [The fact that U.S. corporate tax rates are the third highest in the world, behind the U.A.E. and Chad, is probably the root cause of inversions, not the “attractiveness” of VATs.] VAT does not convey advantage to anyone.
Second, the VAT “border adjustment” on export is simply a governmental rebate of excess tax receipts to the company that paid the taxes. It is not a subsidy. This is a mathematical fact, but we also know this from personal experience. Since 1994 we have operated a company in the U.K. and export from the European Union regularly. If VAT border rebates were actually an export subsidy as has been alleged, we would have been receiving this subsidy since 1994. Although we produce audited financials for our U.K. business, there is no line in those financials for VAT revenues or VAT profits. There is no such thing. Large multinational corporations have been chirping about the “unfairness” of VAT border adjustments in support of the BAT, but notably they are also significant exporters from VAT jurisdictions. If it is possible to profit from VAT, as they assert, they themselves must be receiving this subsidy. The Committee should request information on the benefits large multinationals have received over the last 20 years under VAT tax regimes. Such requests will be greeted with silence.
Finally, the assertion that VAT border adjustment is unfair to Americans is implausible given the careful scrutiny given to trade disputes under GATT. Since 1947, the U.S. has been involved in 379 cases at the WTO either as a plaintiff, defendant or other participant. That’s a major WTO lawsuit involving the U.S. approximately every two months for 70 years. If VAT “border adjustments” have been so prejudicial to American exporters since 1947, why hasn’t it been litigated by the United States? Such a serious charge deserves much greater scrutiny.
Financial Models: I have attached model financials for two hypothetical toycompanies, one with gross margins of 38% (yellow highlights) and one with gross margins of 25% (orange highlights). The 25% gross margin company operates on lower expenses to make similar money (for instance, they might be a “make-to-order” company without a warehouse). Both companies are modeled with simplifying assumptions under the BAT, focusing on the impact of the loss of the COGS deduction. Both companies are modeled as an Illinois-based “S” Corp with steady State taxes.
There are four scenarios presented for each company: (A) current tax law, (B) “A Better Way” Blueprint, (C) Post-ABW (details below), and (D) Economists Optimistic Scenario (details below). Scenarios C and D are essentially opposite scenarios. Scenario D illustrates what economists predict, namely that companies will capture COGS savings from U.S. dollar appreciation to fully pay their new BAT tax bills. Scenario C models what happens when companies capture none of the predicted currency benefits, leaving the model companies no choice but to raise prices (up 34%) and reduce expenses (down 20%) to preserve their financial results. This response will also trigger an immediate sharp decline in sales (down 40% in units). These two scenarios produce the same cash flow as the current law scenario (A) but only with major operational changes. None of scenarios B, C or D are better than the status quo for the model companies, or our company, or the thousands of similarly-situated companies all over the United States.
I would like to draw your attention to the relationship of Payroll expense to net taxable income in the models. Payroll expense (jobs) is much greater than pre-tax profit in most companies. The true social impact of independent businesses stems from their payroll expenses (in other words, jobs, jobs, jobs). This is certainly the case for multi-generational family businesses like ours which are the bedrock of communities through good times and bad. But the BAT threatens payrolls at small business importers. Consider how much Federal taxes increase in the new plan (B v. A) despite the reduction in rate from 39.6% to 25%. The Federal tax bill skyrockets. In the examples here, the Federal tax bill goes up between 8.1x and 11.4x. [A more thorough modeling against our actual financials shows taxes rising between 4-5x over today’s 39.6% Federal tax bill.] Clearly new Federal taxes will endanger payroll expenses (jobs). Is this what taxpayers want?
It is important to note that in the examples here, the model companies must recover 24% of COGS, presumably through resetting dollar contracts after the dollar appreciates by the promised 25%. That’s a fantasy of massive and unachievable savings. We are ecstatic if we can shave 1% off our COGS in any given year. Suspending disbelief, please consider what this asserted exchange rate value transfer means to the guy on the other side of the trade (our vendors). The BAT proposal will suck wealth from every country in the world over to the U.S. By manipulation of the Federal income tax code, Congress will thus force us to become the agent which lands this big wealth transfer . . . all so we can hand it over to Uncle Sam. Not a very appealing prospect, especially because it must be played out against our long-time, trusted vendor partners. This will devastate critical business relationships. Shaking down our supply chain to pay a huge increase in Federal taxes means we become the government’s shills. This is obviously bad tax policy.
No matter how the BAT is spun by the talking heads, no one is going to miss the point that importer tax bills are going to multiply under the BAT. As more business owners and their accountants do the math, and realize that they face unimaginable tax burdens never seen since the institution of the Federal Income Tax system in 1913, they will rise up against the politicians who devised the plan. The voters’ anger will only mount as job losses pile up and prices rise.
There must be another, better way to fix the tax system in this country, and it is Congress’ responsibility to find it. Thank you for considering my views.