The U.S. Must Avoid This Untested Approach To International Taxes

Corporate profits are up, unemployment is down, wages are rising, and markets are breaking new records. These all point to a U.S. economy that is more stable than the economies of other developed countries.

So this seems like an odd time to conclude that the United States should experiment with a tax system that has never been adopted anywhere else in the world.

That’s where we stand, as President Trump and Congress consider corporate tax reform, particularly for international transactions. House Republicans support a “destination-based cash flow tax” designed in significant part by economist Alan Auerbach. President Trump initially cast doubt on the proposal, calling it “too complicated,” but then quickly clarified that the proposal is “still on the table.” 

Contours of the new tax are fairly simple. It is “border-adjusted” so that exports are free of tax (but importantly, the cost of making exported goods and services is deductible), while the cost of imports is not deductible.

The proposed tax also has a “cash flow” feature, which means that expenditures for capital goods, such as machinery, are deductible immediately. This reduces the economic cost of new investment, but the proposal also eliminates net interest expense for at least some taxpayers, muting the benefit.

Most attention has focused on the border adjustment. Advocates see this as an element of the value-added taxes that almost all countries—but not the United States—have adopted over the past four decades. The effect of the border adjustment, and indeed its intention, is to encourage companies to expand production in the United States and discourage imports.

Advocates further maintain that the destination-based cash flow tax will simplify the U.S. tax system by eliminating controversies over transfer pricing, the practice by which companies determine prices for buying and selling goods and services between related parties.

Will the proposal work as advertised?

We think not. We have no client interest in the matter, but we do have a keen interest in successful reform of the U.S. international tax rules. Like the old description of a camel—a horse made by a committee—the destination-based cash flow tax has good components but, cobbled together, misses the mark.

The destination-based cash flow tax is designed to increase, and will dramatically increase, the cost of foreign-made goods and services. If U.S. importers cannot deduct such costs, the additional tax expense will be passed along to consumers, until and unless there are ample supplies of U.S. products that substitute for the imports.

Don’t worry, economists say. U.S. producers will step in to provide alternative products. And in any event, economics textbooks tell us that exchange rates will adjust, the US dollar will strengthen, and the dollar cost to U.S. consumers will stabilize at something like its pre-reform level.

We are not economists but we are skeptics. And our skepticism seems to be shared by lots of folks with practical experience in the world of foreign exchange. Significant currencies around the world do not float freely (as President Trump has noted with China), and rates, if they do change, are not likely to do so instantly after the United States adopts new tax rules.

Suppose, however, the U.S. dollar does strengthen to compensate for the new tax cost of imports. What does that mean for U.S. exporters? A stronger dollar makes U.S. exports less competitive, and that is the obverse of the principal goal of destination-based cash flow tax’s advocates.

We cannot have it both ways. If the U.S. dollar strengthens to blunt the impact of the tax penalty on U.S. imports, the stronger dollar will have a serious adverse impact on U.S. exports.

The destination-based cash flow tax is supposed to bring manufacturing “home” to the United States, to serve both U.S. and export markets. But virtually all growth for most U.S. exporters is outside the United States, which probably requires foreign investment. And the biggest growth in U.S. exports is in services and intellectual property, not manufacturing. The destination-based cash flow tax does not seem well equipped to deal with these matters.

Furthermore, economic analysis supporting the destination-based cash flow tax assumes a static world, in which the United States enacts legislation and the rest of the world stands mute. That won’t happen. In the incisive observation of philosopher Jean-Paul Sartre, “everything is complicated by the presence of the other team.” The same is true for international tax.

Administrative advantages of the destination-based cash flow tax are likely to disappear in the legislative process. In its current version, companies can deduct expenses related to exports without recognizing income from those exports. That creates a negative tax rate, which would shelter from tax the income derived from U.S. production for U.S. purchasers.

There is, however, no justification for failing to impose tax on domestic income from domestic production. If taxpayers are required to apportion expenses between their export business and their domestic business, there will be controversies comparable to those relating to transfer pricing, just in a different guise.

Perhaps the risks of the destination-based cash flow tax would be worth taking if no alternatives were available. But there are well considered proposals for international tax reform all over Washington.

The only law that is immutable is the law of unintended consequences. The visible consequences of the destination-based cash flow tax are scary enough even without the unknown unknowns. There is no reason to adopt this untested, untried approach to taxing international transactions when other good options are shovel ready.

Please visit The Hill’s website to view the op-ed.  

H. David Rosenbloom is an attorney and member at Caplin & Drysdale. He serves as director of the international tax program at New York University School of Law. Peter A. Barnes is of counsel at Caplin & Drysdale and a senior fellow at Duke University.