Better than a border tax

On both sides of the border, businesses are in a flap over a corporate tax reform currently proposed by House Republican leaders. Don’t get your knickers in a twist. There is little chance now that this proposal will be enacted, since Donald Trump said Monday that he thinks it’s too complex. And it’s unclear the Senate would even support it.

The proposal has three major elements. First, the federal corporate tax rate would be reduced from 35 to 20 per cent. Second, comes the cashflow tax, which would allow companies to expense investments, but they could no longer deduct the interest they pay on debt. Third comes the border-adjustment tax, where companies would pay no corporate income tax on all export revenues, but would also no longer be allowed to deduct the cost of imported inputs from their taxable profits.

That border- adjustment proposal is what’s raising the most hackles in the U.S. itself. While it’s supposed to make U. S. exports extremely price competitive, imports would be 20 per cent more expensive. The U. S. is a net importer, so the border adjustment would have importers coughing up taxes to cover the cost of the other parts of the plan — the corporate income tax cut and the investment expensing — which will appeal to politicians anxious about deficits.

But then, some say the U.S. competitive advantage might not turn out the way people think. Harvard University economist Martin Feldstein argues the border tax will cause the American dollar to rise by 20 per cent, cancelling out the tax benefit for exporters while keeping U.S. importers competitive. This is due to a simple economic law that has to do with the exchange rate being determined by the “current account” balance, related to exports, investments and savings. It’s not necessary to get into the details, but in short, the law says that if the dollar value of savings or in- vestment don’t change, and they won’t in this case, then the value of exports net of imports won’t either — which means the U. S. dollar will have to appreciate by 20 per cent, fully offsetting the border-adjustment impact.

What probably worried Trump is that this economic prediction is based on a simple model, and one that is woefully inadequate for our complex world.

For one thing, the predicted exchange-rate effect will only happen if the cash-flow tax is applied to all tradable goods and services. That probably won’t happen. It’s almost certain that financial services and insurance would be exempted, for various good reasons, and it’s not hard to imagine politically favoured sectors, like small businesses, getting special exemptions from the cash- flow tax. Exchange rates also fluctuate for reasons other than taxes, such as commodity prices and interest rate shifts. So, the U. S. dollar won’t likely adjust by the full 20 per cent.

That doesn’t mean we should downplay the effect a border-adjustment tax would have on the U. S. and on Canada. It would be substantial. The U. S. dollar will rise (even if it’s not by the projected 20 per cent) since American companies will be able to fully expense any capital investments under the new plan, rather than depreciating them over time. That full, immediate writeoff will lead to capital rushing into the U. S., driving up the dollar.

Even a moderate rise in the U.S. dollar will see Canada losing skilled talent, as workers get a better return on their labour in the States. Meanwhile, although unprofitable American companies won’t gain much, profitable U. S. exporters, with foreign sales exempt from taxes, will likely find themselves with a windfall of tax losses, which they’ll be looking to deploy into tax shelters.

What the U. S. government will sacrifice, meanwhile, is the ability to tax rents on anything exported. So every barrel of oil taken from U. S. soil but sold overseas, or every bit of American ingenuity that’s priced into an Apple iPhone sold abroad is suddenly lost to the U. S. tax system. Meanwhile, as mentioned earlier, any American business that imports inputs will suddenly face higher tax rates, unable to deduct those import costs, with the real possibility of some U. S. businesses end up paying more than 100 per cent tax rates on their shareholder-reported profits.

American companies that are highly leveraged, however (think utilities and distressed oil producers) will find themselves struggling as they lose the ability to deduct interest on their old debt.

So the House Republicans’ corporate tax reform proposal would have a profound impact on U.S. companies, some of it good, and some of it bad. And while it is appealing in terms of tax competitiveness, there are a lot of difficult issues that will be challenging to sort out to get it adopted by 2018 as planned. I suspect the Trump administration and Congressional Republicans will find themselves preferring a simpler way to spur economic growth: a sharply lower corporate income tax, accompanied by tighter rules to tax profits left abroad and fewer special carve-outs for favoured businesses. That would stoke American competitiveness and most U. S. companies would end up better off with that kind of straightforward reform.

TRUMP COULD BE REALIZING THESE PREDICTIONS ARE TOO SIMPLE FOR OUR COMPLEX WORLD.