Reawakening the border adjustment

With certain provisions of the 2017 Tax Cuts and Jobs Act (TCJA) expiring this year, Congress has an opportunity to take another step toward radically remaking the tax system in a way that could simultaneously increase efficiency and opportunity. At the same time, policymakers are increasingly worried about foreign competition, profit shifting, and offshoring by corporations, which have led some stakeholders to recommend a heavier reliance on tariffs. I recommend that policymakers instead think about reviving one of the better ideas that died on the House floor prior to TCJA’s passage: destination-based cash flow taxes (DBCFT), also known as the border adjustment.

What is DBCFT and how does it work?

Prior to TCJA, business taxes were “worldwide.” If firms made profits overseas, they would have to pay taxes on that income as soon as it was repatriated to the United States. This led firms to engage in complicated but legal tax accounting practices, including the so-called “Double Irish with a Dutch Sandwich.” To exploit that, multinationals would use two Irish companies and a Dutch subsidiary to shift profits to tax havens. When done correctly, it results in paying no income tax.

Another strategy involved firms simply relocating to tax havens like Ireland to avoid U.S. income taxation entirely, something which distorts the way policymakers  measure GDP.  Such complications favored large multinational companies over smaller domestic companies that simply did not have the resources to follow the same tax avoidance strategies. TCJA introduced a number of provisions to help address the problem, but they were complicated and difficult to interpret. 

An alternative solution is a border adjustment mechanism. Under a DBCFT, goods and services are taxed based on where they are consumed instead of where they are produced. Businesses would be taxed based on the net cash flow: domestic revenue minus domestic cost inputs. Consequently, exporters would not be taxed at all.

In practical terms, if an American business sells a product to a domestic customer, the revenue it earns is taxed under the DBCFT. However, if the same company exports a product to a foreign customer, that sale does not incur U.S. tax because the consumption is taking place outside the United States. Likewise, businesses cannot deduct the cost of imported inputs under a strict border adjustment because those inputs were not produced domestically unless specific policy levers, exceptions, or credits are introduced.

If policymakers wish, they could introduce differential tax treatment for certain types of imports or exports. For example, if they wanted to discourage electric vehicle imports, they could levy an additional tax on those cars. However, one of the key benefits of the DBCFT is the simplicity it introduces. Opening the door to differential taxation risks collapsing the system into what we already have, which is a complicated morass of provisions and exceptions. That complexity largely hurts domestic workers and firms. 

Why should policymakers prefer a DBCFT?

There are three key reasons why policymakers, workers, and firms should get behind a DBCFT as an alternative to the current system:

1.     Economic Growth. One of the key components of a DBCFT is that it would result in businesses fully expensing all investment immediately. Today, a firm building a new plant has to depreciate it over several decades. Similarly, a restaurant buying a vehicle for delivery has to depreciate it over several years. This creates three separate distortions. First, the difference in how long assets are depreciated makes firms more willing to invest in equipment than structures. Second, current tax treatment makes firms less willing to invest overall than if the return on investment was tax-free—which would happen if the investment were expensed immediately.  Third, because maintaining old capital is tax deductible, firms over-maintain their existing capital instead of investing more in new capital, which considerably depresses growth.

Under TCJA, firms were temporarily able to expense all equipment investment, something which led to a considerable increase in corporate investment and GDP growth. A DBCFT would extend that generosity to all kinds of assets, which would correct all three distortions at once and lead to considerable economic growth. That would benefit domestic workers and raise wages for everyone. In the long run, the cost of an inefficient tax system is borne entirely by workers.

Moreover, the DBCFT method of achieving efficiency is cheaper than a corporate tax cut. For all its benefits, TCJA created a big hole in the ability of the federal government to raise revenue from corporate taxes. Eventually, that has to be paid for by American workers. A DBCFT with a positive tax would be just as efficient as a zero percent corporate tax rate but with a far lower revenue cost for the government. 

2.     Encouraging Domestic Production. A DBCFT would encourage multinational companies to locate in the United States instead of abroad. If firms are taxed based on where their output is consumed rather than produced, then they may as well produce in the United States. That addresses one of the core shared complaints of the populist right and the left: firms are offshoring production and locating abroad. Theoretically, a DBCFT would also raise demand for domestic labor, resulting in wage growth.

At the same time, populists express considerable interest in raising tariffs. A DBCFT effectively replicates a key component of a tariff by encouraging domestic producers to export goods and services while shedding the costly and distortionary burden of a complex tariff policy.

3.     Simplifying a Complex Tax System. The tax system remains complex and time-consuming. That is significantly easier for large businesses to handle than domestic producers. A DBCFT is considerably simpler than what we have now and would ease the administrative burden faced by small businesses.

Worth the potential risks

There are reasons to be skeptical of a DBCFT, many of which are outlined by Adam Michel of the Cato Institute here. For example, we do not fully understand the effect on currency appreciation and a DBCFT could turn into a value-added tax, something that may be worse than the current system. Nevertheless, implementing a destination-based cash flow tax would have substantial benefits for the economy as whole and for the American middle class in particular. It would raise wages through new investment and new domestic production and simplify the tax system. That simplification would be a boon to small businesses. Although it could lead to challenges in the transition, the benefits outweigh the costs.