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Deductions Could Spell WTO Trouble for the GOP “Border Adjustable Tax” Plan

Tuesday, February 28, 2017 9:27
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(Before It's News)

In a previous Cato blog post, I explained how the House Republican “Better Way” corporate tax plan, which replaces our current 35% corporate income tax with a 20% “destination-based cash flow tax” (DBCFT), could theoretically avoid litigation at the World Trade Organization (WTO) and member countries’ eventual, WTO-approved retaliation against billions of dollars worth of US exports. I concluded therein that, while there wasn’t yet enough concrete information about the DBCFT’s final form to determine its WTO-consistency, the conventional wisdom was wrong to assume that any US corporate tax plan would violate the United States’ international trade obligations. Today, on the other hand, I’ll explain the quickest way that the DBCFT could get into trouble at the WTO. 

 

 

 

Spoiler: it’s all about the deductions.

 

 

 

I won’t reiterate here how the DBCFT is intended to operate and again will acknowledge that we haven’t actually seen any legislative text yet. That said, there is a pretty clear consensus view among economists that the DBCFT would essentially operate as a modified “subtraction-method” value-added tax (VAT) on US corporations’ domestic sales revenue, minus taxable input purchases. This was helpfully summarized in a recent Paul Krugman blog post (emphasis mine):

 

 

 

[A] VAT is just a sales tax, with no competitive impact. But a DBCFT isn’t quite the same as a VAT. With a VAT, a firm pays tax on the value of its sales, minus the cost of intermediate inputs—the goods it buys from other companies. With a DBCFT, firms similarly get to deduct the cost of intermediate inputs. But they also get to deduct the cost of factors of production, mostly labor but also land. So one way to think of a DBCFT is as a VAT combined with a subsidy for employment of domestic factors of production. The VAT part has no competitive effect, but the subsidy part would lead to expanded domestic production if wages and exchange rates didn’t change.

 

Just so we’re clear that I’m not playing partisan favorites here, Krugman’s view was essentially echoed by Republican/conservative economist Greg Mankiw, who called the DBCFT “like a value-added tax” on corporations’ US sales with “a deduction for labor payments.”

 

 

 

While economists disagree about the economic and trade effects of the DBCFT, the aforementioned descriptions have generated significant (though certainly not consensus) concerns with respect the whether the new tax would be consistent with WTO rules—concerns that don’t arise with a VAT. As I discussed last time, the DBCFT would have to clear at least three hurdles at the WTO—two on the export subsidy side and one on the import side:

 

 

 

  • Export subsidy: The DBCFT would be found to confer prohibited export subsidies under the Article 3 of the WTO Subsidies Agreement where (1) the tax is found to be a “direct tax,” which the Agreement defines as “taxes on wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property” (VATs are a type of “indirect tax”); and (2) the “border adjustment” (i.e., tax exemption or rebate) for a company’s export sales is greater than the actual amount of tax due or collected.
  • Import discrimination: The DBCFT would violate the “national treatment” principle of GATT Articles II and III (on internal taxes) where it imposes a higher tax burden on an imported good than that imposed on an identical domestically produced product.

 

The concern among us trade lawyers rests in the deductions for labor and (maybe) land that a VAT doesn’t have but the DBCFT does—deductions that could generate violations of one or more of the aforementioned disciplines. This can be pretty difficult to see in the abstract, but the problems—as well as their absence for a normal VAT—become clearer through a simple hypothetical assessment of the tax’s effect on two identical US companies selling and exporting the same product, with one company selling only imported final goods and the other selling identical products with 100% US content. So let’s do that now, starting with a classic example used by the US Government Accounting Office to show how a standard subtraction-method VAT, which taxes corporations’ domestic (not export) sales revenue and permits one deduction for domestic (and thus taxable) input purchases, works in practice.

 

 

 

Effect of Basic Subtraction-Method VAT (No Export Sales)

 

 

 

The table below illustrates the tax treatment under a standard, 10% subtraction-method VAT for two different value chain scenarios. In this example, we presume no export sales by any company involved to make it as simple as possible.

 

 

 

Scenario 1: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

$20 $70 $80 $170

Taxable (US) Purchases

$0 $20 $70 $90

Net Receipts (i.e., Tax Base)

$20 $50 $10 $80

VAT Amount

$2 $5 $1 $8

 

Scenario 2: Import-Only Value Chain (VAT=10%)

 

US Retailer

Sales

$80

Taxable (US) Purchases

$0

Net Receipts (i.e., Tax Base)

$80

VAT Amount

$8

 

As shown above, the total effective tax paid on the final product (baseball bats) is the same in both value chain scenarios: $8. (This assumes, consistent with economic theory, that the full amount of the VAT in the US-only scenario is passed through in each stage to the final sale, so the retailer in this example is in effect paying the full $8 tax, even though he’s only paying $1 directly to the IRS. The tax is thus embedded in the “taxable purchases” value in each of the Scenario 1 tables shown throughout.) As a result, concerns that the VAT imposes a higher tax burden on the import-only retailer (Scenario 2)—thus raising a potential import discrimination problem under GATT Articles II and III—are minimal.

 

 

 

Effect of Basic Subtraction-Method VAT (Export Sales)

 

 

 

The next example shows the effects of a US corporation exempting 100% of its export sales value from its tax base (a “border adjustment”). For the sake of simplicity, only the retailer here exports—50% of total sales—in these scenarios.

 

 

 

Scenario 1A: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

US

Export

US

Export

US

Export

US

Export

$20 $0 $70 $0 $40 $40 $130 $40

Taxable (US) Purchases

$0 $20 $70 $90

Net Receipts (i.e., Tax Base)

$20 $50 $-30 $40

VAT Amount

$2 $5 $-3 (credit) $4

 

Scenario 2A: Import-Only Value Chain (VAT=10%)

 

US Retailer

 

US

Export

Sales

$40 $40

Taxable (US) Purchases

$0

Net Receipts (i.e., Tax Base)

$40

VAT Amount

$4

 

Even with the border adjustment on export sales, the effective tax burden is the same in both value scenarios, thus obviating concerns regarding discriminatory tax treatment against imports under the GATT. Furthermore, this tax raises no concerns regarding prohibited export subsidies because (i) VATs aren’t a “direct tax” under the Subsidies Agreement and (ii) the amount of the tax exemption ($4) for export sales isn’t greater than the amount of the tax that the exporter (retailer) in each scenario would have owed if the baseball bats had just been sold in the United States instead of exported (also $4). As a result, the risk of a WTO challenge to this type of tax system is low.

 

 

 

This risk increases significantly, however, once you add other deductions—such as the wage/salary deduction mentioned by Krugman and Mankiw above—to the corporate tax. This is shown in the next examples.

 

 

 

Effect of a “Modified” Subtraction-Method VAT with Wage/Salary Deduction (No Export Sales)

 

 

 

A provision that permits US corporations to deduct from the tax base both taxable input purchases and domestic wages and salaries would reduce the tax base for all upstream participants in the “US-only” value chain (Scenario 1), thus lowering the total tax paid on the product(s) at issue. However, because a retailer/importer (Scenario 2) would only be able to deduct its own wages/salaries, the imported baseball bats would face higher total tax burden than the 100% American-made baseball bats

 

 

 

Scenario 1B: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

$20 $70 $80 $170

Taxable (US) Purchases

$0 $20 $70 $90

Wages/Salaries

$10 $10 $5 $25

Net Receipts (i.e., Tax Base)

$10 $40 $5 $55

VAT Amount

$1 $4 $0.50 $5.50

 

Scenario 2B: Import-Only Value Chain (VAT=10%)

 

US Retailer

Sales

$80

Taxable (US) Purchases

$0

Wages/Salaries

$5

Net Receipts (i.e., Tax Base)

$75

VAT Amount

$7.50

 

In the example above, the total VAT paid on the imported good (baseball bats) is now greater ($7.50) than the VAT paid on the American baseball bats ($5.50), thus creating an apparent disincentive to sell the imported bats. In other words, if given the choice between selling an imported bat and an identical American-made bat, the US retailer operating under this “modified” VAT would have a financial incentive to buy American because he’d be paying higher total tax on the import. This same incentive would apply to other companies in the United States, and not just at the retail level. As such, the additional wage/salary deduction—very similar to the one described by Krugman and Mankiw above for the DBCFT—raises serious concerns that the DBCFT would be found to impermissibly discriminate against imports in violation of the United States’ national treatment obligations for internal taxes under GATT Articles II and III. 

 

 

 

One could try to argue that this discrimination is not a WTO violation because (i) it’s equivalent to a labor/wage deduction provided through a separate tax measure like the payroll tax (which raises no WTO concerns); or (ii) its discriminatory effects are eliminated through currency adjustments or through an examination of the actual economic effects of US tax reform as a whole. However, there’s little indication that a WTO panel would undertake such a comprehensive analysis, instead of simply examining the basic, superficial impact of the DBCFT measure itself in a manner similar to what I just did above. Indeed, I doubt WTO Members—including the United States!—would want the WTO to undertake such a speculative economic and legal analysis (and panels have in the past shied away from examining actual trade effects).

 

 

 

The border adjustment for export sales provides one final concern, as shown next.

 

 

 

Effect of a “Modified” Subtraction-Method VAT with Wage/Salary Deduction (Export Sales)

 

 

 

If the “modified” VAT included a border adjustment on exports, while still permitting corporations to deduct 100% of wages/salaries (instead of proportional to export sales), the system could create a higher effective tax on an import-only value chain and a possible subsidy for exports due to the over-exemption of tax otherwise due on export sales. Again, in this scenario only the retailer exports (50% of its sales).

 

 

 

Scenario 1C: US-Only Value Chain (VAT=10%)

 

US Lumber Company

US Baseball Bat Manufacturer

US Retailer

Total

Sales

US

Export

US

Export

US

Export

US

Export

$20 $0 $70 $0 $40 $40 $130 $40

Taxable (US) Purchases

$0 $20 $70 $90

Wages/Salaries

$10 $10 $5 $25

Net Receipts (i.e., Tax Base)

$10 $40 $-35 $15

VAT Amount

$1 $4 $-3.50 (credit) $1.50

 

Scenario 2C: Import-Only Value Chain (VAT=10%)

 

US Retailer

 

US

Export

Sales

$40 $40

Taxable (US) Purchases

$0

Wages/Salaries

$5

Net Receipts (i.e., Tax Base)

$35

VAT Amount

$3.50

 

In this case, the same import discrimination issue arises as the one noted in the previous example, but the exported baseball bats in the US-only value chain also receive an extra $2.50 tax benefit ($4 in Scenario 1A versus $1.50 in Scenario 1C) due to the labor deductions taken at all stages of the US value chain. It would be difficult to argue, however, that the full value of that labor benefit was due on those exports where only a portion of the labor was used to produce taxable goods (i.e., domestic sales). Put another way, the export sales should not benefit from any tax deduction for labor because they did not generate any tax owed in the first place, and providing this benefit could be considered an export subsidy. Thus, there is a legitimate argument to be made that the DBCFT would generate prohibited export subsidies under Article 3 of the SCM Agreement (over-exemption/rebate of internal taxes owed/due) where it permitted a 100% deduction for a firm’s wages/salaries plus a 100% exemption for that firm’s export sales. That appears to be the case with the DBCFT, though we’ll have to wait for the final legislative text to be sure.

 

 

 

Finally, there is a risk—not shown in the charts above—that the DBCFT would be found to constitute a “direct tax” where it permits so many additional deductions that it more closely resembles a corporate income tax than a VAT or sales tax. In short, the more deductions, the more likely it’s a direct tax (and thus confers prohibited export subsidies, regardless of the over-exemption/rebate of taxes on exports). This question is far murkier, however, that the other two issues above.

 

 

 

Maybe the final DBCFT will resolve these WTO problems by eliminating the extra deductions, or maybe Congress just simply ignores them and takes its chances at the WTO (risking billions in US exports in the process). But that doesn’t mean the problems don’t exist, no matter what some DBCFT cheerleaders might have you believe.



Source: https://www.cato.org/blog/deductions-could-spell-wto-trouble-gop-border-adjustable-tax-plan

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