Written Testimony Submitted by Andrew F. Quinlan
Center for Freedom and Prosperity
To the House Committee on Ways and Means hearing on
“Increasing U.S. Competitiveness and Preventing American Jobs from Moving Overseas”
May 23, 2017
There’s widespread agreement regarding the need for comprehensive tax reform. High U.S. corporate tax rates leave U.S.-based multinationals at a competitive disadvantage, while excessive complexity burdens taxpayers and the economy with unneeded costs. It is long past time to make correcting these problems a top legislative priority.
Unfortunately, the path to tax reform is being hindered by the prospect of adopting a destination-based cash-flow tax (DBCFT). The proposed switch to a “border adjustable” system has divided both businesses and the free-market advocacy community, constituencies whose full support is needed to help shepherd tax reform through the legislative process.
The strong opposition to the DBCFT is due to its significant political and economic risks. These include the similarity between the tax and European-style VATs that have fueled the growth of governments on the continent, the ambiguity of WTO rules regarding the tax structure, and the likelihood that currency appreciation will not fully offset the shifting of the corporate tax burden onto consumers, among other concerns.
The False Promise of the DBCFT
The DBCFT is being sold as a correction to a tax injustice, or what some call a “Made in America Tax.” Supposedly, U.S.-based exporters pay a tax penalty that foreign producers who sell in the U.S. do not, and the DBCFT is thus the solution. This understanding is flawed.
Proponents compare the U.S. corporate income tax to European VATs, but they ignore that these countries also have corporate income taxes, too. Only by misleadingly switching back and forth between domestic income taxes and foreign consumption taxes can it be claimed that there is not tax parity between imports and exports sold both within the U.S. and in foreign markets. Simply put, it makes no sense to complain that the U.S. does not border adjust like European nations when the reason is that the U.S. does not have a European-style VAT. To put it yet another way, you can’t rebate a zero percent consumption tax.
The real source of imbalance between the U.S. and foreign governments is our excessively high corporate income tax and uniquely destructive worldwide tax system. The obvious solution to this problem is to lower the corporate income tax and move to a territorial system.
The U.S. is Better Off Without a VAT
VATs provide easy revenue because they are characterized by large tax bases that allow for the collection of significant revenue with only small rate hikes, while also being largely hidden from consumers. This combination helps explain why the widespread adoption of value-added taxes precipitated dramatic growth in the size of European governments, and why advocates for bigger government in the U.S. have long sought to impose such a tax here as well.
The DBCFT is very similar to a subtraction-method VAT, except in that labor compensation is deductible under the DBCFT. It’s unclear, however, if the World Trade Organization would permit border adjustments on this type of tax. WTO rules distinguish between direct and indirect taxes, as border adjustments have been ruled to be allowed for the latter but not the former. And since the DBCFT is a direct tax that mimics the tax base of an indirect tax, it’s not at all clear how the organization would rule should the DBCFT be challenged.
Not only would this uncertainty undermine some of the pro-growth benefits of tax reform, but an adverse ruling would almost certainly lead to the adoption of a full VAT as the most politically expedient solution. That would start the U.S. down the same path forged by our European counterparts of bigger government, higher tax burdens, and, ultimately, slower economic growth.
Consumer Pain and Political Peril
The DBCFT shifts much of the corporate tax burden from exporters to importers, though the former will also face higher priced inputs from their international supply chains. On its face, that means consumers will take a hit. Proponents of the DBCFT claim higher costs for consumer goods will be offset by an accompanying appreciation of the dollar. Currency markets, they say, will immediately and perfectly adjust. Unfortunately, the evidence for this claim is mixed, and complications like the many foreign currencies that are pegged to the dollar leave the currency market less than perfectly efficient.
Even if currencies did entirely adjust, higher costs on consumer would remain a perceived reality if not an actual one. That would obviously pose an electoral challenge to lawmakers who backed tax reform, but more importantly from a policy perspective, would leave the new tax system vulnerable to demagoguery. Voters who felt they were bearing the burden of corporate tax reductions could demand that businesses pay their fair share. Advocates for bigger government and the higher taxes needed to fund it would be all to happy to offer the return of the corporate income tax, in addition to the DBCFT, to satisfy these complaints. Needless to say, such would completely undermine the entire purpose of this exercise.
Dangers of a Destination-Based System
A major downside of moving from an origin-based to a destination-based system that has received too little attention is the impact it would have on international tax competition. There’s a reason why left-leaning economists like Alan Auerbach tout destroying tax competition as a primary feature of the DBCFT. He bragged that the DBCFT “alleviates the pressure to reduce the corporate tax rate,” and would “alter fundamentally the terms of international tax competition.”
Advocates for higher taxes and bigger governments understand the role that tax competition has played in discouraging excessive taxation globally. If your goal is to make it easier for governments to raise tax rates, then the DBCFT looks like a great idea. But if you want to maximize economic growth and keep political greed in check, then it’s a big step in the wrong direction.
Tax Reform Without the DBCFT
Pro-growth tax reform should not need to be immediately and simultaneously paid for using an arbitrary and short-term budget window. The Kennedy and Reagan cuts were enacted without such constraints and the economy benefited as a result. If legislators nevertheless insist on paying for pro-growth tax cuts, the goal should be deficit rather than revenue neutrality, opening up the possibility of pairing pro-growth tax reform with much-needed spending reductions.
Although some arguments have been put forward to suggest that the DBCFT is desirable in its own right, it is only being proposed as a “pay-for” to offset the provisions of tax reform that are actually pro-growth. But even if it is decided that offsets are necessary, it makes little sense to choose a bad policy to pay for tax reform when there are alternatives available that also represent good policy. Or taking another approach, the need for revenues from the DBCFT could be eliminated by removing the switch to full and immediate expensing from proposed reforms and focusing instead on competitive rate cuts and tax code simplification.
Current reform plans rightly call for the elimination of the state and local tax deduction. This is good policy because the deduction encourages states to raise their tax burdens. However, other distortion-creating tax expenditures remain unchallenged, like the mortgage interest deduction, the municipal bond interest exemption, and the employer-provided health care exclusion. Closing these loopholes would not only provide the means to pay for rate reductions, but would simultaneously remove costly distortions from their respective markets.
Removing the unnecessary constraint of “revenue-neutrality” would open up further pay-for alternatives to the DBCFT by allowing for spending reductions. Rather than presupposing that the government is entitled to a particular share of taxpayer dollars, the alternative “deficit-neutral” approach would recognize that true pro-growth reform requires not only fixing the tax code, but also tackling out-of-control federal spending. Rather than implementing a dangerous new government revenue stream in the form of a DBCFT, a fiscally responsible approach to reform would pair the pro-growth cuts and tax code simplification with a combination of eliminating tax distortions and cutting wasteful and counterproductive programs.