Monday, January 16, 2017

Gavyn Davis on Auerbach’s Border Adjustments

Gavyn Davis struggles to grasp the Destination-Based Cash Flow Tax starting with this misconception:
The financial markets have begun to wake up to the fact that the Republican reforms to US corporate taxation will probably include important new “border adjustments” to the definitions of company revenues and costs. The basic idea is that US should shift to a “territorial” system, with corporations being taxed only on revenues and costs incurred within the US itself, and not on their worldwide aggregates, which is the principle behind the present system.
A lot of people are advocating getting rid of the repatriation tax and have the US join the rest of the world by having a territorial system. But the rest of the world taxes income at its source – not at its destination. Davis gets to this point eventually:
Although most other countries already operate “territorial” systems, the Republican plan includes other features that would make the new tax regime operate like a tariff on imports into the US, combined with a subsidy on many exports from the US, a combination that would have profound international economic consequences. This is not just an obscure change to the details of America’s corporate tax code. It would be seen by trading partners as a protectionist measure that could disrupt world trade.
Auerbach has noted that this plan is akin to replacing the corporate profits tax with a sales or VAT tax but with a twist – a subsidy to labor costs. Davis continues his discussion assuming that this labor subsidy would raise U.S. net exports, which would be the case if the exchange rate were fixed. Auerbach on the other hand has assumed that the dollar would so appreciate that there would be no effect on net exports. Davis notes this later:
Some proponents of a border tax, like Martin Feldstein, argue that the discriminatory nature of a border tax would be offset by an immediate rise in the dollar exchange rate which would exactly offset the impact of the tax on import and export prices.
If so – then what is the point of this proposal? Davis suggests:
Why would the US want to do this? First, in practice the new tax would be likely to raise a lot of revenue which could be used to pay for other reforms to the corporate tax system. Imports into the US exceed exports, so there would be a net gain reflecting the trade deficit.
Sure we import more goods than we export right now. But this is in theory a tax on profits with the big issue being that we would tax the intangible income created by foreign firms consumed in the U.S., while we would exclude the intangible income created by U.S. firms consumed abroad. As I noted:
we generate more IP income that most nations and DBCFT makes any IP income involved when foreigners consume our products tax free ... if we passed the DBCFT, then we would simply give up on taxing U.S. generated IP income when it is consumed abroad. This strikes me a very bad retreat from trying to enforce the transfer pricing rules.
I know I have been harping on this issue for a while but the other discussions of the transfer and income tax aspects of the Auerbach proposal strike me as falling horribly short.


Jerry Brown said...

Nice post.

I believe it is spelled Gavin Davies.

ProGrowthLiberal said...

Gavyn. Thanks Jerry. I sometimes screw up when I have to do a work around the Financial Times subscription wall.

Jerry Brown said...

I know what you mean. Place makes me register every time.

MaxSpeak said...

You didn't mention that expensing is supposed to goose domestic investment. More broadly, this is a consumption tax, which is supposed to boost saving. I'm skeptical, as was David Bradford, a major advocate of consumption taxation. said...

Neither of you have it right. He is Gavyn Davies.

Davies is right that this will have a tendency to appreciate the dollar. To put it mildly, a lot of the protectionist proposals being pushed by Trump and gang are likely to have this effect, which has already happened to some extent in anticipation of that. That this will not help out competitiveness of US industry goes without saying, snort! said...

BTW, I should add that we really do not know what will happen with the dollar, and Davies's assumption of some sort of equilibrium outcome is also unwarranted. Forex rates are very simply the least predictable of all macro variables and are notorious for doing the darndest things.

If one looks at the Wikipedia entry on "Unanswered Questions in Economics," 3 are supposedly on "Behavioral Economics," 3 are on "Financial Economics," but fully 6 are on "International Economics," with the majority of those ultimately boiling down to "Foreign exchange rates do not behave like our theories and models say they ought to." So, yeah, probably the dollar will go up like it did under Reagan, but we really do not know. Could plunge if he really screws up, which would ironically be good for all that midwestern manufacturing he promised to help out. said...

Correction: There are 4 unanswered questions in financial economics, not just 3. Examples of such are the equity premium puzzle. The behavioral list is goofy, with such things as tatonnement on the one hand and the search for a unified theory of biases on the other. On the international list, well, almost nothing in the theory of international economics seems to hold up in reality. I mean, heck, in a lot of markets the simple intro level law of supply and demand usually works, at least sort of most of the time.

ProGrowthLiberal said...

Barkley - I'm fine with what Gavyn said about the border adjustment issue as yes the dollar appreciation will tend to offset the labor subsidies either in part or fully (the fully said is what Auerbach is saying). I think this angle has been well covered.

My complaint is that the transfer pricing side is not being well covered. Auerbach makes the bold claim that transfer pricing will no longer matter. That is just wrong. What Auerbach's proposal is effectively doing is turning the US into a tax haven and the world of transfer pricing on its head. Foreign governments who do take transfer pricing seriously are going to be quite unhappy if this mess passes.

But here is the good news. Trump finds this idea to be "too complicated". I know people are laughing at Trump but it is too complicated.

Max notes the alleged benefits of just switching to a consumption tax. That's fine but if that is what Speaker Ryan wants to do - then just do it without all the complications.

Diana Sparks said...

Thanks for the information provided. I think that the US tax system needs improvement. Everything should work for people and be comfortable for them. I also think that the US tax system is quite complicated and it’s not always easy to figure out exactly what and how you have to pay. It’s easy to get loan but not easy to pay taxes. And of course, tax system must be fair. It’s wrong that middle class people pay a lot of taxes.