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.