Small aside on the border adjustment: a border adjustment eliminates the incentive to game the system by shifting profits offshore, but it does so by exempting profits on exports from any onshore tax. It basically abandons the notion of trying to tax the intellectual property (IP) rents on export income, or the economic rents from the export of natural resources for that matter. And it could create incentives for other kinds of gaming. I am convinced that the current system is heavily gamed in ways that hurt U.S. exports of IP and high-margin products (the active ingredient in pharmaceuticals for example), but the proposed border-adjustment gets rid of some of the games by in effect not taxing certain kinds of hard-to-tax income.I have seen some rough guesses of the alleged net revenue gains from DBCFT based on the simple minded notion that our imports exceed our exports. But if Greg Mankiw is right about this being eliminating the corporate profits tax in favor of VAT, then these rough guesses may be all wrong. I will try to explain using four examples two of which we shall discuss today. A 1989 discussion from the GAO explained how both a tax-credit VAT and a subtraction VAT works:
Both the subtraction and tax-credit methods of calculating a value added tax are based on the premise that value added is equal to a firm’s sales minus purchases. The methods differ in what information is used to calculate the tax. The subtraction method calculates the tax once during the reporting period on the total business activity of the firm. It is simply the total value of sales minus the total value of purchases multiplied by the tax rate. In contrast, the tax-credit method is calculated on the basis of individual transactions, i.e. on each sale and purchase. The individual calculations are then aggregated into the total taxes on sales and the total taxes on purchases. The difference is the tax liability of the firm.We will deal with subtraction VAT later this week but our current examples are based on imports from Europe which relies on tax credit methods. Rick Steves provides the relevant tax rates for European nations. Let’s imagine you bought a $10 bottle of French wine on the way home to celebrate Valentine’s Day with your wife. The multinational that sold you this bottle spent $7 in France making the wine and $2 in the U.S. on distribution costs. The intercompany price between the French parent and the U.S. affiliate was set a $7.50 by a bilateral Advance Pricing Agreement (APA) where the multinational did care want to game anything as French income tax rates are almost as high as the current U.S. profits tax rate. The French parent ended up paying $0.10 on French VAT since its value-added of $0.50 was taxes at a 20% rate. Auerbach would have us have the same VAT but then abandon the profits tax. So at this transfer price we would also get $0.10 in VAT after the tax credit and the labor subsidy are factored in but lose out on the $0.175 in income taxes. Auerbach et al. admit:
Taxing business income in the place of destination also has the considerable advantage that the DBCFT is also robust against avoidance through inter-company transactions. Common means of tax avoidance – including the use of intercompany debt, locating intangible property in low-tax jurisdictions and mispricing inter-company transactions - would not be successful in reducing tax liabilities under a DBCFT. Here however the distinction between universal and unilateral adoption is important. With adoption by only a subset of countries, those not adopting are likely to find their profit shifting problems to be intensified: companies operating in high tax countries, for instance, which may seek to artificially over-price their imports, will face no countervailing tax when sourcing them by exporting from related companies in DBCFT countries.As Brad notes – gaming the system will continue as our multinational will be tempted to lower the transfer price to $7 a bottle wiping out French profits. This change if allowed would increase U.S. VAT by lowering French VAT. Of course the French tax authorities would strongly object. Auerbach might advise the French to follow our lead by eliminating their corporate profits tax and relying exclusively using VAT. I don’t exactly see that happening but let’s talk about your lovely wife who was the real big spender buying you a $100 Swiss watch, which cost the Swiss parent $70 to make and its U.S. affiliate $20 to distribute. The current transfer price is set at $75, which makes this example a lot like that cheap bottle of wine you bought her. Since Switzerland has both low income taxes and a low VAT, I leave it to your brilliant wife to explain to you the details.