Batting for Uncle Sam
Let me be clear: I am not an economist. But even as a tax lawyer, I can appreciate the superficial attraction (at least to some) of the US ‘blueprint for tax reform’. While it’s a radical departure from many of the tax norms we know today, it does seem to me brilliant in its simplicity (this is not the simplicity which accompanies President Trump’s own tax reform proposals which owe their simplicity more to their lack of detail).
So what's wrong (or right) with it?
I am certainly not blind to some of the weaknesses of the blueprint, for example its potential for putting US importers out of business due to the non-deductibility of imports, or the alternative scenario whereby there is a massive increase in the cost of dollar denominated debt. However, putting these objections to one side, and without entering into the whole globalization vs protectionism debate, the proposal really did seem to have something going for it. One feature that particularly stood out for me as a tax lawyer was its ability to tackle a whole raft of cross-border tax avoidance (and related regulations) by simply removing cross-border sales and purchases from the tax equation. From a tax administration’s point of view, that must seem like a dream (about to) come true. Nevertheless, the reality is that its prospects of making it onto the statute book seem less and less certain – although of course in the Trumpian world of politics anything could still happen.
Illegal or immoral?
Anyway, it came as a bit of a surprise when debating the blueprint’s merits with a former colleague, to hear it labelled as ‘immoral’. Now, I know there are illegality arguments under the WTO/GATT agreements, but immorality was not an objection I had heard raised before. Of course, he could have been referring to the possible impact on the cost of repaying third world dollar denominated debt, but he wasn’t. His point had to do with VAT. Now VAT is not a feature of either the blueprint or the Trump plan, but while there are some fundamental differences, there are also some similarities. The blueprint is the more obvious example, since it takes the form of a tax on (net) cash flow whereby inputs are generally deductible and outputs taxable, at each stage of the supply chain. More importantly, like most VAT systems it is destination based, in the sense that only domestic sales are taken into account. Under the blueprint this would mean that exports are exempt while imports would be non-deductible. This is the (in)famous ‘border adjustment’ part of the blueprint proposals, or ‘BAT’ as it has come to be known. This is also the bit that resolves a lot of the tax avoidance issues already mentioned, by taking out cross-border transactions.
A level playing field....but which one?
The border adjustment feature would likely have triggered President Trump’s interest for a number of reasons. One of these is the idea is that if US products are being subject to a tax (VAT) when they are imported into a foreign country, then the US should be imposing a similar tax on foreign goods imported into the US. And vice versa: if exports to the US are free of foreign tax, the same should apply to US exports to foreign countries - in order to ‘level the playing field’. A similar idea underlies Trump’s recent calls for some kind of ‘reciprocal tax’. On the face of it not an unreasonable proposition.
However, in reality a BAT could actually introduce a much greater distortion into the existing playing field, when seen from the perspective of US and foreign businesses selling to the same customer. Take for example a US company purchasing goods from (a) a US supplier and (b) a foreign supplier. The purchase price on the domestic transaction would be deductible but not the price paid for the imported goods; another way of looking at this is to say that the US company purchasing from the domestic supplier will only be taxed on its net ‘profit’ when it on-sells the goods, whereas it will effectively pay tax on its gross sales price when it on-sells the imported goods. Other things being equal, it is obvious which supplier the US company would choose. And that is of course part of the objective behind the border adjustment mechanism: to promote US business.
A VAT system works differently. Even though the imported goods would be taxable (the equivalent of being non-deductible under a cash flow tax), so would the purchase from a domestic supplier. The purchaser then has the same possibility to deduct the VAT whether it bought from a domestic or a foreign supplier. The playing field would be level for both domestic and foreign suppliers competing for the same customer. An imbalance also arises under border adjustment if the customer is based outside the US. The US supplier would not be taxed on the sales price it receives whereas a foreign supplier selling to the same (foreign) customer would typically be subject to corporate income tax on its (net) income. Under a VAT system, the foreign (non-US) customer would have to pay local VAT whether purchasing from a US or a local supplier.
So it will create an unlevel playing field
As the OECD puts it in its recent International VAT/GST Guidelines, the idea behind the destination principle in a VAT system is that it “places all firms competing in a given jurisdiction on an even footing”. But the border adjustment mechanism, far from creating a level playing field could actually distort it. Whether or not you call that immoral, it is certainly not playing cricket (which of course also needs a level playing field).
Or will it?
Now some economists predict that these imbalances will be neutralized by a corresponding uplift of the dollar. So, for example, the US importer may not get a deduction for the price it pays, but because of a stronger exchange rate it will need less dollars than it would if it bought the same product from a US supplier. Even if this turns out to be the case – and as everyone knows economic predictions have a nasty habit of disappointing – it’s not going to happen overnight. And if it did happen, where does that leave the benefit for US businesses? So despite its initial attraction, it’s perhaps not surprising that President Trump hasn’t yet decided whether he’s going in to bat…..