Trump Wants a Win, But This Tax Plan Is a Loser
(Bloomberg View) -- Now that President Donald Trump has failed to repeal and replace the Affordable Care Act, he’s turning to tax cuts to get a much-needed political win. There’s just one problem: What the Republicans want violates international law. If the reform bears any resemblance to the leading proposal, favoring corporate exports over imports, it’s going to get the U.S. sued in the World Trade Organization -- where it will lose.
It’s conceivable that Republicans won’t care about the defeat or the trade sanctions from other countries that the tax plan would likely bring. But ignoring the real-world consequences of the proposed reform would be self-destructive. It won’t mean a win for the Trump administration, not even the short term.
The House Republican tax plan was released in June 2016. Its central logic is to give an advantage to U.S. exports while taking advantages away from imports. The wisdom of that approach is open to discussion, but I’ll leave that issue to the economists.
The most pressing legal difficulty is that the proposal’s very objective is in tension with the treaties the U.S. has signed that commit it to the basic principle of international trade law: in particular, the commitment not to treat goods made outside the country differently from goods made inside.
The Republican tax plan reduces the corporate income tax rate from 35 percent to 20 percent. To pay for that, the proposal imposes a 20 percent tax on imports. (Currently, when a U.S. company imports goods, it can deduct the cost of those goods from its earnings when computing its corporate income tax. The plan eliminates that deduction, too.)
The proposal also exempts U.S. exports from taxes. Yet in doing so, it treats U.S. companies differently from foreign companies.
U.S. companies can continue to deduct the cost of their employees’ labor when computing their corporate income tax. But when computing the 20 percent tax on imports, there would be no adjustment made for foreign companies’ labor costs.
This sounds fairly blatant, but the Republicans do offer a justification.
Under international trade law, they admit, the U.S. can’t just tax imports. That would count as a tariff, which violates the basic principle of treating imports and exports equally.
To claim it hasn’t created an illegal tariff, the Republican plan transforms the basic structure of how corporate income tax now works. Instead of taxing U.S. companies’ income on whatever it sells, at home or abroad, the Republican plan would tax the consumption of goods in the U.S.
Tax experts call this a “destination tax” system, because instead of taxing goods where they are created, in their country of origin, it taxes them where they end up, in their destination. The most familiar example is the value-added tax. Almost every country in the world has some form of a VAT. The U.S. is an outlier.
VATs are not only ubiquitous but also legal. Under international law, the VAT has to be the same on imported goods as on goods produced and consumed locally. So long as there’s no discrimination between locally made goods and foreign goods, the VAT isn’t a tariff.
In other words, if a German wants to buy a BMW in Germany, the VAT has to be the same as if the German buys a U.S.-made Ford there.
But Germany can exempt exports from the VAT, because it’s taxing consumption in Germany, not consumption outside. That’s why, when you’re a tourist, you can get VAT payments back at the airport when leaving a VAT-charging country -- because you will be consuming the goods abroad, not where they were produced.
Congress can pass the plan anyway and the president could sign it, notwithstanding the violation of international law. But that would open the U.S. to retaliatory sanctions from other countries. It would also probably lead to a lawsuit against the U.S. before the WTO, which could result in significant damages.
Countries sometimes violate international trade law on purpose, knowing they will be sued and hit with retaliation. That can even be rational, if the immediate advantages of the breach outweigh the costs of enforcement over time.
This isn’t such a case. The world would see the U.S. as instituting a discriminatory tariff and breaking the rules of international trade. That’s a good way to start a trade war.
Following international law is the way to go here. Otherwise the Trump administration is going to see another defeat, not the win it so badly wants.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Justin Fox is a Bloomberg View columnist. He was the editorial director of Harvard Business Review and wrote for Time, Fortune and American Banker. He is the author of “The Myth of the Rational Market.”
The plan also seeks to eliminate incentives for U.S. companies to keep their profits abroad, in lower-tax jurisdictions. That’s fine, but it isn’t my focus here.
The U.S. trade deficit is approximately billion a year, meaning that the U.S. imports that much more stuff than it exports. Taxing that at percent would in theory yield billion a year, or trillion over years.
Under WTO precedent, a system of exempting exports from taxes called a “border adjustment” is only allowed for “direct taxes” on goods, like the VAT, not for “indirect taxes,” like the corporate income tax. That alone may be enough to sink the plan before the WTO. But at least the U.S. would be able to claim in future litigation that in economic terms, the tax worked enough like a VAT to be lawful.
According to economic theory, U.S. consumers will be able to pay the tax on imported goods because the value of the dollar will automatically go up in parallel to the tax. No one knows if that will happen in practice. The fact that U.S. exporters love the proposal while U.S. importers hate it is a sign that both don’t necessarily believe the theory.
There's a forced argument that it doesn’t, because the U.S. could in theory separately lower the payroll tax while enacting a VAT. But because the plans are inextricably intertwined in reality, it’s hard to imagine the WTO accepting that argument.
To contact the author of this story: Noah Feldman at nfeldman7@bloomberg.net.
To contact the editor responsible for this story: Stacey Shick at sshick@bloomberg.net.
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