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Trump to GOP On Corporate Taxes: Keep it Simple, Stupid

January 17, 2017, 11:30 PM UTC

Donald Trump wants a simple plan that could dangerously deepen the deficit. Paul Ryan advocates a complex new regime that even wonks strain to explain, but mainly pays for itself. The shared goal of encouraging the world’s corporate titans to create jobs and build factories in the U.S.—to restore our dominance as the colossus of exports—is setting the White House and Congress on a collision course.

The Republicans in the House of Representatives, led by Speaker Ryan, are championing a novel-as-they-come, intricately crafted measure known as “border tax adjustment” (BTA).

President-elect Trump famously shares their goals, but wants to do it his way. He advocates keeping things basic by using a combination of steep cuts in U.S. corporate tax rates and the threat of stiff tariffs to lure landmark investments stateside. In an interview with the Wall Street Journal on January 13, published online late Monday, Trump slammed his party’s plan, declaring, “Any time I hear ‘border adjustment,’ I don’t love it,” and assailing the Ryan-backed proposal as “too complicated.”

The House GOP Plan

Trump isn’t alone in denouncing the House proposal. Many of America’s largest importers, including retailers, energy producers, and Koch Industries, whose owners Charles and David Koch are big Republican contributors, strongly oppose the BTA.

Despite the shower of brickbats, the BTA does offer major advantages versus the Trump plan. Assessing its virtues requires studying how it actually works—no easy task. The BTA is not a direct tax on the dollar value of goods that are imported, coupled with a credit for products that are exported—that would be a classic value-added tax, of the kind deployed by virtually every country except the U.S. Instead, the BTA is an all-American invention. It provides all incentives through exclusions and deductions from the U.S. corporate income tax.

The BTA aims to lift America’s exports by making cars and computers shipped abroad far more profitable for anyone building them in the U.S., and making it a lot more costly to import goods made in China, Brazil or France.

Here’s how it works: We’ll begin with the proposed drag on imports. Take the example of a European carmaker that today manufactures in its home country, or any other country, and ships its vehicles to the U.S. Let’s say their luxury sedan costs $30,000 to make in Frankfurt, and sells in the U.S. for $50,000. Today, they’d pay our 35% corporate tax on the profit of $20,000, sending the Treasury $7,000.

Under the House plan, the U.S. tax would drop from 35% to 20%, but the foreign automaker would still be far worse off. That’s because all importers would pay the 20% rate not on their profits, but on every dollar in revenue they collect—in this case, the full price of the car, $50,000. Hence, the tax bill rises to $10,000 (20% of $50,000), an increase of 43%. The carmaker is now netting $10,000 ($20,000 in profit less tax of $10,000). If it manufactured those cars in the US, it would pay just $4,000 in taxes (20% of its $20,000 in profits), and its margin would jump to $16,000 per vehicle, an increase of 60%.

That’s a giant carrot for keeping production to the U.S., or moving it here. Naturally, the incentive applies equally to U.S. companies deciding whether to manufacture at home versus China, India or Ireland.

Now let’s look at how the new regime would encourage exports. Consider a U.S. automaker that exports SUVs from America to Ireland; we’ll use the same numbers. The vehicles cost $30,000 to make in the U.S., and the U.S. parent sells them to its subsidiary in Ireland for $50,000, representing the markup to the wholesale price. Today, the manufacturer would owe $7,000 on that transaction—the 35% U.S. rate on that $20,000 in profit. But under the House plan, all of the export is tax free. The only amount that counts for taxes is the expense, in this case $30,000. The automaker can deduct the $30,000 from its worldwide corporate income, generating a savings of $6,000. So instead of owing $7,000 in U.S. taxes, the company is getting a break of $6,000. That’s a swing of $13,000. Instead of making $13,000 per vehicle ($20,000 in profit minus $7,000 in taxes), the carmaker is effectively pocketing $26,000 ($20,000 in profit plus an effective rebate of $6,000).

As this example shows, the new rules, all operating through the tax code, could double margins for exporters.

But wouldn’t the House plan swell the prices of clothing, computers, toys, luxury cars and sundry other imports, sharply raising the cost of living for American consumers? Not so, according to some economists, including Kyle Pomerleau of the conservative-leaning Tax Foundation. For imports, the increased costs via higher taxes would be offset by a sharp rise in the dollar. “The reason is two-fold,” says Pomerleau. “First, the tax break on exports would lift U.S. sales abroad, so foreigners would need to acquire more U.S. dollars to buy them.” The second tonic for the dollar, says Pomerleau, is that the higher tax on imports makes it harder to sell their goods in the U.S., so that they have to pay more in euros or yen for each dollar they collect to keep supplying, say, the Wal-Marts of the U.S.

Among its supporters, the plan’s big selling point is that the U.S. will sell a lot more goods to the rest of the world, and import a lot less. Pomerleau isn’t buying it. “When nations make imports more expensive, they also tend to sell less to the other country,” he says. “So if we buy less from South Korea, we’ll also sell them less. And if we sell more from the [European Union], we’ll buy more from EU nations as well. So the trade balance will not be influenced.” The reason is basic: If U.S. producers overall sell more to the EU, they get paid in euros, and those euros can only be used to buy things or invest in Europe. So if U.S. industry collects more euros, it will spend more euros as well on plants and products there.

On the other hand, the plan offers three big pluses. First, as Pomerleau says, it’s “pro-growth,” chiefly because it lowers the U.S. corporate tax rate, making new investments potentially a lot more profitable. Second, it discourages companies from playing games with transfer pricing to lower their tax bills in the U.S. In our previous example, an importing company gets no benefit from inflating the declared price of a car to their U.S. subsidiary from $30,000 to $40,000, because it’s paying tax on the full sales price of $50,000.

Third, it would raise lots of money. Pomerleau esimates that because the U.S. now imports far more than it exports, the higher taxes paid by importers would dwarf the breaks granted to exporters, and net around $120 billion a year in new tax revenues. That money would be sorely needed to help offset the reduction in rates from 35% to 20%.

Trump’s Simpler Take

What about the Trump plan? On the campaign trail, Trump pledged to lower the corporate tax rate even more, to just 15%. Trump’s plan hasn’t been publicly released yet in any detail, but the idea is pro-growth. Like the House plan, it would discourage corporate “inversions” by bringing America’s levies closer to those of rival nations.

The rub is that the Trump plan would likely lower corporate income tax receipts by as much as 50%, or 5% of everything the Treasury collects annually. “That creates a big political problem,” says Pomerleau. “The Senate is unlikely to pass a bill with 60 votes because Democrats would never back a bill that greatly increases the deficit.” He adds that even if the Republicans try to use “reconciliation,” an approach that requires only 51 votes, they would still need to present a plan that did not increase budget deficits over the long-term, as required under the reconciliation rules.

The two approaches pit the need for lots of new revenue to pay for tax reduction, versus a simpler, more transparent plan that could add hundreds of billions a year to the deficit. Turning “pro-growth” from a slogan into a renaissance in jobs and manufacturing could prove Trump’s greatest domestic challenge.