by Michael Stumo
The House GOP Tax Reform plan is very bold and includes some very helpful conceptual shifts. But it has some very strange results too. Let’s take a look at how it matches up against CPA’s preferred tax reform for trade competitiveness.
Speaker Paul Ryan and Chairman Kevin Brady (Ways and Means Committee) have proposed a very interesting destination based cash flow (DBCF) tax for business tax reform. The plan has these important features:
– 20% business tax rate to replace 35% statutory rate;
– Immediate expensing of most purchases which would otherwise be depreciable;
– Disallows interest expense in most cases;
– Disallows the deduction of imported goods and services; and
– Export sales are untaxed
The good part is that the GOP now agrees with CPA that border adjustable taxes – imports are taxed but exports are exempt from tax – are important to combat the trade unfairness of other countries’ value added taxes (see CPA’s VAT explanation here). The bad part is that we are concerned the GOP Plan can be easily gamed to eliminate tax liability. The ugly is that there is an extreme and apparently irrational variation in tax liability results among companies with different levels of imports and exports.
First, the good. The US needs to shift more of its tax system to border adjustable taxes, as Ryan/Brady suggest, so we apply taxes to imports and exempt exports. Over 150 countries have border adjustable consumption taxes (usually VATs) averaging 17%. VATs are like a tariff (they are charged on imports at the border) and a subsidy (exporters get a 17% VAT rebate, a government benefit like an export subsidy). When Mexico agreed to the North American Free Trade Agreement (NAFTA), it cut tariffs. But it also created a 15% VAT to replace the tariffs and to subsidize its exports.
The GOP has not yet agreed with CPA that a US VAT should be established in a way that offsets specific domestic taxes (like payroll taxes) and thus increasing trade competitiveness. But the DBCF tax does act as a consumption tax. Basically and with substantial caveats, it disallows the cost of imports as a deductible expense resulting in a 20% tax on imports, sort of. It also ignores export sales for tax purposes, which aims in the right direction but then gets weird, about which more in a moment.
Second, the bad. Tax evasion seems, at first blush, to be easy. If ACME Widgets Inc. has $10M in pretax income, what is to prevent the company from buying $10M in wheat that is already destined for foreign sale to increase its deductible domestic expenses. The export sale of that wheat, at $10M for no profit, does not result in taxable income. The result is ACME wipes out its tax liability with this strategic and irrational transaction.
Third, the ugly. While the DBCF tax and a VAT both tax imports and exempt exports, the DBCF tax produces wild fluctuations in tax results that seem wrong.
Compare the tax results of a 20% VAT (in the context of our current corporate tax system) and the GOP Plan 20% DBCF tax as applied to ACME Widgets Inc. ACME has $100M domestic sales, $50M domestic costs and $40M import costs for $10M pretax income.
1. Tax result for ACME with a 20% VAT and a 35% corporate tax rate (CBO says the effective tax rate is about 27%)
$100M revenue from domestic sales
– $25M domestic labor cost
– $25M domestic goods cost
– $40M imported goods cost
= $10M pretax income
x 27% effective corporate rate (as per CBO)
= $2.7M income taxes owed
Let’s assume there is also a 20% VAT, then ACME pays a $7M VAT amount on the $35M value it added to the goods – $100M sales minus $65M goods costs. It collects the VAT upon sale and remits it to the government. Any VAT, properly implemented, should be offset by a reduction in payroll taxes for a near net zero aggregate tax revenue result.
2. Tax result from GOP Plan with 20% corporate tax rate
$100M revenue from domestic sales
– $25M domestic labor cost
– $25M domestic goods cost
– $0 imported goods deduction for tax purposes (although they have $40M actual imported goods costs)
= $50M pretax income
x 20% (GOP proposed statutory rate)
= $10M income taxes owed (an amount equal to the pretax income of ACME)
The current tax system (plus a VAT) and the 20% DBCF tax rates produce very different results. Retailers and importers are strongly against the GOP Plan. While CPA usually disagrees with the import lobby, in this case they have a point.
[Note: This example #3 has been added after first publishing this post]. I believe one more illustrative example is needed, that of ACME exporting goods. Again, the point is that the border adjustability based upon destination of sales is a good idea, but pegging it on cash rather than profit produces strange results.
3. Tax result from GOP plan where ACME exports 50% but all costs are domestic
$50M revenue from domestic sales (taxable under GOP plan)
+$0M revenue from export sales (not recognized as revenue under GOP plan)
– $90M domestic labor and goods costs
= -$40M pretax income
x 20% (GOP proposed statutory rate)
= $0 income taxes owed
THE BETTER PLAN: Destination Based Profit Tax plus a Value Added Tax
Congress should propose a border adjustable business profit tax for federal tax reform based upon formulary apportionment/sales factor apportionment (SFA). All states use formulary apportionment now for corporate income tax, and most use sales as the only factor (rather than including payroll and property, as a few states also include).
CPA believes that SFA for business income tax plus a consumption tax is the best ultimate combination for trade competitiveness, i.e. tamper proof territorial income tax and consumption tax. Our policy states, regarding SFA: “Lower corporate tax rates and end corporate inversion and profit shifting tax avoidance by taxing the income of consolidated business groups, whether domestic or foreign, based upon proportion of global sales in the US.”
This flyer explains the basics of the plan. If adopted, it probably should be across all businesses, including C corporations, S corporations, LLCs, partnerships and sole proprietorships. CPA is agnostic on the business tax rate, but we do note that the same tax revenue can be collected with a lower rate because transfer pricing and profit shifting are eliminated.
Consider these much more rational SFA tax results for Domestic Corp, Multinational Corp and Foreign Corp, all who produce widgets. They are simply taxed based upon the proportion of sales in the US (territorial tax) regardless of domicile.
1. Domestic Corp produces 100% in the USA and exports 20% of its widgets.
– pretax income is $10M, tax rate is 20%
– 80% of pretax income ($8M) is taxed in US, $2M is untaxed here
– tax owed is $1.6M ($8M x 20%)
2. Multinational Corp (domicile in US) produces 10% of its widgets in the US, sells 50% here, and has many tax haven subsidiaries to whom it used to transfer price in order to shift profit and avoid US tax.
– pretax income is $100M, tax rate is 20%
– 50% of pretax income ($50M) is taxed in US, $50M is untaxed here
– tax owed is $10M ($50M x 20%)
3. Foreign Corp (domicile in Ireland) produces 0% of its widgets in the US, sells 20% here, and has many tax haven subsidiaries to who it shifts income through transfer pricing to avoid US tax
– pretax income is $100M, tax rate is 20%
– 20% of pretax income ($20M) is taxed in US, $80M is untaxed here
– tax owed is $4M ($20M x 20%)
If you add a US value added tax (say 10-20%), all imported and goods and services have a 10-20% tax on top. But that money should fund an equal reduction in payroll taxes. The result is that domestic consumers and businesses are held harmless because they higher costs of purchases are offset by the higher earnings (payroll tax reduction). Exports are shipped VAT free, reducing prices to increase export sales, while imports are taxed, increasing their price in our domestic market.
The result can easily be revenue neutral, maintain progressivity, and spur tremendous job and economic growth. The GOP Plan breakthrough on border adjustability could achieve astounding gains.
