Border adjustment tax is dangerous unknown

Congress is finally moving on tax “reform” and House Ways and Means Committee’s hearings brought forth a bevy of corporate executives — including from our own Target Corp. — to opine on the proposed “border adjustment tax” — a tax on imports, cast as a component of a revised corporate income tax. This is House Speaker Paul Ryan’s pride and joy but gets little support from the Trump administration itself.

My personal opinion is that, first, the tax is a bad idea and, second, that it isn’t going to get through Congress. So I hope the issue is moot. But the current political situation is one in which we should never say “never,” so it is useful to consider key aspects of the idea.

It also offers key elements of fundamental economics.

First, how will the tax, as proposed, operate?

It will be part of the corporate income tax. In any such tax, businesses total up revenue and deduct allowable expenses. Inputs purchased by manufacturers or finished merchandise purchased by retailers clearly are business costs and always are counted as expenses against sales revenue when calculating taxable income. But that would no longer be true across the board. The cost of any such items imported from other countries would not be deductible.So if companies cannot offset income with the expense of imported items, the end effect is the same as an import tariff equal to the marginal income tax rate faced by the corporation.

This non-deductibility of the cost of imported items as business expenses would be paired with the ability to exclude any revenue from goods exported from the income side of the tax return — a seeming incentive to promote “made in the U.S.A.” But that is less controversial and is the subject of a different column. Target, for example, does not make things for export.

Second, if this works as a tax on imports, who will actually bear the cost of the tax?

Advocates of import taxes in general argue that such taxes hit the Mexican, Chinese or other foreign manufacturers selling things to us. Many supporters of a BAT say the same. This largely is incorrect. Yes, the United States will import less and foreign producers will sell less. Their income will thus drop somewhat. So businesses and individuals in other countries will bear some fraction of the cost of the tax. But these businesses have other markets among developed countries around the globe, so they can adjust.

Opponents of the tax, including Target CEO Brian Cornell, assert that U.S. consumers would bear the entire burden of the tax and would face price hikes of 20 percent on everyday essentials — things like towels, toys, electronics, clothes, etc. This is based on the assumption that the new marginal corporate rate would be 20 percent and fully passed on to the consumer to protect Target’s bottom line. This argument, putting it very politely, also is highly misinformed.

The proportion of a tax that buyers must bear depends on how sensitive to price changes quantities purchased are and on how quantities produced respond to the same price changes. Do people buy fewer towels when the price goes up? Do factories make less when demand goes down? In econ 101 terms, the incidence of the tax depends on the elasticities of supply and demand for a specific product.

These vary from product to product and they vary with the length of time given for the economy to adjust. In a few cases, the price increase may be near zero and in others near 20 percent. No one really knows what the weighted average will be across tens of thousands of different things we import and buy and sell.

In fairness to Cornell and other retailers who oppose the tax, while the exact 20 percent figure is in error, consumers will indeed bear by far the largest burden of the tax. There is ample evidence of this from economic theory and centuries of experience.

Note, however, that there is a logical error in the whole argument made by retailers. They argue that the BAT will increase their own tax burden greatly and that it will all be borne by consumers. But it can’t do both.

If buyers face a 20 percent increase in prices, then retailers are not really paying the tax themselves. Yes, the total amount of money that a retailer will remit to the U.S. treasury under a BAT will be large relative to their profits, but they will have additional revenue from consumers in the form of the 20 percent tacked on to relevant items. If retailers really pay more out of profits, then consumers are not paying more.

Also consider effects of a 20 percent tax on such imports as crude oil, coffee, cocoa, tea, shrimp, coconut, tin and chrome. Advocates of import taxes give the impression that the tax will largely affect manufactured goods. Shuttered factories in Ohio, Michigan and other regions that once turned out such goods magically will reopen overnight and start cranking out U.S. substitutes at only a slightly higher cost to consumers than they were paying for these items sourced in Bangladesh or Mexico. This is delusional. There are many imports we never produced in the U.S. and many others that could only be made here at a substantially higher price and only after years of structural readjustment.

So it is not just a matter of paying an extra dollar for a jacket to send your child off to school in September or a few dollars on a new set of dishes — all to support U.S. manufacturing; it is tens of added dollars per ton of potash fertilizer or tens of cents per gallon of diesel fuel for Minnesota farmers. It is higher cost steel for manufacturers like Graco and Toro and for highways and high rises.

Third, what about the effects of changes in the value of the dollar on who is affected by the tax and how?

Many economists pointed out that, considering all the likely effects of the BAT, the U.S. dollar would increase in value relative to the currencies of countries that have been exporting to us. This increased buying power in international trade would act in an opposite direction to the tax. So the net effect on consumers would not be as large as one might think. This is correct in very general terms.

Advocates have seized on these findings to make a having-the-cake-and-eating-it-too arument. Consumers need not worry since appreciation of the dollar will offset the tax and consumers won’t be hurt at all. Don’t fall for this.

First, no economist has argued that the adjustment will be exactly equal to the tax averaged across all items and sectors. Secondly, exchange values of currencies are driven by many different factors, including the overall states of national economies, interest rates, investment flows, national saving or dissaving and so forth. BAT advocates assume the economy will buzz right along after these proposed “reforms” are instituted and that other nations will not react in ways that will harm us or the global economy. Such assumptions are dangerous and unsupported.

Moreover, to the extent that the value of the dollar would rise, it would also offset any incentives to exports generally. It would offset the effects of the excludability of revenue from export sales that is the counterpart of the BAT. And it would hit traditional export sectors like agriculture just as any increase in the value of the dollar does. Minnesota farmers have a lot at stake anytime we start changing trade policy and the BAT would the biggest change in 80 years.

An additional question is the legality of the proposed tax under treaties we have signed. This is doubtful. If we really reformed out tax system and replaced the corporate income tax with the sort of value added tax used by nearly every other nation in the world, the legal precedents would be clearer. But we are not and the preponderant legal view is that a BAT would break World Trade Organization rules to which we have subscribed.

True, standing by contractual commitments we have made to other nations doesn’t seem to be a high priority to the Trump administration nor, for that matter, to many Democrats either, at least in terms of trade. But every time we violate promises we made, we undermine our credibility as a nation going forward. That has a cost, even if not immediately visible.

Finally, if we unilaterally break our side of these contracts, we can be sure two things will happen. Other nations will begin legal challenges. Many apparently shrug these off. But other nations will take retaliatory measure of their own. The period of 1929-1933 showed us the degree to which trade wars are first and foremost self-destructive. But once started, domestic politics in all affected nations are such that tit-for-tat is hard to avoid. The border adjustment tax is a huge can of worms that we should leave sealed up.