TWN Info Service on Finance and Development (Feb17/06)
21 February 2017
Third World Network
US protectionist border adjustment tax plan likely WTO-illegal
Published in Published in SUNS #8406 dated 21 February 2017
Penang, 20 Feb (Martin Khor*) - A new US tax plan, being considered by
Congressional Republican leaders and the President of the United States, is
likely to be violative of the fundamental principles of the World Trade
Organisation and its agreements, and could have a devastating effect on the
exports and investments of American trading partners, especially the developing
The plan, known as a border adjustment tax, would have the effect of taxing
imports into the United States, while providing a subsidy for US exports which
would be exempt from the tax.
The stated aim is to improve the competitiveness of US products, drastically
reduce the country's imports while promoting its exports, and thus narrow the
huge US trade deficit.
If adopted and enacted into law, it would significantly reduce the
competitiveness or viability of goods and services of countries presently
exporting to the US.
The US domestic prices of these exports will have to rise due to the tax
effect, depressing their demand and in some cases make them unsaleable.
And companies from the US or other countries that have invested in developing
countries because of cheaper costs and then export their products (final or
intermediate inputs) to the US will be adversely affected because of the new US
Some firms will relocate to the US. Potential investors will be discouraged
from opening new factories in the developing countries.
In fact this is one of the main aims of the plan - to get companies to return
their production to the US.
BACKGROUND TO THE BORDER TAX PLAN
The plan is a key part of the America First strategy of US President Donald
Trump, with his subsidiary policies of "Buy American" and "Hire
The border adjustment tax is part of a tax reform blueprint "A Better
Way" whose chief advocates are Republican leaders Paul Ryan, speaker of
the House of Representatives, and Kevin Brady, Chairman of the House Ways and
President Trump originally called the plan "too complicated" but is
now considering it seriously.
In a recent address to congressional Republicans, Trump said: "We're
working on a tax reform bill that will reduce our trade deficits, increase American
exports and will generate revenue from Mexico that will pay for the (border)
The proposal has however generated a tremendous controversy in the US, with
opposition coming from some Congress members (including Republicans), many
economists and American companies whose business is import-intensive.
It however has the strong support of Republican Congress leaders and some
version of it could be tabled as a bill.
Whether it will be passed remains to be seen.
Trump had earlier threatened to impose high tariffs on imports from countries
having a trade surplus with the US, especially China and Mexico.
This might be a more simple measure, but is so blatantly protectionist that it
will trigger swift retaliation, and would almost certainly be found to violate
the rules of the World Trade Organisation.
The tax adjustment plan may have a similar effect in discouraging imports and
moreover would promote exports, but it is more complex and thus difficult to
The advocates hope that because of the complexity and confusion, the measure
may not attract such a strong response from US trading partners.
Moreover, they claim that it is permitted by the WTO and are presumably willing
to put it to the test.
DETAILS OF THE BORDER TAX PLAN
In the tax reform plan, the corporate tax rate would be reduced from the
present 35% to 20%.
The border adjustment aspect of the plan has two main components.
Firstly, the expenses of a company on imported goods and services can no longer
be deducted from a company's taxable income. Wages and domestically produced
inputs purchased by the company can be deducted.
The effect is that a 20% tax would be applied to the companies' imports. This
would especially hit companies that rely on imports such as automobiles, electronic
products, clothing, toys and the retail and oil refining sectors.
The Wall Street Journal gives the example of a firm with revenue of $10,000 and
with $5,000 imports, $2,000 wage costs and $3,000 profit.
Under the present system, where the $5,000 imports plus the $2,000 wages can be
deducted, and with a 35% tax rate, the company's taxable total would be $3,000,
the tax would be $1,050 and after-tax profit would be $1,950.
Under the new plan, the $5,000 imports cannot be deducted and would form part
of the new taxable total of $8,000. With a 20% tax rate, the tax would be
$1,600 and the after-tax profit $1,400.
Given this scenario, if the company wants to retain its profit margin, it would
have to raise its price and revenue significantly, but this in turn would
reduce the volume of demand for the imported goods.
For firms that are more import-dependent, or with lower profit margin, the
situation may be even more dire, as some may not be financially viable anymore.
Take the example of a company with $10,000 revenue, $7,000 imports, $2,000
wages and $1,000 profit.
With the new plan, the taxable total is $8,000 and the tax is $1,600, so after
tax it has a loss of $600 instead of a profit of $1,000.
The company, to stay alive, would have to raise its prices very significantly,
but that might make its imported product much less competitive. In the worst
case, it would close, and the imports would cease.
The economist Larry Summers, a former US Treasury Secretary, gives a similar
example of a retailer who imports goods for 60 cents, incurs 30 cents in labour
and interest costs and then earns a 5 cent margin.
With 20% tax, and no ability to deduct import or interest costs, the taxes will
substantially exceed 100% of profits even if there is some offset from a
On the other hand, the new plan allows a firm to deduct revenue from its
exports from its taxable income. This would allow the firm to increase its
The Wall Street Journal article gives the example of a firm which presently has
export sales of $10,000, cost of inputs $5,000, wages $2,000 and profit $3,000.
With the 35% corporate tax rate, the tax is $1,050 and after-tax profit is
Under the new plan, the export sales of $10,000 is exempt from tax, so the
company has zero tax. Its profit after tax is thus $3,000.
The company can cut its export prices, demand for its product increases and it
can expand its sales and export revenues.
IMPLICATIONS FOR DEVELOPING COUNTRIES
At the macro level, with imports reduced and exports increased, the US can cut
its trade deficit, which is a major aim of the plan. On the other hand, the US
is a major export market for many developing countries, so the tax plan, if
implemented, will have serious adverse effects on them.
The countries range from China and Mexico, which sell hundreds of billions of
dollars of manufactured products to the US; to Brazil and Argentina which are
major agricultural exporters; to Malaysia, Indonesia and Vietnam which sell
commodities like palm oil and timber and also manufactured goods such as
electronic products and components and textiles; Arab countries that export oil
and African countries that export oil, minerals and other commodities; and
countries like India which provide services such as call services and
accountancy services to US companies.
American industrial companies are also investors in many developing countries.
The tax plan, if implemented, would reduce the incentives for some of these
companies to be located abroad as the low-cost advantage of the foreign
countries would be offset by the inability of the parent company to claim tax
deductions for the goods imported from their subsidiary companies abroad.
Perhaps the most vulnerable country is Mexico, where many factories were established
to take advantage of tariff-free entry to the US market under the North
American Free Trade Agreement (NAFTA).
President Trump has warned American as well as German and Japanese auto
companies that if they make new investments in Mexico, their products would
face high taxes or tariffs on entry, and called on them to invest in the US
RESPONSES TO THE TAX PLAN
After the implications of the border adjustment plan are understood, it is
bound to generate concern and outrage from the United States' trading partners,
in both South and North, if implemented. They can be expected to consider
immediate retaliatory measures.
A former undersecretary for international business negotiations of Mexico
(2000-2006), Luis de la Calle, said in a media interview: "If the US wants
to move to this new border tax approach, Mexico and Canada would have to do the
same...We have to prepare for that scenario."
In any case, it can be expected that countries will take up complaints against
the US at the WTO.
The proponents claim that the tax plan will be designed in a way that is
compatible with the WTO rules.
But many international trade law experts believe that the tax plan's measures
will violate several of the WTO's principles and agreements, and that the US
will lose if other countries take up cases against it in the WTO dispute
This prospect may however not decisively deter Trump from championing the
Republicans' tax blueprint and signing it into law, should Congress decide to
The President and some of his trade advisors have criticised the WTO's rules
and have mentioned the option of leaving the organisation if it prevents or
impedes the new America First strategy from being implemented.
If the US leaves the WTO, it would of course cause a major crisis for
international trade and trade relations.
There are many critics of the plan.
Lawrence Summers, a former US Treasury Secretary, warns that the tax change
will worsen inequality, place punitive burdens on import-intensive sectors and
companies, and harm the global economy.
The tax plan is expected to cause a 15-20% rise in the US dollar.
"This would do huge damage to dollar debtors all over the world and
provoke financial crises in some emerging markets," according to Summers.
While export-oriented US companies are supporters, other US companies including
giants Walmart and Apple are strongly against the border tax plan, and an
influential Republican, Steven Forbes, owner of Forbes magazine, has called the
It is not yet clear what Trump's final position will be. If he finds it too
difficult to use the proposed border tax, because of the effect on some
American companies and sectors, he might opt for the simpler use of tariffs.
In any case, whether tariffs or border taxes, policymakers and companies and
employees especially in developing countries should pay attention to the trade
policies being cooked up in Washington, and to voice their opinions.
Otherwise they may wake up to a world where their products are blocked from the
US, the world's largest market, and where the companies that were once so happy
to make money in their countries suddenly pack up and return home.
WILL THE BORDER TAX MEASURE VIOLATE WTO RULES?
A major question is whether the border tax measure will violate the rules of
the World Trade Organisation.
Experts have good reason to believe that the tax in several ways goes counter
to the WTO.
But there are also shortcomings in the WTO system that could limit its
usefulness in stopping the US if it is determined enough.
If adopted, the tax measure is sure to attract the opposition of the United
States' trading partners, as their exports to the US will have the equivalent
of a 20% tax imposed on them, whereas the exports from the US will be exempted
from a 20% corporate tax.
The tax on US imports, without the same being applied to US-made products,
discriminates against foreign products, and US exports being exempted from
taxes is tantamount to being an export subsidy.
How will this be taken at the WTO, the guardian of the multilateral trading
US Congressman Kevin Brady, chairman of the House Ways and Means Committee, and
the plan's main advocate, is convinced the plan is WTO-consistent, but has yet
to explain why.
On the other hand, many trade and legal experts think the plan violates the
principles and rules of the WTO, although they caution that a final opinion is
possible only when the language of the law is known.
Their general view is as follows:
Firstly, the inability to deduct import expenses from a company's tax (while
allowing deductions for locally sourced products and services and wages)
discriminates against imports vis-a-vis domestic products, and violates the
national treatment principle of the WTO and the rules of the General Agreement
on Tariffs and Trade (GATT) which specify that imports must be treated no less
favourably than similar locally produced goods.
Secondly, the exemption of export revenues from the taxable income would be
most likely assessed as a prohibited export subsidy under the WTO's subsidies
The renowned international trade expert, Bhagirath Lal Das, says that there are
two separate issues to be considered: firstly, the differential treatment of a
domestic product used as input and a like imported product used as similar
input in domestic production; and secondly, the differential tax treatment of
income based on whether the product is domestically consumed or exported.
On the first issue, Das says: "Some reports indicate that the proposal is
to deduct the cost of domestic input (product) from the income while computing
the tax, whereas there is no such deduction if a like imported input (product)
is used in the production. If this be the case, such a provision will clearly
violate the principle of national treatment contained in Article III of the
[Article III.4 reads: "The products of the territory of any contracting
party imported into the territory of any other contracting party shall be
accorded treatment no less favourable than accorded to like products of
national origin in respect of all laws, regulations and requirements affecting
their ... use."]
Adds Das: "If the 'use' of the domestic product results in tax reduction
whereas the 'use' of the like imported product does not get similar treatment,
clearly the imported product will get 'less favourable' treatment. And that
will violate the principle of national treatment contained in Article III. Even
without going into the fine print of the provisions of subsidy, such a
provision can be successfully challenged in the WTO on this ground."
On the second issue, Das commented: "Some reports indicate that the
proposal is to differentiate between the earning from domestic sale and that
from export in the matter of taxation in respect of a product. Here it would
appear that the exemption of the tax is conditional on export. Thus some
revenue is forgone conditional on export. This practice will clearly qualify
for being categorised as export subsidy which is prohibited under Article 3 of
the WTO's Subsidy Agreement."
Das cites a case of an American company, the Domestic International Sales
Corporation (DISC). A portion of its profit which was engaged in export was
The EEC, the predecessor of the EC, raised a dispute in the GATT in 1973. The
matter was delayed for a long time until in 1999 a panel at the WTO ruled that
the US practice was in fact an export subsidy and was prohibited.
"This case may not be exactly the same as the currently anticipated
proposal, but it does point to the fallibility of providing government benefit
contingent on export," says Das.
Das was formerly Chairman of the General Council of GATT, Indian Ambassador to
GATT, and subsequently Director of Trade in the UN Conference on Trade and Development,
and has written many books on the WTO and its agreements.
According to another eminent expert on the WTO, Chakravarthi Raghavan, whether
the US law is considered "legal" depends on the language of the law
and its actual effects.
"There is little doubt that the 'pith and substance' of the Republican
border tax proposal or ideas will be in violation of Articles II and III of
GATT and Article 3.1 of the Subsidies Agreement."
Raghavan, Editor Emeritus of the South-North Development Monitor, followed and
analysed the negotiations of the Uruguay Round and of the WTO on a daily basis
LIMITS TO WHAT THE ACTION AT WTO CAN ACHIEVE
Countries can challenge the US at the WTO and if they succeed the US has to
change its law or face retaliatory action. The winning party can block US
exports to it equivalent in value to the loss of its exports to the US.
However, there are many shortcomings with the WTO dispute system. Few countries
have the courage or financial resources to take up cases against the US.
If some countries do take up cases, it takes as long as three to four years for
a case in the WTO to wind its way through panel hearings and to a final verdict
at the Appellate Body, and for the winning Party to get the go-ahead to take
retaliatory action. During that period, the US can continue with its laws and
If the US loses, it need not pay any compensation to the successful Party for
having suffered losses.
Moreover, in the past, when it loses cases at the WTO, the US has typically not
complied with the orders made on it. Even if it does comply, it needs to do so
only in respect of the Parties that brought the action against it; it need not
do so for other Parties.
If it does not comply, the complainant countries are allowed to take
retaliatory action by blocking US goods and services from entering their
markets up to an amount equivalent to the losses they have suffered. This
retaliatory action can only be taken by those countries that successfully took
up the cases.
Thus, the US may decide to implement the border adjustment taxes and wait two
to four years before a final judgment is made at the WTO, and for retaliatory
action to be allowed. It can meanwhile reap the benefits of its border tax
Another possibility is that Trump may make good his threat to leave the WTO, if
important cases go against it. That would cause a major crisis for the WTO and
for international trade.
With regard to the WTO process, Raghavan said: "Apart from the
difficulties of taking up cases in the WTO, including costs, the lengthy
process and no retrospective damages when any WTO member raises a dispute, the
onus of proving the violation is on them.
"To the best of my knowledge, in none of the rulings against US, requiring
changes in law or regulations, has the US implemented them, and even major
trading partners have been chary of taking retaliation action.
"Countries that are affected, could act to unilaterally deny the US some
rights; but they cannot justify that this is retaliation, until there is a
ruling in their favour."
IS THE BORDER TAX SIMILAR TO VALUE ADDED TAX?
American advocates of the border adjustment tax plan have claimed that it is
similar to a value added tax (VAT) which is considered by the WTO to be a
legitimate measure; and thus that the border adjustment tax would also be
compatible with the WTO.
Almost all major developed countries have instituted the VAT system, with the
notable exception of the US.
The Republican Congress leaders and Trump have argued that this places the US
at a disadvantage in its trade relations because the VAT system imposes a tax
on imports, whilst allowing companies to obtain a refund for taxes paid on
They claim the border tax would correct this disadvantage and that the WTO should
similarly recognise the border tax as legitimate.
However, several well-known economists and lawyers are of the opinion that
there are important differences between the VAT and the border tax.
There are two parts to their arguments.
Firstly, the VAT imposes taxes on both imports and locally produced goods and
services and therefore does not discriminate against imports; whereas the
border tax system imposes a tax on imports whilst excluding domestic inputs and
wages from tax, which therefore discriminates against imports.
Secondly, the VAT system does not subsidise exports, whereas the border tax
In a 1990 paper, Martin Feldstein and Paul Krugman found that the VAT does not
improve the trade competitiveness of countries using it.
They said: "The point that VATs do not inherently affect international
trade flows has been well recognised in the international tax literature... A
VAT is not a protectionist measure."
Krugman, in a recent blog, reiterated that "a VAT does not give a nation any
kind of competitive advantage, period."
But a destination-based cash flow tax like the border adjustment tax has a
subsidy element that "would lead to expanded domestic production."
In another paper, Reeven Avi-Yonah and Kimberly Clausing from Michigan Law
School and Reed College respectively, analyse the difference between the VAT
and the proposed border adjustment tax and why the former is WTO-consistent
whereas the latter would violate WTO rules.
They said: "US trading partners are likely to be hurt in several ways. The
effects of the wage deduction render the corporate cashflow tax different from
a VAT, and these differences have the net effect of increasing the incentive to
operate in the United States.
"In addition, such a tax system would exacerbate the profit shifting
problems of our trading partners, since the United States will appear like a
tax haven from their perspective."
UNCERTAINTY OVER HOW MUCH A BORDER TAX WILL RAISE THE DOLLAR
Economists also agree that the border tax will raise the value of the US dollar
but there is a debate as to how long this will take and by how much it will
If the dollar appreciation is significant, this may have an adverse effect on
countries that hold debt in US dollars, as they would have to pay out more in
their domestic currency to service their loans.
This would include many developing countries with substantial
dollar-denominated debts of the public or private sectors, and some of them may
tip into new debt and financial crises.
According to former US Treasury Secretary Lawrence Summers: "Proponents of
the plan anticipate a rise in the dollar by an amount equal to the 15 to 20 per
cent tax rate. This would do huge damage to dollar debtors all over the world
and provoke financial crises in some emerging markets."
From the above, it is clear that a border tax measure by the US would have
terribly adverse, if not horrendous, effects on the economies of its trading
partners, the world trade system and even the stability of global finance.
Using the WTO's dispute system to discipline the US would be a useful way of
countering such an action, but this will have limited effect if the US
administration is determined to pursue with its new protectionist device, and
will also involve a lengthy process, and thus damage will be done for several
Some countries, like Mexico, are already considering more immediate
counter-actions, matching a unilateral US measure with a similar unilateral
Making these intentions known may get the US administration and the
Congressional Republicans to think twice.
Prevention is better than cure, especially if the cure involves a trade war of
giant proportions. How to succeed in prevention is the really big question.
[* Martin Khor is Executive Director of the South Centre. An earlier and
shorter version of the article above was published in a two-part series by the
Inter Press Service.]