US' protectionist border adjustment tax plan likely WTO-illegal

Trump's proposed 'border adjustment tax', an integral part of his 'America First' strategy, besides being likely to run afoul of the WTO rules, will hit the exports of developing countries to the US.  Martin Khor explains.

A NEW US tax plan being considered by Congressional Republican leaders and the President is likely to be violative of the fundamental principles of the World Trade Organisation (WTO) and its agreements, and could have a devastating effect on the exports and investments of American trading partners, especially the developing countries.

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 the demand for them and in some cases making them unsaleable.

And companies from the US or other countries that invest in developing countries because of lower costs and then export their products (final products or intermediate inputs) to the US will also be adversely affected by the new US tax plan. Some firms will relocate to the US and potential investors will be discouraged from opening new factories in 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 Americans'.

The border adjustment tax is part of a tax reform blueprint, 'A Better Way', whose chief advocates are Republican Party leaders Paul Ryan, Speaker of the US House of Representatives, and Kevin Brady, Chairman of the House Ways and Means Committee.

Trump originally called the plan 'too complicated' but is now seriously considering it. In a recent address to Congressional Republicans, he 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] wall.'

The proposal has however generated 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 Congressional 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 simpler measure, but is so blatantly protectionist that it will trigger swift retaliation and would almost certainly be found to violate the rules of the WTO.

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 understand. 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 the 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 company's imports. This would especially hit companies that rely on imports such as those in the automobile, electronic product, clothing, toy 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. Under the new plan, the taxable total would be $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 down 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 stronger dollar.

On the other hand, the new plan would allow a firm to deduct its export revenue from its taxable income. This would allow the firm to increase its after-tax profit.

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 $1,950.

Under the new plan, the export sales of $10,000 would be 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 will increase 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 include the likes of China and Mexico, which sell hundreds of billions of dollars of manufactured products to the US; Brazil and Argentina which are major agricultural exporters; 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 its 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).

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 instead.

Responses to the tax plan

After the implications of the border adjustment tax plan are understood, it is bound to generate concern and outrage from the US' 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 (2000-06), 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 settlement system (see below).

This prospect may however not decisively deter Trump from championing the Republicans' tax blueprint and signing it into law, should Congress decide to adopt it. The president and some of his trade advisers 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 border adjustment tax plan.

Former US Treasury Secretary Summers warns that the tax change will worsen inequality, place punitive burdens on import-intensive sectors and companies, and harm the global economy.

While export-oriented US companies are supporters, other US companies including giants Walmart and Apple are strongly against the plan, and an influential Republican, Steve Forbes, owner of Forbes magazine, has called the plan 'insane'.

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, policy-makers and companies and employees especially in developing countries should pay attention to the trade policies being cooked up in Washington, and 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 WTO.

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 adopted, the tax measure is sure to attract the opposition of the US' trading partners, as their exports to the US will have the equivalent of a 20% tax imposed on them, whereas 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 an export subsidy.

How will this be taken at the WTO, the guardian of the multilateral trading system?

US Congressman 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) 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 agreement.

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 GATT 1994.'

(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 comments: '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 an export subsidy which is prohibited under Article 3 of the WTO's Subsidies Agreement.'

Das cites the case of a particular type of American company, the domestic international sales corporation (DISC), where a portion of its profit which was engaged in export was tax-free. The European Economic Community raised a dispute on this in the GATT forum 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 International Trade Programmes at the UN Conference on Trade and Development (UNCTAD), 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, has followed and analysed the multilateral trade negotiations of GATT and the WTO over the years.

Limits to what action at the 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 settlement system. Firstly, 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 WTO 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 practices.

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 case.

Thus, the US may decide to implement the border adjustment tax and wait two to four years before a final judgment is made at the WTO and for retaliatory action to be allowed. In the meanwhile, it can reap the benefits of its border tax measures.

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 the 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. Republican Congressional 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 their exports. 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 system does.

In a 1990 paper, economists 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 post, 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 impact on 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 rise.

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 affect 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 Summers: 'Proponents of the plan anticipate a rise in the dollar by an amount equal to the 15 to 20% 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 go ahead with its new protectionist measure and will also involve a lengthy process, and thus damage will be done for several years.

Some countries, like Mexico, are already considering more immediate counter-actions, matching a unilateral US measure with a similar unilateral counter-measure. 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.                          

This article is reproduced from the South-North Development Monitor (SUNS, No. 8406, 21 February 2017). An earlier and shorter version was published over two parts by Inter Press Service (IPS).

*Third World Resurgence No. 317/318, Jan/Feb  2017, pp 22-26