Beware the new US “border tax” plan

US leaders are hatching a new protectionist instrument that may even be worse than tariffs, with potentially devastating effects on developing countries.

by Martin Khor 

A new and dangerous form of protectionism is being considered by US leaders that could have devastating effects on the exports and investments of developing countries as well as destabilize the world economy.

The plan, known as a border adjustment tax, would have the effect of taxing imports of goods and services that enter the US, while also providing a subsidy for US exports which would be exempted from the tax.

The proponents’ aim is to drastically reduce imports while promoting exports and thus cut the huge trade deficit in the US. It fits in with US President Donald Trump’s goals to “make America great again”, to buy American and hire Americans. 

On the other hand, if adopted, the plan would depress the competitiveness or viability of other countries’ goods. Their exports to the US will rise in price due to the tax effect, depressing the demand for them and, in the worst case, making them unsaleable.   

Companies from the US that invested in developing countries because of lower costs and then exported to the US may find their business affected because their products will cost more.  Some will think of relocating back to the US, and investors will be discouraged from opening new factories in developing countries. 

The border adjustment tax is part of a tax reform bill being drafted by the ruling Republican Party in the US, with Paul Ryan, the Speaker of the House of Representatives, being the chief advocate.

Trump originally criticized the plan for being “too complicated” but is reportedly now seriously considering it. The proposal has generated a tremendous controversy in the US but also enjoys strong support, and some version is expected to be tabled.

Originally, Trump favoured the simple imposition of a tariff on products from selected countries, especially China and Mexico. But this would be too blatantly protectionist and surely trigger swift retaliation.

The tax adjustment plan would have a similar effect in discouraging imports and moreover would promote exports, but is quite complex. 

The tax works like this. Firstly, as part of an overhaul of the corporate tax system, the expenses of a company on imported goods and services can no longer be deducted from a company’s taxable income. The corporate tax rate would be reduced from the present 35% to 20%. The effect is that a 20% tax would be applied to companies’ imports.

Take the case of a company with a revenue of $10,000, with $7,000 in imports, $2,000 local costs and $1,000 profit. Under the present system, the $7,000 imports plus the $2,000 wages can be deducted. At a 35% tax rate, the company’s taxable total would be $1,000, tax would be $350 and after-tax profit would be $650.

Under the new plan, the $7,000 imports cannot be deducted and would form part of the new taxable total of $8,000. At a 20% tax rate, the tax would be $1,600, so after tax the firm has a loss of $600.

The company, to stay afloat, would have to raise its prices sufficiently, but that might price the product out of the market. Some firms may close down and the imports would cease.

The new plan would also allow a firm to deduct export revenue from its taxable income. This would allow the firm to increase its after-tax profit.

An article in the Wall Street Journal 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. At 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. This would enable the company to cut its export prices, resulting in increased demand for its product and expanded sales and export revenues.

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.

Adverse effects

The US is a major export market for many developing countries, so the tax plan, if implemented, will have serious adverse effects on them. An equivalent of 20% tax on their exports may render some firms that use or sell these products less profitable; and if the prices are forced upwards, they may become less competitive against substitute products or similar locally made products.  

US industrial companies are also investors in many developing countries. If implemented, the tax plan would reduce the incentives for some of these companies to invest abroad, as the parent company can no longer claim tax deductions for the goods imported from its subsidiaries abroad. 

The plan is bound to generate outrage from the US’ trading partners, in both South and North.  They may lodge cases against the US at the WTO, which is likely to rule against the US. The new tax deduction system discriminates against imports, thus violating the WTO rules of non-discrimination. The exemption of income tax for export sales would most likely be assessed as an export subsidy prohibited by the WTO subsidies agreement.

While countries can challenge the US at the WTO, it can take three to four years for a case in the WTO to be finally settled. Meanwhile the US can continue with its laws and practices and reap the benefits.

Another possibility is that Trump may make good his threat to leave the WTO if important cases go against the US. That would cause a major crisis for multilateral trade.

There are many critics of the tax plan. Larry 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. 

US retail companies like Walmart are strongly against the plan, and an influential Republican, Steve Forbes, owner of  Forbes magazine, has called it “insane.” 

 It is not yet clear what Trump’s final position will be. If he finds the plan too difficult to implement because of the effect on some US companies and sectors, he might opt for the simpler use of tariffs.

In any case, whether tariffs or border taxes, policymakers, companies and workers 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.                                                        

Martin Khor is Executive Director of the South Centre, an intergovernmental think-tank of developing countries, and former Director of the Third World Network. This is an edited and expanded version of an article which first appeared in The Star (Malaysia) (13 February 2017).

Third World Economics, Issue No. 632, 1-15 January 2017, pp13-14