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 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 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 tax plan.

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 Americans".

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 Means Committee.

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) wall."

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 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 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 stronger dollar.

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 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 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 instead.

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 settlement system.

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 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 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, 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 system?

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 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 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 tax-free.

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 ever since.

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 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 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 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 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 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, 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 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 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."

CONCLUSION

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 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.

[* 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.]