The Next Big Policy Fight?

Trump’s tax reform plan has, at last, been outlined — and the border adjustment tax looks like it’s been excluded. However, nothing is certain with this administration, and we spoke with one of the intellectual authors of the idea of cash flow taxation in the U.S., Berkeley economist Alan Auerbach, about the concept’s intricacies and its likely medium-term effects if it becomes a reality.

The GOP proposal to shift from taxing corporate income to taxing corporate cash flow faces an uphill battle.

CORBIS. The GOP proposal to shift from taxing corporate income to taxing corporate cash flow faces an uphill battle.

With the announcement in late April of the Trump administration’s broad strokes for tax reform — its highlights being big relief for individual taxpayers and bigger relief for corporations of all sizes — the President may have set himself his toughest challenge yet. Tax reform is a heavy legislative lift, even when your party enjoys control of the Congress.

That does not, however, mean that tax reform is impossible as a medium-term event under Trump — all the more so given that the labor picture has brightened a bit since his inauguration. This could in theory give the GOP a serious tailwind. A convincing show of unity on taxes by the Republicans would do much to restore momentum to the party’s agenda.

With granular detail on the plan not projected to come for months, the reform effort at the moment is still in its infancy. Given the black-box nature of his White House and the tendency of its plans to morph radically during execution, it seems prudent to consider an idea that has been circulating among wonks for decades but has recently come into its own: the proposal to shift the basis of corporate taxation from income to cash flow, a possible component of which is the border-adjustment tax.

Current indications are that these will not be part of Trump’s plan. But with this administration, nothing is certain.

Tax issues can be difficult enough to understand on their own, even for educated laypeople. But cash flow taxation in particular is perhaps thornier than others, not least because of the vicious internal politics over the border adjustment tax itself, which many people presented as or misunderstood to be akin to tariffs — something to which self-described financial conservatives have long been violently allergic. To help clear the fog, we spoke with one of the intellectual authors of the ideas behind the aforementioned proposal, Berkeley economist Alan Auerbach.

He stresses, first of all, that the border tax would be only one potential part of the move to cash flow taxation. This would be a major shift, but one that Auerbach sees as potentially advantageous both to corporate taxpayers and the wage-earners they employ (should it come to pass). “The advantages of cash flow taxation are,” he tells us, “three. One is it levels the playing field between debt and equity — payments of interest and payments of dividends are treated the same, as they are not under the current system. That would discourage excessive borrowing. Second, because capital investments are written off immediately, the incentive to invest is higher. Finally, it’s a much simpler tax system: you’re not trying to measure income generated by a business’s activities in a given year, you’re just looking at the cash coming in and going out. Characterizing the nature of payments isn’t really important. It’s cash in minus cash out.” In other words, cash flow taxation would put paid to the deduction for interest expenses and incentivize greater capital investment.

This much bigger potential change, however, was somewhat eclipsed by the more politically flammable topic of the border adjustment itself. Auerbach points to the plan’s similarity to a value-added tax as a possible source of the confusion around it: “It certainly has a piece,” he says, “which is a tax on imports. Viewed in isolation, that would be an import tariff and it would be a distortion of trade.  Under the current system, we tax the income from offshore operations of companies when they repatriate the earnings. One change would be not to do that anymore. We don’t have border adjustments now, and they would be implemented: the border adjustments would involve imposing a tax on imports and having an offsetting relief of tax on exports. Those border adjustments are identical, essentially, to the border adjustments that exist under a value-added tax in other countries. This system is very closely related to a value-added tax. So we’re not familiar with this kind of procedure. If you were in Europe, you’d understand that this is how things work, and you wouldn’t think of it as a trade distortion. And finally, a lot of the rhetoric around this proposal, particularly coming from the Trump administration as well as other opponents of trade, has been to look with favor upon this proposal on the grounds that it somehow is seen as a discouraging imports, which, again, should not be the overall impact. But the fact that it has been more or less intentionally cited as a trade distortion even if it isn’t — well, one can certainly understand why that would lead to confusion.”

Border adjustments (if they end up being implemented) should not have, Auerbach argues, the distortionary effect on trade that selective and even punitive tariffs would have: “They apply to both imports and exports rather than just to imports. It’s a way of providing some intuition about why that makes such a difference. If we simply had tariffs on imports, we would discourage imports. That would tend to increase the value of the dollar because we’re not demanding as much foreign currency to buy. That would tend to push the dollar up; that in turn would tend to discourage exports because American producers have a higher currency and therefore, their costs are higher for foreign purchasers. The imposition of a tariff would not only discourage imports, it would discourage exports as well. In general, it would discourage trade. This proposal does two things differently. First of all, it’s broad, it’s not narrow. It doesn’t just apply to some commodities. Second, by having the export subsidy on the other side, it counteracts what would otherwise be the effect of an import tariff. In particular, export subsidies actually encourage trade because they make it cheaper for American sellers to sell abroad and that tends to stimulate demand for U.S. exports. That in turn pushes the dollar up further and makes it easier for U.S. importers to purchase things because they aren’t so expensive in dollars anymore because they’re being provided by foreign suppliers. And that, at least, is analytically consistent with the way trade arrangements recognize the validity of the value-added tax. Its border adjustments would have no net impact on trade, wouldn’t discourage imports or exports, and should basically represent a shift in the locus of taxation from where things are produced to where they’re sold. It doesn’t have the impact effect of distorting trade.”

So what would its effect be over the medium term, should the plan be resurrected? “We’re going to see an appreciation of the dollar,” says Auerbach. “The thing to keep in mind here is that the dollar appreciation would be in response to the border adjustments. The border adjustments make U.S. producers a lot more competitive. The dollar appreciation, in a sense, undoes that, but it doesn’t make it harder for companies to export. It simply leaves exports and imports, more or less, where they started. One might then ask, ‘Well, if that’s true, why do this?’ Because the benefits are elsewhere. We’d get rid of all this cross-border transfer pricing manipulation, so companies that are currently paying very low U.S. taxes because they’re inflating their profits abroad would no longer be able to do that. The incentive to invest in the U.S. would be strengthened because by shifting the locus of taxation to where things are sold from where things are produced, there would no longer be any additional tax on company profit simply because they’re producing in the U.S. And that would be further enhanced by the investment expensing, which encourages purchases of capital equipment and structures. I would expect to see a strengthening of U.S. production, with higher wages as a result. Capital helps workers become more productive. There might be some small negative impact on interest rates because there’d be less demand for borrowing, and so that might push interest rates down a bit.”

Given that, as Auerbach puts it, “the ball’s being carried by Congress” on the Trump administration’s policy enactment, Trump’s tax reform plan as is could still have an uphill battle even if the midterms go well for the Republicans. Bringing back the border tax might sweeten the deal if House Speaker Paul Ryan proves to be recalcitrant (though it has a formidable opponents in Mike Lee, who in general favors a move to cash-flow taxation but dislikes the border adjustment element). Again, full details will not be forthcoming for weeks. And it is necessary to remember that with Trump, all things seem to be possible. Even if at the moment the issue looks like it has a low likelihood of becoming relevant, staying ahead of the curve on it is important — however hard it is to discern political probabilities in our current atmosphere.