The Corner

The Poison Pill in the Ryan-Brady Tax Reform

Now that Donald Trump has won the presidency along with Republicans retaining control of Congress, we are all hoping to finally see fundamental tax reform implemented. It’s been 30 years — and it is about time.

That being said, I have a real concern with one aspect of the otherwise decent tax-overhaul plan put forward earlier this year from House speaker Paul Ryan and Ways and Means chairman Kevin Brady. The plan, which lowers the U.S. corporate-tax rate, moves to a territorial taxation regime, and reduces some of the double taxation on savings and investments, also includes a feature that reeks of protectionism. Businesses would be allowed to deduct the cost of domestically produced inputs but there would be no deduction for foreign-produced inputs. In addition to that discriminatory provision, there also would be no tax levied on export-related income, a mercantilist policy approach that already has been rejected by the World Trade Organization.

In wonky terms, the House bill would turn the corporate-income tax into a “destination-based cash flow tax” with many similarities to European-style value-added taxes (VAT).

While I wouldn’t call it a full-blown crony provision, it’s hard to argue that it is not protectionism (no more deductions for business costs incurred for buying foreign inputs and no tax on exports). Maybe it’s better described as “export mercantilism.” As you can imagine, this populist move makes my blood boil over since it is another case of Congress not realizing that imports, not exports, are what create value to Americans. Or maybe they realize that but they prefer to cater to the current anti-free-trade movement. I guess in that sense, it is a crony feature meant to favor exporters at the expenses of consumers and businesses that use imports to produce output.

The Cato Institute’s Dan Mitchell has a bit more to add on that point:

For mercantilists worried about trade deficits, “border adjustability” is seen as a positive feature. But not only are they wrong on trade, they do not understand how a VAT works. Protectionists seem to think a VAT is akin to a tariff. It is true that the VAT is imposed on imports, but this does not discriminate against foreign-produced goods because the VAT also is imposed on domestic-produced goods.

Under current law, American goods sold in America do not pay a VAT, but neither do German-produced goods that are sold in America. Likewise, any American-produced goods sold in Germany are hit be a VAT, but so are German-produced goods. In other words, there is a level playing field. The only difference is that German politicians seize a greater share of people’s income.

So what happens if America adopts a VAT? The German government continues to tax American-produced goods in Germany, just as it taxes German-produced goods sold in Germany. There is no reason to expect a VAT to cause any change in the level of imports or exports from a German perspective. In the United States, there is a similar story. There is now a tax on imports, including imports from Germany. But there is an identical tax on domestically-produced goods. And since the playing field remains level, protectionists will be disappointed. The only winners will be politicians since they have more money to spend.

I assume the reason behind this feature is that they were looking for a way to pay for the good features of the reform such as the reduction of double taxation on savings, lower tax rates, a move to a territorial system, and simplification. But that doesn’t make it okay in my opinion. Besides, can you imagine the compliance nightmare it would create for companies?

Finally, if I must find a positive thing to say about this, I would add that it could have been much worse. They didn’t, at least, propose a destination-based VAT. But let’s face it, once this feature is embedded in our tax code, a VAT-friendly administration will find its work halfway done, especially since the World Trade Organization presumably will rule against this protectionist approach and the “easy” solution will be to change the plan into a full-blown VAT, which is acceptable according to World Trade Organization rules.

So maybe I don’t have anything positive to say about it.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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