Why a destination-based cash-flow tax can be a tariff, and why VAT can’t.
Republican members of the House of Representatives have proposed replacing the US Federal corporate income tax with a ‘destination-based cash-flow tax’ (DBCFT) (sometimes referred to as a ‘border adjustment tax’ (BAT)). The intention is to reform US corporate tax system so it applies on a territorial basis, rather than worldwide, reduce the rate from 35% to 20%, and close down opportunities for avoidance.
An important feature of the DBCFT is that it is ‘border adjusted’: it taxes domestic sales of goods/services, but exempts exports. It gives a tax deduction for goods/services acquired domestically, but not for imports. Some have suggested that this feature amounts to a tariff and/or export subsidy, and justified this on the basis that the EU and many other countries impose VAT, which they say also amounts to a tariff/subsidy.
The examples in the infographic above illustrate the differences in effect between a conventional VAT and DBCFT. The total VAT cost across a supply chain is solely dependent upon the location of the final purchaser. With a domestic purchaser, the total VAT cost will always be 20% (if that is the rate), regardless of the location of the suppliers. With a foreign purchaser, the total VAT cost will always be zero, regardless of the location of suppliers.
The DBCFT is different, because (unlike VAT) there is a deduction for labour costs. This deduction is available only to domestic businesses. This means that the DBCFT cost across a supply chain is affected by both the location of the final purchaser and the location of businesses in the supply chain. A domestic supply chain will generally result in reduced total DBCFT cost and, with a foreign final purchaser, the total DBCFT cost may be negative (potentially a cash payout).
Whether this is the result in practice is a difficult economic question, because prices, wages and/or FX rates will adjust as a result of the DBCFT. If the dollar were to appreciate by 25%, then the tariff/subsidy effect of the DBCFT would effectively be cancelled. The extent and timescale of such an appreciation is, however, contested.
All this is relevant to the question of whether the DBCFT is consistent with World Trade Organisation (WTO) rules. WTO rules only permit border adjustments on indirect taxes, such as VAT. However, the DBCFT is not a traditional VAT and arguably not a VAT at all. It is generally the legal form which is relevant for WTO purposes and not the overall economic effect; hence, even if exchange rates do adjust to neutralise any impact of the border tax adjustment, that would not eliminate the possibility of a WTO claim.
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US proposals for a border adjustment tax
Why a destination-based cash-flow tax can be a tariff, and why VAT can’t.
Republican members of the House of Representatives have proposed replacing the US Federal corporate income tax with a ‘destination-based cash-flow tax’ (DBCFT) (sometimes referred to as a ‘border adjustment tax’ (BAT)). The intention is to reform US corporate tax system so it applies on a territorial basis, rather than worldwide, reduce the rate from 35% to 20%, and close down opportunities for avoidance.
An important feature of the DBCFT is that it is ‘border adjusted’: it taxes domestic sales of goods/services, but exempts exports. It gives a tax deduction for goods/services acquired domestically, but not for imports. Some have suggested that this feature amounts to a tariff and/or export subsidy, and justified this on the basis that the EU and many other countries impose VAT, which they say also amounts to a tariff/subsidy.
The examples in the infographic above illustrate the differences in effect between a conventional VAT and DBCFT. The total VAT cost across a supply chain is solely dependent upon the location of the final purchaser. With a domestic purchaser, the total VAT cost will always be 20% (if that is the rate), regardless of the location of the suppliers. With a foreign purchaser, the total VAT cost will always be zero, regardless of the location of suppliers.
The DBCFT is different, because (unlike VAT) there is a deduction for labour costs. This deduction is available only to domestic businesses. This means that the DBCFT cost across a supply chain is affected by both the location of the final purchaser and the location of businesses in the supply chain. A domestic supply chain will generally result in reduced total DBCFT cost and, with a foreign final purchaser, the total DBCFT cost may be negative (potentially a cash payout).
Whether this is the result in practice is a difficult economic question, because prices, wages and/or FX rates will adjust as a result of the DBCFT. If the dollar were to appreciate by 25%, then the tariff/subsidy effect of the DBCFT would effectively be cancelled. The extent and timescale of such an appreciation is, however, contested.
All this is relevant to the question of whether the DBCFT is consistent with World Trade Organisation (WTO) rules. WTO rules only permit border adjustments on indirect taxes, such as VAT. However, the DBCFT is not a traditional VAT and arguably not a VAT at all. It is generally the legal form which is relevant for WTO purposes and not the overall economic effect; hence, even if exchange rates do adjust to neutralise any impact of the border tax adjustment, that would not eliminate the possibility of a WTO claim.
