The Trump Administration, working with a coalition in Congress, apparently intends to propose a border-adjustment tax or “BAT.” Under this tax, a company subject to US tax law will no longer be permitted to deduct the cost of any good or service that it imports, and it will no longer pay any tax on proceeds from its sale of any good or service abroad. Its taxable income, taxed at 20%, will be limited to the difference between (1) its domestic sales, and (2) its domestic costs.

The BAT, if enacted, will transform the manner in which companies pay tax under United States law. It would likely precipitate trade wars as well as massive commercial disruption around the world with unforeseeable repercussions. If its proponents are correct about its long-term consequences, it will not likely lead to the pollyanna scenario that they have described, but instead to an international monetary crisis as well as galloping, runaway inflation in the United States.

Offsetting these disasters, the BAT would certainly offer immediate relief to US exporters, at least for a brief duration before trade wars ensued, and it would encourage US companies to buy locally whenever possible, even when they can offer better goods and services by considering all possible providers of inputs, not only local ones. It would also give Donald Trump some engaging sound bites that might tickle the fancy of his dwindling constituency. Overall, the BAT is decidedly a very bad idea whose time has not come.

Let’s consider its workings more closely.

First, the BAT will directly and openly punish imports by ending the deduction of all costs that companies incur for imported goods and services. The ending of this deduction will apply even if the imported good or service is an input that a company uses in order to provide its own goods or services: any such company cannot deduct this cost, but can deduct the cost of the exact same input if it is purchased in the United States. That is a direct tax discrimination, directed against goods and services provided abroad. The ending of this tax deduction will apply not only to firms that import inputs, but also to distributors of imported goods: they will not be permitted to deduct the cost of the imports. To the extent that foreign goods compete against US goods, the US goods will cost far less because distributors of the US goods can deduct the cost of procuring them from their taxable income, but cannot deduct the cost of the same goods when purchased abroad. Foreign suppliers will immediately complain to their own governments about this tax, since it plainly and openly discriminates against foreign-supplied goods and services at every level of the supply chain in the United States. US customers who prefer particular foreign goods, or who lack any local replacement, will be forced to pay substantially higher prices for them.

Second, the BAT will openly subsidize exports by affording a tax subsidy on every sale abroad made by a company subject to US tax – mainly, US companies, as well as all other companies that operate in the United States. When such a company sells a good or service in the United States, it must treat the sale proceeds as taxable income; but when it sells the exact same good or service abroad, the revenues will be exempt from taxation. That is a direct export subsidy. Suppliers abroad will immediately complain to their foreign governments that the tax exemption for US exporters is an unlawful export subsidy, and that US exporters are selling their wares at an unfair advantage abroad. (Some exporters might exclaim that other countries already apply similar tax regimes, imposing value-added taxes (“VATs”) on imports while not imposing them on exports; but these VATS, which are collected like sales taxes, are mutually coordinated under international treaties on the common assumption that consumers should pay only one VAT on any particular good without regard to where it was made; if we wish to address the issue of VATs that apply only to imports, then the US should impose its own VAT on all goods, or impose a national sales tax on all goods no matter where made, and the sales tax will not apply to foreign sales made to countries that impose VATs on them).

To understand the BAT better, let’s consider a hypothetical example. Suppose ACME corporation makes and sells metal chairs in the US and abroad, using components made in both the US and abroad. Under the BAT, its sales of chairs outside of the US will no longer be taxable; and its costs for components purchased in the US will be fully deductible, but it will no longer be able to deduct the cost of any component that it purchases abroad. Its tax under the BAT will be 20% of the difference between (1) its domestic sales, and (2) its domestic costs. To the extent possible, then, Acme Corporation will seek to purchase inputs locally, so that it can fully deduct their cost, and it will avoid importing any of its inputs, whose costs it cannot deduct. It will then try to make its sales abroad, since it will pay no tax on these sales, but must must pay a 20% tax on all of its domestic sales.

Acme Corporation might be able to adjust to the BAT successfully, increasing its exports and reducing or eliminating its imports. If it does so, however, its foreign competitors will complain to their governments that Acme’s exports to their home markets are subsidized, and that their sales in competition against it in the US are subject to a punitive tariff. ACME will likely find itself embroiled in trade litigation before too long.

Countless US companies, however, will not be able to adjust to the BAT, since they might require inputs that they can purchase only from abroad and/or might sell only in local US markets. There are companies that must import, other companies that cannot export, and many companies that must import inputs and then make sales only in domestic markets. For this last category of companies, the BAT will be a tax nightmare: it will increase their costs, since they can no longer deduct the cost of their foreign inputs, but they will derive no benefit from the absence of tax on exports, since they do not make any. These companies will naturally pass along their higher costs to their customers, which will be either consumers who pay higher prices for the final products or companies that in turn will pass along the higher costs to their own customers. Consumers/end-users at the end of these supply chains will pay higher prices because of the discriminatory tax. If a company makes sales only in the US, but competes against others that make sales both in the US and abroad, it might find that its competitors can generate outsized profits on their exports and use some of these profits to fund expansion and predatory competition in US markets. At a minimum, the BAT tries to pick winners (exporters that purchase their inputs in the United States) and to punish losers (importers of goods and services, including those used as inputs); but a tax should not pick winners and losers in commerce, let alone openly punish free trade as the BAT would do.

Countless companies that operate in global supply chains will immediately seek to adjust to the BAT by altering their structures, supply chains, and logistics, so as to minimize their tax burden under US law. They will likely do so in a way that openly favors the US economy at the expense of other economies. Governments abroad will inevitably and quickly find themselves under pressure to take action: there will be interminable trade litigation before the World Trade Organization, under foreign trade laws, and in international arbitration of every variety, as well as a profusion of trade litigation in the United States over these matters. US victims of this law – US importers and consumers – will also likely challenge the law. Worse, foreign governments might invoke their own retaliatory measures, such as their own BATs or other kinds of tariffs and export subsidies.

I therefore believe that this tax, if enacted, will likely precipitate immediate trade tension and a possible trade war with our most important trading partners – the European Union, the United Kingdom (which is withdrawing from the EU), Canada, countries in East and South Asia (including Japan, South Korea, China, India and other emerging tigers), Oceania, Mexico, the rest of Latin America, and other regions. Some or all of these diverse regions might initially try to negotiate a resolution and otherwise avert an open trade war, but their own suppliers will place increasing pressure on their various governments. Our BAT will thus sow the seeds of an eventual, full-blown trade war, which, if it occurs, will likely prove ruinous for everyone involved, just as every trade war has always done throughout history.

The proponents of the BAT are betting that the rest of the world must accept our BAT because we have the largest economy in the world. That is an arrogant, increasingly unfounded assumption. At a minimum, by this tax we will forfeit our role as the world’s leader of free trade. We may already have done so by withdrawing from the giant Pacific trade treaty, the TPP, while inviting resentment and encouraging our trading partners to form trade pacts among themselves and exclude us from them. The first hints of such an unwelcome development have already begun in response to our withdrawal from the TPP and our protectionist rumblings in the name of “America First.”

Apologists for the BAT say that it will neither penalize imports, nor subsidize exports, since its natural long-term effect will be to (1) increase the value of the US dollar by 25%, and (2) increase US wages and prices by 25%, so that these offsetting increases in US costs will ensure that the real prices of US exports will remain more or less the same as they are now. This prediction is speculative and unproven, even if economic theory predicts some increase of US prices and wages and some appreciation in the dollar in response to the BAT. But an appreciation of the US dollar will impose hardship and crisis in emerging markets whose principal debtors owe large debts denominated in US dollars, and an increase in prices and wages in the US high enough to offset the BAT would be a general increase of 25%, which, if it were to occur within one or two years, might set off runaway inflation – i.e., a self-reinforcing cycle of price increases and corresponding wage increases.

Let’s consider each of the above two points more closely. The apologists claim that the BAT will induce the dollar to rise in value against other currencies by approximately 25%, and that this appreciation of the dollar will offset the lower cost that US exporters would otherwise offer because they will pay no tax on their sales. If this proves true, it will likely involve many emerging markets in a full-blown monetary crisis. Many companies, individuals, and governments in these markets owe large debts in US dollars. To pay these debts, they must generate income in their local currencies and convert their local earnings to dollars to pay down their US-dollar debts; doing so will become increasingly more expensive or unaffordable for them, likely leading to hardship, possible economic panic, and possibly even an international monetary crisis.

BAT apologists also say that US wages and prices will rise by approximately 25% because more companies will purchase locally and sell abroad, which in turn will require them to hire more employees and pay them better to attract them, and also because the prices that they charge for domestic goods and services will be subject to the BAT, and so they will be under pressure to keep these prices higher in order to meet their tax burdens. This is likewise speculative conjecture. If it is true, however, the BAT apologists are saying we should not worry about the BAT because its effects will be offset by inflation in the US of 25% over an uncertain period – likely at a rate approaching 10-15% per year for two years. Such inflation would immediately punish the holders of obligations, savers, retirees, those who live on fixed pensions, etc., prodding or requiring them to make radical adjustments to avoid ruin. The usual consequence of such collective behavior is a self-reinforcing cycle of inflation, since everyone expects prices to continue rising and behaves accordingly.

The BAT sounds like a good idea only if you gloat over US power and believe that we can impose tariffs and export subsidies with impunity, while defending them with a straight face by invoking speculative scenarios that, if true, might well foretell an international monetary crisis and galloping inflation in the United States. If the US wishes to address the issue of VATs that are applied to all goods sold in a home market but not to the exports sold by producers in the home market, it should impose its own VAT on all goods sold in the US and even use it to replace payroll taxes. Such a VAT would not apply to goods and services that US companies sold abroad. It would be in full compliance with our treaty obligations under the World Trade Organization, and its effects would not include trade tensions, possible trade wars and endless trade litigation, international monetary crises, and unmanageable inflation at home. The BAT is a batty idea whose time has not come.

William Markham (San Diego © 2017)