House Republicans seeking to overcome resistance to tax reform from retailers and other importers have only one card to play: special rules to ease them into the new system.
Transition rules are the best way to mollify fears about the provision of the GOP tax proposal that most worries CEOs: the plan to adjust taxes at the border.
Under border adjustment, corporations are taxed not on where they are located, but instead whether their products are sold in the U.S. It works by allowing companies to deduct sales abroad from their taxable income, but disallowing deductions of the cost of imported goods.
That last part effectively would entail a 20 percent import tax on goods imported for resale at retailers such as Walmart or on oil imported by refiners like those owned by Koch Industries. Accordingly, those and other companies have launched a major lobbying effort against the GOP plan.
While they might be enticed by other features of the GOP proposal, such as the cut in the corporate tax rate from 35 percent to 20 percent, those companies are willing to oppose the entire package if it includes the import tax.
As a result, the House Republican version of tax reform faces a tough path to passage. In particular, enough Republican senators have raised concerns about the import tax’s effects on consumer prices that the math for passing reform in the upper chamber is daunting. One such senator is Tom Cotton of Arkansas, the home state of Walmart.
Nevertheless, House leaders remain adamant that the border adjustment is staying in the plan. One major reason is that, according to the nonpartisan Tax Foundation, it would raise $1.1 trillion over 10 years. That revenue can be used to lower tax rates further, without adding to the deficit.
Goldman Sachs economist Daan Struyven crunched the numbers and estimated that if Republicans dropped the border adjustment, they would have to settle for a 25 percent corporate rate, rather than a 20 percent one, to break even and not increase the debt. That rate, however, would be above the average corporate rate for advanced nations, meaning that U.S. companies would still face incentives to move their headquarters overseas.
That means House Republicans are left to try to overcome corporate resistance to the border adjustment one way or another.
One way would be to convince businesses of the merits of border adjustment.
Rep. Kevin Brady, chairman of the House Ways and Means Committee tasked with writing the law, has repeatedly said that he is convinced that the dollar will rise in response to border adjustment, leaving importers no worse off. In terms of economic theory, the case is strong.
The export subsidy would increase demand for U.S. goods, meaning that foreigners would need more dollars to buy them, strengthening the dollar. Meanwhile, the import tax would strengthen the dollar by decreasing demand for imports. Altogether, the stronger dollar would offset the effect of the import tax because importers’ greater purchasing power would absorb the hit.
Yet skeptics aren’t convinced that the theory would play out in real life. For one thing, many countries manage their currencies relative to the dollar, meaning that the dollar couldn’t simply rise against them. Federal Reserve Chairwoman Janet Yellen this month suggested “uncertainty” about the idea that the dollar would appreciate.
Douglas Holtz-Eakin, the president of conservative think tank American Action Forum and an early and prominent backer of the border-adjusted tax system, suggested that the way to win companies over was to convince them that they wouldn’t be left to face an import tax without other changes.
“Tell me the combination of growth and dollar appreciation you need to be made whole,” he said, noting that the purpose of the tax reform is to accelerate economic growth. Faster economic growth would boost corporate sales and, separately from the effects of the border adjustment, lead to a stronger dollar.
But if companies cannot be won over with that overture, the next step is to offer transition rules, which Brady has said will be done.
Kyle Pomerleau, an expert at the Tax Foundation, suggested one such possibility that tax writers might consider. Rather than impose the border adjustment all at once, with companies immediately losing the ability to deduct import costs and gaining the ability to deduct export revenues, the adjustment could be phased in. In the first year, for example, companies could lose 10 percent of their deductions for import costs and gain the ability to write off 10 percent of their exports.
While that approach might alleviate the concerns of companies such as Walmart, it would leave the government, in effect, speculating against taxpayers. If, as Brady and other proponents of the reform maintain, the dollar immediately adjusts as investors look ahead, retailers would get the advantage of the stronger dollar while not being fully subject to the tax. “They’d actually receive a windfall in the interim” at the expense of taxpayers, Pomerleau noted.
In an analysis of the House Republican plan, tax experts with PricewaterhouseCoopers mentioned that a 2005 proposal by an advisory panel set up by George W. Bush proposed a border-adjusted tax with a four-year phase-in. The phase-in would “more than compensate” importers, PwC noted, meaning that those companies would “earn higher after-tax profits.”
Different variations on transition rules could be gamed out. The border-adjustment idea’s biggest critics, however, have basically staked out the position that no transition rules will fix the problem.
“While we will earnestly evaluate whatever Chairman Brady proposes, we are skeptical that transition rules will prevent the border-adjustment tax from forcing American families to pay more for the products that they need,” said Christin Fernandez, a representative for the Retail Industry Leaders Association, a group of the biggest importer companies that has waged a campaign against the House GOP proposal.
But supportive businesses are counting on transition rules.
“The implementation of a border-adjustment system has to be very well thought out and done in a systemic manner to allow currencies time to adjust and to allow pre-existing contracts to also run to ensure there are no negative effects,” said Tony Simmons, the CEO of the McIlhenny Co., which produces Tabasco. The company supports the GOP proposal and the border adjustment.
