January 18, 2017

Why Trump Is Right to Oppose Part of the House GOP Tax Plan

Veronique de Rugy

George Gibbs Chair in Political Economy
Summary

I understand the appeal of hoping to pay for the great features of the tax plan (such as death tax repeal, lower rates and full expensing) with this revenue. But that's an abdication of the idea that these tax cuts should really be paid for with spending cuts and entitlement reforms before the negotiations with Democrats even begin.

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Late on Monday, the Wall Street Journal reported that President-elect Trump wasn't crazy about part of the House Republican corporate income tax reform plan, known as border adjustment.

The measure, which could raise up to $1 trillion in revenue to be used to offset tax cuts in the rest of the plan, would tax imports and exempt exports. For that reason, it's been pitched by many of its supporters as an alternative to Trump's destructive import tariffs, including Speaker of the House Paul Ryan, R-Wis., and House Ways and Means Committee Chairman Kevin Brady, R-Texas.

I, for one, am not surprised that Trump wouldn't bite.

First of all, if Trump has been following the policy fight on this issue, he knows that, as Clark Packard noted yesterday in these pages, many advocates of the measure claim it's not at all a protectionist feature since "exchange rates should react immediately to offset the initial impact of these adjustments." If that's the case, it's hard to argue that border adjustment is, in effect, a replacement for punishing imports if most people are alleviating protectionist concerns by saying that it's not.

Second, Trump may have been willing to overlook the "it-looks-protectionist-but-don't-worry-it's-not" trick if not for one thing. If the dollar were to appreciate as much as it needs to offset the impact of the taxes, the distortions would create large amounts of wealth losses for American holders of foreign assets. As he noted with the Wall Street Journal, Trump thinks the dollar is already too strong and wouldn't welcome further appreciation.

I also assume that, being a large holder of foreign assets, Trump understands the impact to his portfolio. In case he didn't make the connection on his own, Stan Veuger made it for him in a blog post brilliantly called, "How border adjustment reduces the value of your Scottish golf course."

While I share Trump's skepticism about the border adjustment feature (I'm against the border adjustment proposal), my opposition to the measure is based on very different concerns.

First, the claims that nominal exchange rates will adjust immediately when the new tax system is implemented without anyone adjusting their behavior in anticipation of the change is at best an article of faith. The issue is far from settled in academia, contrary to what the pro-border adjustment advocates are claiming.

If anything, assuming that no one will anticipate the nominal exchange rate shift and change their behaviors is implausible at best. As a result, trade flows will be affected, making this measure protectionist. Most free-trade advocates (the few ones who are left) and consumers should be concerned about this. (For a good conversation on this issue, I recommend listening to this Cato Institute podcast with Dan Mitchell and Dan Ikenson called "Trump and Trade: Peril and Promise of a border Adjustment Tax").

I'm also disappointed that, by preemptively including border adjustment in their tax reform plan, Republicans are signaling that they're okay with the Democratic demand that tax reform, including any tax cuts, be paid for with a new large tax increase.

I understand the appeal of hoping to pay for the great features of the tax plan (such as death tax repeal, lower rates and full expensing) with this revenue. But that's an abdication of the idea that these tax cuts should really be paid for with spending cuts and entitlement reforms before the negotiations with Democrats even begin.

If history is any guide, when you look at what happened when Republicans agreed to a tax increase in exchange for what they wanted (for instance, $3 in spending cuts for $1 of tax increase), they've ended up with tax increases and not much of what they really wanted. In this case, there is a real risk that we'll end up with a tax on imports but less than the expected rate cuts or only partial expensing.

Finally, border adjustment taxes are destination-based taxes. This could seriously undermine tax competition, as I and others have explained. One might argue that it won't really matter that taxpayers are trapped in this destination-based system, since tax rates will be so low that we would be winning the tax competition anyway. However, that won't be the case if and when President Elizabeth Warren and her Democratic Congress decide to raise revenue by jacking up this destination-based tax.

It's too bad that Republicans have decided to add this feature to what is otherwise a very good plan. I understand that most people advocating for the measure mostly see it as a way to pay for the good aspects of the plan. They often sell the border adjustment as being a consumption tax, a territorial tax and other nice things, which destination-based taxes are. However, we could get these features without border adjustability and the risk that comes with it.

In the end, it's all about how much revenue border adjustment can raise. In reality, it could be the poison pill that sinks the whole ship.