Republican Representatives Paul Ryan and Kevin Brady are promoting as part of corporate tax reform what is now being called the “border adjustment tax.” This complex plan would require a lengthy column just to explain it all, but in the very simplest terms you can think of it as a move toward a value-added-tax structure with corporate investment subsidies built in. Under one somewhat-neglected feature of the tax, companies could no longer deduct advertising, interest, rent and employee benefit costs from their bills for tax due. This is a recipe for major tax dodges and the further politicization of government-business relations.
To think through these problems, note that under circulating versions of the tax reform a company still can deduct its asset acquisition and inventory costs. So, to cite one potential problem, if a company acquires a building it can deduct that expense, but not if it rents a similar building. The result is that the rental market would suffer badly. Some companies would put up their own structures, but others might engage in temporary “repurchase” agreements so they are owning their space (“asset acquisition”) rather than renting it. That’s just one example of the big loopholes the new tax code could create.
There is no single canonical account of how a border adjustment tax would work, so maybe that loophole won’t apply to your preferred version. (Here is a 2016 outline, but expect further changes and details; this KPMG document is useful on options.) But the general point is this: By creating such a sharp distinction between deductible and nondeductible business expenses, the opportunities for tax arbitrage and tax-code lobbying are huge. The suspicion is that most business expenditures could, one way or another, be converted into forms that allow for full and immediate expensing.
How about a version of the tax that allows for deductibility of newly constructed but not purchased buildings? Well, that would encourage over-investment in new construction. You can also imagine building purchases accompanied by over-billed site modifications (with some of that money being returned in another associated transaction), so the refitted structure could count as new construction.
If you think these kinds of problems can be removed from the tax, well, I have a bridge to sell you (or would it be a repurchase agreement with a few new cables tacked on to the structure for tax purposes?).
Similar loophole problems arise from the elimination of interest deductibility. Let’s say my company is buying a machine from your company, and normally you would offer trade credit to ease the purchase. If the interest on that trade credit is not deductible, we would build the interest payments into the upfront price of the machine, making the expense deductible and circumventing the intent of the tax reform. Or I could seek such trade credit from you (and your bank behind the scenes), rather than taking out a traditional loan, again converting a nondeductible expense into a deductible expense.
Again, you might identify a policy modification that would limit such tax code arbitrage, but I’ll predict that would open up another loophole in turn. Like our current system, the border adjustment tax would become a game of tax lawyers on each side, where the better paid advocates are working for the corporations rather than Uncle Sam.
When you add lobbying to this mix, corporations will care a great deal about the legal interpretations that allow these deductions to stand. I don’t expect citizens’ groups will have the knowledge or the motivation to put comparable effort into such arcane political battles. If the goal is to lower the tax burden on business, it would be better to simply cut or eliminate the current corporate tax rate.
Or, to consider another part of the proposed reform, how about removing the deductibility for advertising expenses? A lot of advertising today is done on social media, and software plays a significant role in placing the ads. Businesses could sell “advertising machines,” with the accompanying stream of ads bundled into the price of the equipment. That’s probably not an efficient way to manage ads, but it would get the tax bill down.
You might think it’s easy to fix these problems by allowing companies to deduct the expenses discussed above. But then the tax would no longer bring in enough revenue to support the rate cuts. Another problem is more conceptual. The tax generates some of its (ostensible) efficiency gains by taxing what is considered to be the consumption of corporations rather than their net income per se, and allowing the deductibility of further expenses would move the system back toward a regular corporate income tax, thus vitiating a goal of the reform.
So often, tax reforms that appear to be simplifying lead to further complications and manipulations, and that seems to be the case here.