President Trump is confused. Specifically, he is confused about the GOP’s proposed “border adjustment tax”.
To be fair, it is not his proposal – it is a scheme promoted by Speaker Paul Ryan. President Trump himself has said it is too complex. He favors import tariffs for selected countries and industry sector. He would like to put a tariff of 20% on all imports from Mexico, and a tariff of 35% on all imports from China, and…..you get my drift. He also quite likes the idea of imposing tariffs on steel imports (his new trade secretary Wilbur Ross, who made a fortune from steel manufacture, suggested that one).
U.S. President Donald Trump waves as he walks towards the Marine One for a departure on the South Lawn of White House March 2, 2017 in Washington, DC. (Photo by Alex Wong/Getty Images)
Nonetheless, it appears that President Trump is beginning to warm to the idea of a border adjustment tax. But I fear that what he is warming to is not quite what he thinks. Here is his explanation of what the proposed border adjustment tax would mean for US companies and consumers, as revealed to Reuters and released by Caroline Freund on Twitter:
“It could lead to a lot more jobs in the United States….I certainly support a form of tax on the border because everyone else does. We’re the only country, we’re one of the very few countries, possibly the only country, that has no border tax. And that’s not a tax to the consumer, because that’s going to be a tax to companies and it’s going to be a tax to other countries much more so than it is to the consumer. That’s a tax to other countries. And what will happen is, don’t forget there is no tax if we make our product in the United States. So I don’t consider it a tax. That’s a tax if companies are buying their product outside the United States. But…if they make their product inside the United States, there is no tax. So what is going to happen is, companies are going to come back here, they’re going to build their factories and they’re going to create a lot of jobs and there’s no tax”.
This shows a serious misunderstanding about what a border tax is and how it would work.
The heart of the misunderstanding is this:
I certainly support a form of tax on the border because everyone else does. We’re the only country, we’re one of the very few countries, possibly the only country, that has no border tax.
This is simply wrong. Explicit border adjustment taxes are a rarity. So where does this idea come from?
It comes from the GOP’s “A Better Way” paper, in which the border adjustment tax is proposed. This is the relevant paragraph:
Today, all of our major trading partners raise a significant portion of their tax revenues through value-added taxes (VATs). These VATs include “border adjustability” as a key feature. This means that the tax is rebated when a product is exported to a foreign country and is imposed when a product is imported from a foreign country. These border adjustments reduce the costs borne by exported products and increase the costs borne by imported products. When the country is trading with another country that similarly imposes a border-adjustable VAT, the effects in both directions are offsetting and the tax costs borne by exports and imports are in relative balance. However, that balance does not exist when the trading partner is the United States. In the absence of border adjustments, exports from the United States implicitly bear the cost of the U.S. income tax while imports into the United States do not bear any U.S. income tax cost. This amounts to a self-imposed unilateral penalty on U.S. exports and a self-imposed unilateral subsidy for U.S. imports.
This is, unfortunately, a lamentable misunderstanding of VAT. It does not work in the way that the GOP – or indeed Navarro & Ross – describe. VAT does not unfairly discriminate against US companies.
To explain this, we need first to understand what a value-added tax is. A value-added tax aims to tax the additional value added by each company in a value chain. As adding value usually enables companies to charge more for goods and services, we can broadly define added value as the difference between the cost of physical inputs (raw materials, intermediate goods) and the price charged to customers. To get from added value to profits, you also deduct other business costs such as wages and taxes.
So VAT is a net tax. Here in the UK, the standard VAT rate is 20%: there are numerous exemptions and preferential rates, but to keep things simple I will assume for the purposes of this piece that all VAT is paid at the standard rate. It is paid on all purchases, both by businesses and retail customers. Businesses also charge VAT on their sales: if the sale is to a retail customer, the VAT is included in the price, while on sales to business customers VAT is separately disclosed. The reason for separate disclosure of VAT on business invoices is that businesses can reclaim VAT on purchases from the UK tax authorities. Every quarter, a VAT-registered business must file a return with the UK’s tax authorities disclosing the amount of VAT they have charged on their sales that quarter and the amount of VAT they have paid on purchases that quarter. If VAT charged exceeds VAT paid, they must pay the difference to the UK tax authorities. That is deemed to be the tax due on the value the company has added.
Note that this is a return made by British companies only. VAT is payable on all sales by British companies, and it is reclaimable on all purchases by British companies, whether from British suppliers or foreign ones.
As an example, imagine an entirely British supply chain. Suppose there is a widget manufacturer in Dunfermline (Scotland), which supplies components to a manufacturer of automobile steering systems in Cardiff (Wales), which in turn supplies steering systems to Nissan’s car factory in Sunderland (England). Nissan supplies cars to dealerships all over the UK, which in turn sell them on to retail customers.
The widget manufacturer charges the steering system manufacturer its factory gate price, which broadly consists of its business costs plus some kind of mark-up (because they want to make a profit), plus VAT at 20%. In turn, the steering system manufacturer charges Nissan its own factory gate price, plus VAT at 20%. Nissan then charges the car dealers its own factory gate price plus VAT at 20%. And the car dealers add whatever bells and whistles they add to justify charging retail customers above factory gate prices, and also add VAT at 20%.
Clearly, if there were no offsetting VAT rebates, VAT would effectively have been charged four times on the same widgets. This is why companies can reclaim VAT on purchases. We only want to tax the extra bit of value that each company adds – we don’t want to tax the same inputs multiple times. Only the end of the value chain cannot reclaim VAT – i.e. retail customers, who will add no value so must suffer the tax in full. VAT is therefore a tax on household consumption.
But what would happen to this value chain if it included an American company? The USA does not have a VAT. What difference would this make?
On the import side, the absence of VAT in America makes no difference at all. Suppose our steering system manufacturer ended its supply agreement with Dunfermline Widgets and entered into a new agreement with a company in Pennsylvania. It would then pay the US price in dollars, so would be exposed to FX movements which might or might not be advantageous. It would also pay the appropriate World Trade Organization’s “most favoured nation” tariff, since the US does not yet have a free trade agreement with the UK. And it would pay 20% VAT.
Wait, what was that? Isn’t that 20% VAT on imports from America effectively a border tax?
Well, not really. Remember that the steering system manufacturer paid 20% VAT on purchases from its original supplier in Dunfermline. It is simply paying exactly the same VAT on purchases from its new American supplier. The UK government’s decision to impose VAT on imports simply levels the playing field for British companies. It does not confer on them any unfair advantage over American exporters. The American exporter does experience some discrimination, because of the WTO tariff: but then if Dunfermline Widgets exported to America, it would incur exactly the same tariff. None of this is in any way unfair to anyone.
