The Border Adjustment Tax (BAT) proposed by Congress is intended to change how business income is taxed giving it features of a Value-Added-Tax (VAT), a cash-flow tax, and a consumption tax. The idea is to make the corporate income tax function as a quasi-VAT and less as an income tax on the earnings of U.S. producers. Clearly violative of free trade principles affecting the U.S., the practice (of border adjustments by VAT nations) should be made the subject of U.S. trade re-negotiation, a challenge to be rigorously pursued by the new fair trade Administration. This is a fair trade problem, not a problem about income taxation. The BAT “solution” makes for new problems. On several fronts, a BAT for the U.S. is likely to make matters worse. The driving force behind the BAT is the expectation that it will generate considerable tax revenue, an expectation resting on the premise there always will be a major trade deficit.
By James K. Jeanblanc l February 22, 2017
Most income tax reform plans come with varying curtailments of the tax breaks, some lowering of the tax rates, but all leaving the tax system fundamentally as is, in a horrible tax mess and still in a state easy to be made worse. Bottom line, they all are reform plans for betterment of the tax mess, to rearrange it, to give it polish, and to placate the complaints of the moment.
The latest betterment plan now before Congress is bantered as “A Better Way” Plan. It would add to the mess bells and whistles to give the mess features of a Value-Added Tax (VAT), a cash-flow tax, and a consumption-tax. The goal seems to be to make the mess appear as a kaleidoscope to be marveled upon depending on how one looks at it. Clearly, betterment is not real reform.
Real income tax reform is simple: Turn the system into a true income tax. End it as a system for taxing persons. Stop picking winners and losers. Abandon using it to fix problems. The uniform taxation of income must be made the focus.
If what we are supposed to have is an “income tax,” then why isn’t all income taxed? Why isn’t it taxed at the same rate? Why isn’t it taxed without regard to payor, recipient, or use to which put? Questions ignored, the “Better Way” Plan, the latest betterment plan, has been blissfully rolled out with these aberrations –
The BAT (a/k/a the Border Adjustment Tax)
The Border Adjustment Tax (BAT) in the Plan originates from earlier proposals to change how business income is taxed. Under the BAT, companies would be barred from deducting the cost of their imports, and their export revenues would be excluded from income taxation. The idea is to make the corporate income tax function as a quasi-VAT and less as an income tax on the earnings of U.S. producers.
Despite emasculating the concept of corporate income taxation, the BAT has been advanced as a tax solution to the failure of U.S. trade negotiators to counter an unfair trade practice of VAT nations, which have border tax adjustments of their own, hurting U.S. trade. Their border adjustments are a disguised system of tariffs and export subsidies, by which each VAT nation imposes its VAT on imports and rebates its VAT on exports.
The Failure of U.S. Trade Negotiators. The VAT border practice compensates for itself in trade between VAT nations, but not in the case of their trade with the U.S., a non-VAT nation. This unfair practice as to the U.S. should be ended at least with respect to their trade with the U.S. This is not to say they should be barred from the practice in their trade among themselves.
Despite the principles of free trade against tariffs and export subsidies, the World Trade Organization (WTO) accepts border adjustments for so-called indirect taxes, such as the VAT (to the exclusion of income taxes). Defense of VAT-border-adjustments in worldwide trade rests on a claim of acceptance – all VAT nations employ them, and it’s a system that’s been practiced for decades without any real challenge.
[Word games and paperwork aside, there is the economic reality that income taxes are as much a cost of production and value creation as is the VAT. They are government burdens to the production and value-creation process and carry through as part of the price to the consumer, just as the VAT.]
Clearly, violative of free trade principles affecting the U.S., the practice (of border adjustments by VAT nations) should be made the subject of U.S. trade re-negotiation, a challenge to be rigorously pursued by the new fair trade Administration. This is a fair trade problem, not a problem about income taxation.
The BAT “Solution” Makes for New Problems. On several fronts, a BAT for the U.S. is likely to make matters worse.
First, the BAT is certain to face challenge and likely rejection by the World Trade Organization (WTO). If the WTO were to accept the BAT and rule it not to be an unfair trade practice and if it works well in helping the export and import position of the U.S., isn’t it reasonable to expect other countries to also adopt their own BATs? If so, won’t this take away the benefits hoped for from a BAT for the U.S.?
Second, the driving force behind the BAT is the expectation that it will generate considerable tax revenue, an expectation resting on the premise there always will be a major trade deficit. Suppose the BAT is a success in cutting the trade deficit so that imports no longer greatly exceed exports, how is the diminished revenue to be made up?
Third, BAT proponents claim the BAT will not inflate the cost of imports to U.S. consumers because the dollar will increase in value (a claim based upon obtuse computer models) and the increased purchasing power of the dollar will fully offset the BAT’s increase in the import costs. If so, won’t that increased dollar value put the U.S. at a price disadvantage on its exports (if not discount-priced)?
Fourth, a BAT works best only if the business tax rate is kept high, such as at the 20% corporate tax rate now being proposed. At a zero tax rate, the BAT has no juice. So, will the proposed BAT requiring a high tax rate, create a disincentive for true income tax reform? (This question presupposes reform defined in terms of lower tax rates and a tax simplification with fewer tax breaks necessary to offset high tax rates.)
The Expensing of Investments
Another questionable proposal in the Better Way Plan would allow businesses to expense the costs of their investments in the year when made and not be required to depreciate that cost over the life of the investment. This is an anti-income-tax reform measure, to use the tax system to get taxpayers to do something. Even worse, the proposal runs counter to generally-accepted accounting principles for the proper measurement of income, to match the cost of an investment against the revenue it produces.
The proposal is an admission that high taxes, which the proposed tax break is intended to offset, operate as a disincentive for new investment. If the goal of the tax break is to incentify new investment, then why not simply remove the disincentive? Why aren’t business market forces and the profit motive incentive enough? Not to be forgotten is that tax-rate reduction enhances after-tax investment returns.
Will this new-investment tax break work as intended? Take the case of the investment tax credit first added in the 1960s as an incentive for investment in new machinery and equipment. Beyond the idea sounding good at the time, many studies have concluded that the investment tax credit never created an investment need and that the credit served only to reward and subsidize investments which would have been made anyway.
More Detours from the Road to Real Tax Reform
Net Interest Expense to Be Disallowed. Here’s another questionable provision, but having the virtue, in Establishment eyes, of being a significant revenue-raiser and use of the income tax “to fix a problem.” It would deny the deduction for “net interest expense” (i.e., the excess of a business’s total interest expense over its total interest income). It would be another departure from generally-accepted accounting principles, thus making the income tax less of an income tax. Its stated purpose is to fix a problem identified as “too much” debt, but surely this will make the income tax even more complicated.
It’s said the provision is to apply only with respect to “new debt” as contrasted from old debt. How so? Must interest income be reduced by the amount of interest expense on old debt before being made available to make interest expense on new debt allowable? Or, is interest income to be pro rata allocated between old and new debt interest expense? What is “new debt”? Does that include old debt refinanced? Would a change in the terms of old debt make it “new debt”? Would the interest expense imbedded in other business costs have to be separated-out for denial (e.g., regarding the above proposal for cost of new investments to be expensed, such as a company financing the cost of a new factory)? Would the unallowed interest expense in one year be carried to the next year?
In the case of corporations, the “too-much-debt” problem would be tax-reform-dealt-with if all corporations were allowed an income-distribution deduction for dividends paid, thus putting dividends and equity capital on par with interest expense and debt-financing. But, such a simple solution (also resolving the double-tax issue for dividend income) would not be a revenue-raiser and, hence in the eyes of the architects of the “Better Way” Plan, is unsuitable for the Plan.
Unwillingness to Tax All Income the Same. This is dramatized in the Plan’s proposal for the taxation of business income in the case of sole proprietorships and so-called “pass-through entities” (i.e., partnerships, limited liability companies, and subchapter S corporations). While the large-corporation business income is to be taxed at 20%, the business income of proprietors and pass-through entities is to be taxed at 25%, despite personal income (such as salaries and wages) to be tax-bracket taxed at rates ranging from 0% to 33%.
In their personal tax returns, taxpayers will be required to separate their business income to be taxed separately from their personal income. Interestingly, the Plan proposes that a portion of this business income be deemed “reasonable compensation” and treated as a paid salary and personal income to be taxed as such. This nuance is a recipe for tax controversies with the IRS as taxpayers claim their amount of “reasonable compensation” to have the lowest tax bill.
The Most Glamorous Whistle. Who would oppose the “postcard” income tax return? On that postcard, the taxpayer need only list the totals of his income and deductions, aggregate taxable income and enter the tax due from the tax table, and then subtract his tax credits to determine his personal tax bill (or refund).
Isn’t that essentially what happens with Form 1040? Could it be that the postcard idea is bait to attract support for the Plan? Surely, the IRS will want to see what’s behind the totals and will switch back to multiple-page tax-return filings.
The income tax is a mess. Making it better doesn’t change its character; it’s still a mess.
Don’t Give-Up Hope. Thinking outside of the betterment ditch, why not enact real income tax reform? Why not replace that mess with a true income tax, one where all income is taxed, taxed at the same low rate, and taxed without regard to its payor, recipient, or use to which put? The FreedomTax embodies the hope for real income tax reform.
Time for the Revolution. The FreedomTax will free taxpayers and the slow-growth economy from the inordinate tax burdens of the present system. It will make income (which is what’s supposed to be taxed) the sole focus of the tax, not people. All income will be taxed the same and at a flat 10% rate, to raise the same revenue as the tax mess to be junked. As might be expected in any revolution, the main opposition will come from the Establishment, losing its power to use the income tax to pick winners and losers.
Achieved will be vast tax simplification, breath-taking reduction in the compliance burdens, and massive tax efficiency in administering the tax, meaning for most people the income tax will become as easy as paying the motor-fuel tax at the pump. The 10% FreedomTax will be imposed and collected at-source on the payment of dividends, interest, salaries and wages, and retirement income, freeing most people from filing tax returns.
James K. Jeanblanc is tax counsel to the law firm, Grove, Jaskiewicz & Cobert in Washington, D.C. He is a graduate of the University of Illinois School of Law and received his LL.M. degree in Taxation from George Washington University. He is a former adjunct professor of law for the Tax Policy Seminar in the graduate law program of the Georgetown University Law School and has been a lecturer of law in the graduate law program of the George Washington University Law School. He is a former chairman of the Committee on Tax Accounting Problems of the Tax Section of the American Bar Association. Formerly, he was an attorney in the Office of the Tax Legislative, U.S. Treasury Department and an Assistant Branch Chief of the Corporate Tax Branch of the Legislation and Regulations Division of the Internal Revenue Service. He is the author of the FreedomTax and has a half-century of income tax experience involving tax legislation, tax regulation, IRS ruling, tax planning, and tax controversy matters. He is Senior Fellow for Tax Policy at the Selous Foundation for Public Policy Research and a contributor to SFPPR News & Analysis.