Tax Reform in the USA

Paying taxes is turning into an increasingly cumbersome process for natural and legal persons in the USA. The independent Tax Foundation estimates that, since the last reform in 1986, the federal tax code has doubled to around 2.4 million words (Hodge, 2016). According to estimates made by this institution, the average American dedicates around eight hours per year to declaring income, whilst this process for businesses takes more than a day on average.

The Internal Revenue Code contains hundreds of politically motivated deductions and tax breaks, which results in complexity and market distortions. High rates of corporate tax, which can only to some extent be brought back to an internationally comparable level through deductions, have been encouraging businesses to relocate production abroad. In addition, the taxation of profits earned abroad upon repatriation to the USA has also been criticised, as it has resulted in a situation in which American enterprises have accumulated more than two trillion US dollars abroad, rather than reinvesting this capital in their home country. Finally, due to inadequate customer services and chronic inefficiency, the Internal Revenue Service has an extremely poor reputation.

Tax reform proposals

Accordingly, tax law reform is a major concern, in particular in Republican circles. Alongside investment in infrastructure and foreign policy, President Donald Trump’s electoral programme strongly focused on tax reform. Tax reform is also a central pillar of the agenda ‘A Better Way’ of the conservative majority in the House of Representatives, which is serving as a guide for the current 2017–2018 legislature.

Since both the executive and the two houses of the legislature are dominated by the Republican Party, the prospects for tax reform are good. The two proposals are similar, above all in relation to income tax. They envisage three marginal tax rates of 12 per cent, 25 per cent and 33 per cent, instead of the current seven rates of between 10 per cent and 39.6 per cent. Although the lowest rate of tax would be higher than it currently is, tax allowances would however be twice as high. In addition, the ‘Alternative Minimum Tax’ for high earners would be abolished, inheritance and gift tax rates reduced and capital gains taxed at a lower rate.

However, the proposals of the Trump Administration in the area of corporate taxation are different from those of Republicans in Congress. Whilst the most recently presented presidential plan proposes to reduce federal corporate tax to 15 per cent and to impose import duties on selected goods, Republicans in Congress have gone further and propose a fundamental review of corporate taxation. They are considering cashflow-based taxation according to the country of destination, as has been discussed within academic circles for a number of years.

A completely new approach to corporate taxation…

The ‘Destination-based Cash Flow Taxation with Border Adjustment’ has for example been proposed by American economist Alan J. Auerbach and has attracted increasing attention over the last few years as part of discussions concerning tax evasion. ‘Cash Flow Taxation’ means that the actual cash flow into a company is taxed, rather than the profit. This is defined as income from sales less expenditure on intermediate products, investment and wages.

Cashflow differs from profit amongst other things due to the fact that non-cash items such as amortisation, depreciation and capital reserves are not taken into account. It is more difficult to distort it through accounting techniques, and businesses no longer have any incentive to transfer their profits to tax havens or to conceal them through opaque transfers between subsidiaries. Amortisation and depreciation no longer has to be applied over several years in an arbitrary manner as investment costs are eligible for deduction immediately. This results in significant incentives to invest. In addition, borrowed capital would no longer have any tax advantage over equity capital as interest payments would no longer be tax deductible.

‘Destination-based’ means that tax is only levied on domestic income. In this respect the proposed tax is similar to value added tax, although it would be levied directly by businesses rather than indirectly, as here the taxpayer would be the business and not the consumer. Income on exported goods and services would be tax free. This means that there would be no more incentive for businesses to accumulate abroad the profits earned there.

In contrast, expenditure on imported intermediate products and foreign investments and salaries would no longer be tax-deductible. Hence the term ‘Border Tax Adjustment’. A business that produces domestically is able to deduct its production costs from the amount liable to tax. However, if it sources goods from abroad, it will pay tax on the full amount of the selling price as no national costs can be deducted. A tax rate of 20 per cent is being considered. The benefits and drawbacks of this principle of taxation are discussed in detail in Auerbach et al. (2017). However, it is envisaged that its unilateral introduction by the United States would meet with resistance from various quarters.

...the implementation of which is doubtful

According to its supporters, the new form of corporate taxation would increase government revenue and ensure stronger economic growth. Exporters would benefit directly from this tax reform, as they would not pay any tax on income earned abroad and would thus become more competitive. This would also be consistent with the trade policy goals of the new administration.

Importers would bear a burden as they would no longer be able to deduct foreign intermediate products from the amount liable to tax. Who ultimately ends up bearing the cost of the tax reform will be dependent upon elasticity of supply and demand for the relevant goods. If import demand is highly inelastic and there are no competitive national sellers, due to foreign producers’ technology or labour cost advantages, it is likely that most of the cost increases would be passed on to end consumers. On the other hand, if import demand is elastic, foreign sellers would have to cut their prices as there would be tax benefits in sourcing intermediate products nationally rather than from abroad, or in producing them internally.

It is however projected that the increased competitiveness of the US economy would be lost again over the medium term, in part due to an adjustment of the exchange rate or of the relative prices of goods. Since the new tax principle would make exports cheaper and imports more expensive, this would increase the value of the US dollar and thus once again boost the competitiveness of importers and foreign sellers.

It is also expected that this form of taxation would attract opposition from the trade partners of the USA, which still operate source-based tax systems. In contrast to conventional value added tax, a distortion results from the discrimination against foreign labour costs, as foreign companies continue to pay income taxes in their countries of origin. This could result in companies relocating production to the USA.

The rest of the world – potentially also Switzerland – would thus lose some of its tax base. Such a tax would also violate current World Trade Organization rules. Although tax systems with a border adjustment are permitted and also commonplace for conventional value added taxes, this is only the case for consumer taxes that are levied indirectly by businesses, which is something different from this proposal. Were the USA to introduce the tax proposed, the rest of the world would have to adapt accordingly in order to avoid a relocation of real value added to the USA. It is expected that this would give rise to a sharp reduction in transnational production chains, and that its effect would be similar to the introduction or increase of import duties on a global scale.