The Debate Over U.S. Corporate Tax Reform: How Should China Respond?

President Donald Trump and the Republicans in the U.S. House of Representatives are calling for major changes to the U.S. corporate tax system. Although they share some elements, the plan advanced by Trump and the blueprint put forth by the House Republican leadership are not identical.

If either corporate tax reform plan is enacted by the U.S., it will not only have widespread and profound domestic impact, but it will also have a dramatic impact on countries around the world. This is particularly true for countries like China that play an active role in the global economy. China cannot wait idly while the U.S. enacts major reforms; it must prepare or risk being put in an unfavorable position in the fast-moving world of tax competition.

This article begins with a brief look at the existing U.S. corporate tax system and its drawbacks. It then examines the House and Trump plans for U.S. corporate tax reform, concluding that the House blueprint is more likely to proceed and focusing the remainder of the article on its proposals. After discussing two significant hurdles that the House blueprint may face, I consider the impact that the plan would have in the U.S. and elsewhere. In the final section, I make recommendations as to how China should respond if the blueprint’s corporate tax reform plan is put into practice.

I. The Existing U.S. Corporate Tax System

A. Key Elements

The existing U.S. corporate tax system has three key elements:

• It imposes the highest corporate tax rate of any developed nation, totaling about 39 percent when the 35 percent federal rate is combined with the state corporate tax rate (on average, about 4 percent).¹ Only Chad and the United Arab Emirates levy corporate taxes at a higher rate than the U.S.²

• It is a worldwide tax system. The U.S. taxes the foreign earnings of U.S. companies when those earnings are brought back to the U.S., with a credit allowed for foreign taxes paid on those earnings.

• It is an origin-based tax system that taxes exports.

B. Key Drawbacks

At least three negative consequences arise from the existing U.S. corporate tax system:

• U.S. companies have tax incentives to engage in income shifting by a variety of means, including transfer pricing, to lower their overall tax burden;

• U.S. companies have tax incentives to locate production activities overseas; and

• U.S. companies have tax incentives to hold their foreign earnings overseas, rather than bringing them back to and reinvesting in the U.S.

II. An Overview of the Reform Proposals

In October 1986 President Ronald Reagan signed the Tax Reform Act of 1986, landmark legislation widely recognized as the single largest tax reform in the nation’s history. The year 2016 marked its 30th anniversary. Republicans suggest that, like in 1986, America’s tax code has become thoroughly broken. Based on the issues sketched out above, they feel that the existing U.S. corporate tax system hurts investment, lowers employment, and stifles economic growth. They believe that the situation warrants bold and dramatic reform.

A. The House Blueprint

On February 4, 2016, House Speaker Paul D. Ryan, R-Wis., announced the creation of six committee-led task forces, including the Tax Reform Task Force led by House Ways and Means Committee Chair Kevin Brady, R-Texas. Ryan charged the Tax Reform Task Force with developing detailed tax reform policy recommendations. In June 2016 the House Republicans published a blueprint document called “A Better Way Forward on Tax Reform.” The blueprint includes plans to reform the individual income tax, the corporate tax, and the IRS itself.

The blueprint’s corporate tax plan proposes a sweeping, fundamental reform of the U.S. corporate tax system. There are six key points:

• It proposes lowering the corporate tax rate from 35 percent to 20 percent.

• It proposes ending the system of worldwide income taxation for U.S.-based global businesses. It advocates moving from a worldwide to a territorial tax system.

• It proposes moving from an origin-based tax system to a destination-based tax system. Under a destination-based tax system, tax jurisdiction follows the location of consumption rather than the location of production. The plan achieves this using a border-adjustable tax that exempts exports and taxes imports.³

• The plan would provide all businesses with full and immediate write-offs of their investments in both tangible and intangible assets. This is equivalent to a 0 percent marginal effective tax rate on new investment.

• It proposes giving U.S. businesses tax relief for their domestic labor costs.

• No current deduction would be allowed for net interest expense.

B. The Trump Plan

On April 26, 2017, the White House unveiled its own tax plan. The White House’s corporate tax reform plan has three key points:

• it would lower the corporate tax rate from 35 percent to 15 percent;

• like the blueprint, it would move from a worldwide to a territorial tax system; but

• it is silent on the issue of a border-adjustable tax.

C. Analysis: Blueprint More Likely to Succeed

Compared with the blueprint, the White House’s corporate tax reform plan lacks many basic details. Not only are the Trump plan’s tax cuts more aggressive, but the plan includes fewer offsets (for example, the border-adjustable tax) to help finance the tax reductions. Overall, I think the White House’s corporate tax reform proposal is less viable and is better seen as an opening bid to frame negotiations in Congress. It is probable that the corporate tax rate will be lowered to 20 percent. It is also likely that the House will include a border-adjustable tax in its tax reform legislation, although it may be a more modest one. Hence, this article will focus on the blueprint’s corporate tax reform plan and how China should respond if it becomes U.S. law.

III. Understanding the Blueprint’s DBCFT

The six key points of the blueprint’s corporate tax reform plan appear to create a version of the destination-based cash flow tax (DBCFT).⁴

Although the DBCFT has become a highlight of recent policy discussions, it actually evolved over many years, mainly in academic circles. The DBCFT’s earliest roots can be traced back at least 20 years.⁵ Its principal intellectual champion in the U.S. is Alan J. Auerbach, an economics professor at the University of California, Berkeley.

The DBCFT has two basic components. First, it is a cash flow tax. This means it gives immediate relief to all expenditures, including capital expenses, and taxes revenues as they accrue. Second, it is destination-based. It introduces a border-adjustable element like that used by the VAT; exports are exempted, while imports are taxed. Importantly, the proposal also includes an exemption for domestic labor expenses.

In summary, the House blueprint corporate tax reform plan proposes a version of the DBCFT along with a uniform tax rate of 20 percent. This proposal is the economic equivalent of a broad-based 20 percent VAT combined with a corresponding labor tax cut.

IV. Potential Challenges to the Blueprint

The blueprint’s corporate tax reform plan faces two potentially major challenges.

First, due to the border-adjustable tax, import-oriented companies (including many retailers) may think they will be negatively affected by the blueprint and thus may resist it. Auerbach suggests, however, that these worries are misplaced because the U.S. dollar will appreciate 20 percent in response to the 20 percent border-adjustable tax.⁶ Thus, he argues, trade will not be distorted.

Second, the plan may also face a hurdle at the WTO. The blueprint proposes allowing U.S. companies to deduct domestic wages from taxation. A wage deduction is not currently permitted under WTO rules, and it is likely to be seen as an unfair subsidy to U.S. companies and a barrier to trade. However, the economic equivalent of the DBCFT — namely, a VAT combined with a reduction in both payroll taxes and income taxes — complies with WTO rules. Therefore, the plan should pass WTO scrutiny.

V. The Potential Impact of the Blueprint

If adopted, the blueprint’s corporate tax reform plan would be the biggest and most fundamental change in corporate tax law in U.S. history. It would not only have a widespread and profound domestic impact, but also a dramatic impact worldwide.

A. The Impact Within the U.S.

The following nine points summarize the likely impact within the U.S. of the blueprint’s corporate tax reform plan:

• The U.S. dollar would appreciate 20 percent relative to other currencies.⁷

• The plan would remove the tax incentives for U.S. companies to engage in income-shifting activities.⁸

• Due to the border-adjustable tax, the plan would eliminate the tax incentives for U.S. companies to move or locate production overseas.

• Because U.S. companies’ foreign earnings would not be taxed, they would be free to bring the money home without tax penalty. Thus, they could reinvest in the foreign profits in the U.S.

• The plan would promote investment because it provides for the full and immediate expensing of business investments.

• Since interest expense cannot be deducted, it would eliminate the tax advantage of debt and would not distort the capital structure of U.S. companies.⁹

• Because labor costs can be deducted, it would make it less costly to employ workers and encourage companies to raise pay rates.

• Because the DBCFT is a self-enforcing tax system, the U.S. would gain a competitive advantage over countries that do not adopt a DBCFT.¹⁰

• The U.S. would be resistant to tax competition and changes in tax rates.¹¹

B. The Effects on Other Countries

If the blueprint’s corporate tax reform plan is enacted, countries around the world would also be dramatically affected. The main international results would be:

• As the U.S. dollar appreciates 20 percent relative to other currencies, other currencies would correspondingly depreciate 20 percent relative to the U.S. dollar.¹²

• Because the plan would encourage capital to flow back to the U.S., it would exacerbate other countries’ capital outflows.

• While the U.S. gains a competitive advantage over countries that do not adopt a DBCFT, those countries that do not adopt a DBCFT would find themselves in a correspondingly unfavorable position relative to the U.S. in tax competition.¹³

VI. China’s Response to the Blueprint

China’s corporate tax rate is 25 percent, with a special 15 percent rate applicable to high-tech companies. China’s corporate tax system shares two important features with the existing U.S. corporate tax system: It is a worldwide tax system, and it is an origin-based tax system. Therefore, the three negative consequences generated by the existing U.S. corporate tax system also exist, to varying degrees, in China.

If the blueprint’s corporate tax reform plan is adopted by the U.S., the foregoing analysis suggests that it would negatively affect China in at least three ways: The Chinese yuan renminbi would depreciate 20 percent relative to the U.S. dollar, China’s capital outflow would be exacerbated, and China would be put in a very unfavorable position relative to the U.S. in terms of tax competition.

There is still a degree of uncertainty as to whether the blueprint’s corporate tax reform plan will be adopted by the U.S. Nonetheless, given the potential effects on China that its adoption would bring, China must be prepared.¹⁴

Thus, the question becomes: How should China respond? Based on the analysis above, I propose two possible response schemes. One is a simple response scheme, while the other is a comprehensive, systematic, and integrated response scheme. After comparing the two schemes, I make policy recommendations.

A. The Simple Response Scheme

The simple response is to just copy the blueprint’s corporate tax reform plan, changing China’s corporate tax into a DBCFT.

B. The Comprehensive Response Scheme

There are three important factors to keep in mind when crafting a comprehensive, systemic, and integrated response for China should the U.S. adopt the blueprint:

• The DBCFT is equivalent in its economic impact to a broad-based, uniform rate VAT with a corresponding reduction in taxes on wages and salaries.

• The VAT is the most important tax in China. After major reforms in 2016, China achieved a broad-based VAT with four different levels of tax rates (17 percent, 13 percent, 11 percent, and 6 percent). These rates were created to help improve the overall progressivity of China’s tax system.

• China is working to reform its individual income tax.

I propose that China craft a comprehensive, systematic, and integrated response to the DBCFT based on the following three key points:

• Completely eliminate China’s corporate tax.

• Take advantage of this opportunity to unify the VAT rate and, in place of the differentiated rates, allow a reformed individual income tax to assume the role of improving the overall progressivity of China’s tax system.

• Reform China’s individual income tax system — for example, broaden the tax base in order to improve the overall progressivity of China’s tax system and promote equity.

It is important to note that these three key points are interrelated, complementary, and indivisible. Together, they form a complete response to the potential introduction of the DBCFT and related changes to the U.S. system.

C. Policy Recommendations

I am well aware that this comprehensive, systematic, and integrated response scheme involves major tax reform for China. It is, nonetheless, the best approach for several reasons. It takes a coordinated approach to tax reform, rather than a fragmented one. It creates a tax system that is simple, and the administrative costs of taxation will be low. Further, the proposed system would be resistant to international tax competition in terms of tax rates, and it would give China a relatively fair tax system with long-term stability.