In 2017 the centerpiece of the House blueprint for tax reform — the destination-based cash flow tax — suffered a series of setbacks that ultimately led to its demise. It seems to be a dead letter, at least for now, but like many other tax proposals with a positive revenue score, this one might make a comeback in some form.
Upon its June 2016 release, the House Republican tax reform blueprint seemed like more of an academic exercise than a realistic basis for tax reform. It was presented as “a better way to dramatic reform,” but the proposal was painted in broad strokes without some important details and no legislative language was offered. Meanwhile, discussion of corporate taxes on the presidential campaign trail was similarly broad. Democratic presidential candidate Hillary Clinton favored upping the penalties for businesses leaving the United States, and then-Republican candidate Donald Trump said he wanted to lower the corporate tax rate substantially to counteract inversions. Neither candidate embraced the destination-based cash flow tax or even engaged with the idea.
But when Trump won the presidency and Republicans took control of Congress in November 2016, the mostly ignored project of House Speaker Paul D. Ryan, R-Wis., experienced a sudden, somewhat unexpected renaissance. “Businesses started to look at it and think about it. Ryan and [Republican House Ways and Means Committee Chair Kevin] Brady had to start selling it much more to the public, lawmakers, and the president,” said Kyle Pomerleau of the Tax Foundation. And that’s when things started to come apart for the tax.
“One thing that sunk the border adjustment was selling it as a semi-protectionist measure to encourage companies to produce here as opposed to elsewhere,” Pomerleau said. Ryan and Brady may have thought that was the best way to win political support, but that strategy turned out to be a miscalculation with many domestic companies, which regarded it as a tariff, Pomerleau said.
The Tax Foundation argued that the destination-based cash flow tax would end up being a wash for companies and individuals in that it doesn’t meaningfully increase tax burdens, Pomerleau noted. “Ultimately, its demise was [because the tax] was ahead of its time, wasn’t well understood, and was sold in a way that wasn’t right for the political environment,” Pomerleau said.
Although the idea of a destination-based cash flow tax had been in the background — mentioned in more academic policy conversations — it didn’t make the jump into the political world until its proposal in the blueprint, said Greg Leiserson of the Washington Center for Equitable Growth. And when it did, it was still a vague proposal. “The blueprint wasn’t that real on some level,” he said. The hard conversations about things like transition relief did not take place, Leiserson said. He added that the treatment of the financial sector was a huge open question in the blueprint.
The predicted exchange rate movements that would result from the destination-based cash flow tax and the large positive revenue score attached to the proposal helped torpedo the plan, Leiserson said. “The revenue score was part of the reason it was in the plan, but it also made everybody nervous,” he said. The likelihood of exchange rate appreciation made it even riskier, in part because it would have implemented a large transfer from wealthy Americans to wealthy foreigners, Leiserson said.
For his part, the president helped sink the tax in remarks to The Wall Street Journal in January. “Anytime I hear border adjustment, I don’t love it. Because usually it means we’re going to get adjusted into a bad deal. That’s what happens,” he said. The “Big Six” Republican tax reform negotiators nixed it in July in a statement of principles for tax reform.
Not Quite Ready for Prime Time?
“The destination-based cash flow tax is a policy ahead of its time in that if you ask an economist about it, there are lots of attractive features about how the tax is put together,” Pomerleau said. The border adjustment solves many of the base erosion and profit-shifting problems Congress and Treasury have been trying to address, he said. But companies viewed the tax as something other than a VAT with a deduction for labor and therefore rejected it, he said.
Leiserson noted that although the tax is progressive, adopting one would be a regressive tax cut relative to the current system. “One of my concerns if the destination-based cash flow tax were to come back is how would you do it in a context where you’re ameliorating the regressivity?” he said. He noted that accompanying policies could help offset the regressive impact.
Leiserson said a smaller-scale destination-based cash flow tax could help address the exchange rate appreciation issue. He suggested that one way to experiment with the tax would be to integrate it with the payroll tax at a rate of 7.65 percent. Leiserson said part of the challenge for the tax was that it was a wholesale change in the tax code but that a smaller version would result in a comparatively smaller exchange rate movement and allow for a less disruptive transition. He explained in an October 19 blog post on how to address the weaknesses of the Big Six’s unified framework for tax reform that “the essence of such an approach would be to combine reducing statutory business tax rates with the creation of new surtaxes on businesses’ domestic cash flow.”
A Renaissance?
The destination-based cash flow tax may be off the table for this round of tax reforming, but it cannot be declared dead. “If it comes back, I think the most likely form is part of a VAT rather than a cash flow tax,” Pomerleau said, adding that the next political discussion of a border adjustment is more likely to come in the context of a VAT or a carbon tax, in which border adjustments are more familiar.
The challenge of implementing a subtraction method VAT is making it palatable to voters, especially those who may have been conditioned to view the term “VAT” as toxic. “The number one thing is to get people to realize that it’s not a European VAT; it’s a corporate sales tax with a border adjustment,” said Scott Lincicome of the Cato Institute. He pointed out that from the consumer’s standpoint, there is little difference between a corporate sales tax and a corporate income tax because both are passed on to consumers.
WTO Concerns
One of the bigger issues the destination-based cash flow tax confronted was the potential for it to be challenged by trading partners under the WTO rules. Two principal concerns about how the tax would be viewed under the WTO rules presented an obstacle obstacle to future versions of the tax. The first is whether the exemption from tax on exports is a prohibited export subsidy. The second is whether it would impose differential burdens on imports and domestically produced goods. The implications of having a prohibited export subsidy are significant, Lincicome said. “The most immediate commercial risk is not an adverse ruling at the WTO; [it is] having national countervailing duty cases against American exports,” he said. Those cases are resolved more quickly than WTO challenges and have no compliance phase like WTO challenges but have revenue implications that could result in higher prices and compliance costs, Lincicome explained.
Whether the rebates under the destination-based cash flow tax would be a prohibited export subsidy depends in large part on whether it is a direct or an indirect tax because WTO rules generally prohibit direct taxes from being refunded at the border, Lincicome explained. Indirect taxes, like sales taxes and VATs, can be refunded. Lincicome said that although it is not entirely clear whether the tax is an indirect tax, there is a reasonable argument that it is a type of subtraction method VAT and therefore a permissible indirect tax. But that is an open issue that any future iterations of the tax would have to address.
If a future destination-based cash flow tax survives the indirect tax hurdle, it could run into another problem by over-rebating export sales, Lincicome said. The same risk existed in the House blueprint, although because the exact structure of the deduction for wages and salaries wasn’t detailed, it’s impossible to determine whether the proposed tax would have had this problem, he said. “If they did a proportional deduction for wages and salaries, it might not result in an over-exemption of sales revenue on exportation — we just don’t know,” he said.
The import discrimination issue had a simpler solution but not one that was politically feasible. Eliminating the wages and salaries deduction in the destination-based cash flow tax and providing the relief through another mechanism like a payroll tax would have eliminated many of the discrimination concerns under the WTO rules, Lincicome said. But it would have turned the tax into a subtraction method VAT, which seemed likely to be politically ruinous. Lincicome said another possible fix would be to try to provide imported products a proportional exemption for salaries and wages, but that option would be administratively difficult.
The importance of 2017 for the destination-based cash flow tax is that the preliminary discussions about the concept moved it from academic idea to potential policy proposal. Reworking the tax to be more politically palatable will be a challenge given its history, but a revitalized version seems like a definite possibility. There are many options for tweaking and revising the blueprint’s plan that have yet to be fully explored by policymakers.