By Richard Rubin 

House Republicans are proposing a border adjustment as part of a major rewrite of the U.S. business tax system, and President Donald Trump is considering it as a way of saying Mexico is paying for a border wall. Here's an explanation of what's going on:

What is a border adjustment?

It is a way of making sure a tax applies only to domestic consumption of goods and services.

How does it work?

Think of it as a tax getting added at the border to imports and subtracted from exports. Target Corp.'s cost of buying toys from China wouldn't be deductible from U.S. taxes. Exports -- think of an American apple farm's shipments to Canada -- wouldn't count as income for U.S. tax purposes.

What is the tax rate?

The Republican plan would add the border adjustment to the U.S. corporate income tax, which is expected to drop to 20% from 35%. So the tax on imports for corporations would be 20%.

What is the point?

The adjustment is expected to raise roughly $1 trillion over a decade, and could offset the cost of cutting corporate-tax rates. The U.S. imports more than it exports leading to a trade deficit. If you tax imports and exempt exports, you're raising money by effectively taxing the trade deficit.

Are there other reasons?

Because taxes would be based on where goods and services are consumed, border adjustment removes the incentive to book profits outside the U.S. or to put a country's legal address outside the U.S. for tax purposes. That could remove significant complexity from the tax system.

Does any other country do this?

Yes and no. Corporate income taxes aren't border-adjusted. But value-added taxes, which are a tax on consumption, follow that principle. Every country with a VAT uses border adjustment because it is the way that those taxes hit only domestic consumption. The U.S. is the only major nation without a VAT.

Is this a tariff?

No. A tariff is a tax that applies to imports only. A border adjustment attempts to make sure an existing tax -- in this case the U.S. corporate income tax -- applies to imports, too. And the symmetrical exemption for exports makes it a border adjustment, not a tariff.

If the U.S. is taxing imports, won't prices go up?

That is the worry that large retailers, oil refiners and some conservative groups have, and that is why they are fighting this idea. But economists say if the U.S. implements border adjustment, the dollar will rise in value by as much as 25%, making imports cheaper and offsetting the tax change.

How certain is this currency movement?

Economists and proponents of the plan say it is likely to happen based on experience with VATs around the world. Opponents don't believe it at all and argue that some countries would manage their currencies to prevent the dollar from rising fully. Some studies of VAT changes have found no impact on trade balances, consistent with the idea that the dollar will adjust. But no country has quite tried what the U.S. is considering.

What's this about using the tax to pay for a wall on the border with Mexico?

Border adjustment operates like a tax on the trade deficit. The U.S. runs a $50 billion trade deficit with Mexico annually. Tax that at 20% and you have plenty to pay for the wall without leaving much of a dent in the tax plan.

But are Mexicans paying that?

The Mexican government isn't. The tax would be embedded in imports from all countries, and would be borne by workers and shareholders similar to current corporate tax. If the dollar doesn't rise to offset that change and make imports cheaper, American consumers probably would pay.

Who else loses under the proposal?

Americans who own foreign assets get hurt by the rise in the dollar. A pension fund with assets denominated in euros would suddenly find it much more expensive to convert that money into dollars to pay its U.S. liabilities. Economists estimate that this one-time wealth loss is more than $2 trillion. And that is if the plan works as intended. It's also important to remember that this is just one piece of a larger tax plan that would lower rates and make other major changes that would also scramble the existing tax burden.

What are the big open questions?

House lawmakers haven't released the bill and there are tons of tricky technical questions they have to resolve. Among them are how to treat financial services companies that have lots of cross-border transactions that aren't really like imports.

Any other problems?

Other countries may not like this plan. They could see it as a repeal of the U.S. corporate-income tax and a way for companies to put their profits here and avoid foreign taxes. They could also see it as a U.S. export subsidy. They could file challenges at the World Trade Organization and the U.S. could face penalties if it loses.

Write to Richard Rubin at richard.rubin@wsj.com

 

(END) Dow Jones Newswires

January 29, 2017 16:14 ET (21:14 GMT)

Copyright (c) 2017 Dow Jones & Company, Inc.
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