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Steve Bannon is the White House's biggest fan of Paul Ryan's tax ideas

Leading Conservatives Gather For Annual CPAC Event In National Harbor, Maryland Alex Wong/Getty Images

White House chief strategist Steve Bannon famously told his former staffers at Breitbart that "destroying Paul Ryan's political career" was a central part of the site's mission. But now he and Ryan appear to have come to a truce on a rather unexpected issue: border taxation. Bloomberg's Anna Edgerton and Jennifer Jacobs report that Bannon has been won over by Ryan's plan to radically change how the US taxes corporations, by adding a border adjustment and converting the corporate income tax to a destination-based cash flow tax.

The plan is supported by Bannon, policy adviser Stephen Miller, Chief of Staff Reince Priebus, Commerce Secretary Wilbur Ross, and National Trade Council Chair Peter Navarro, while National Economic Council Director Gary Cohn and Treasury Secretary Steve Mnuchin remain skeptical. “The argument that the border tax could boost goods stamped ‘Made in America’ resonates with Bannon, according to the person familiar with the meetings,” Edgerton and Jacobs report.

A border adjustment is a major change, one that its proponents argue would make tax evasion substantially harder and make the corporate tax more favorable to investment. While most economists advocating for it don’t think the change would favor US exports over imports and thus boost American manufacturing, a lot of its on-the-ground political advocates, like Bannon and exporting companies such as Boeing and GE, do believe that, and the belief accounts for a lot of the idea’s success so far.

But it also faces fierce opposition from retailers and importers such as Walmart and Nike, which fear that the border adjustment will cut into their bottom line and render their business models untenable. That means the plan faces an uphill battle in Congress, even with a White House heavy hitter like Bannon arguing for it.

Why Congress is interested in border adjustment

Apple Holds Event To Announce New Products
A sign for Apple headquarters at 1 Infinite Loop, Cupertino, California. Apple is a big innovator in tax evasion.
Stephen Lam/Getty Images

Right now, the US taxes companies on their profits, both those earned in the US and those earned abroad that are brought back into America. But because foreign profits aren’t taxed until they’re brought back to the US, companies have a big incentive to make US profits look like foreign profits to avoid taxes.

For example, suppose that a car company — let’s just call it, uh, General Motors — makes $1 billion in profit manufacturing cars in the US and selling them domestically and exporting them to subsidiaries abroad. That would normally subject it to about $350 million in taxes, since the US has a 35 percent corporate tax rate. But GM could instead have its foreign subsidiaries pay $1 billion less for the cars they buy from the US branch of the company. That wipes out GM’s US profits, leaving it with no US tax liability and shifting the profits to the subsidiaries abroad. If those subsidiaries are in countries with a low or nonexistent corporate income tax, that could wind up being a very good deal.

Same goes for companies that import goods. Imagine a company — call it Chiquita Banana — that has subsidiaries in Latin American countries, buys up bananas from banana farmers, and then sells them to the US branch for resale. Suppose it, too, makes a $1 billion profit doing this. It could then just have its Latin American subsidiaries charge $1 billion more for the bananas, leaving the US branch with no profits and shifting them to Latin America.

These are very, very simplified examples; most corporate tax evasion schemes are vastly more complicated. But in broad strokes, this is how most of it works: You manipulate transactions between US and non-US branches of the company so that the money winds up abroad.

A destination-based tax makes all of this impossible. It makes two big changes:

  • Imports would no longer be deductible as a cost when calculating profits and taxes, the way company expenses usually are.
  • Exports would no longer be counted as revenue when calculating profits and taxes; only domestic sales would count.

This makes most tax evasion schemes pointless. Want to evade taxes by undercharging subsidiaries abroad for your cars? Too bad: All exports are excluded, so it doesn’t matter for the tax how much you charge foreign subsidiaries. Want to evade taxes by overpaying subsidiaries abroad for bananas you’re importing? Too bad: You can’t deduct the cost of imports, so making them cost more doesn’t do anything.

Indeed, while Republicans in Congress are the main champions of border adjustment today, some Democratic-leaning tax experts have expressed enthusiasm for it in the past, in large part due to its potential to prevent tax evasion. Alan Auerbach, an economist at UC Berkeley, worked out a detailed proposal for a border-adjusted corporate tax back in 2010 in a paper for the Center for American Progress and the Hamilton Project, two institutions with links to the Obama administration and the Democratic Party establishment more broadly.

On top of all of that, when the US is running a trade deficit, the new tax on imports raises a lot of money. The Tax Policy Center estimated that the border adjustment in the House Republican tax plan devised by Ryan and Texas Rep. Kevin Brady would raise nearly $1.2 trillion over a decade. That greatly helps in paying for the sweeping rate cuts most Republicans want, but in theory it could help pay for Republican priorities too — or for a border wall, as Trump now appears to want.

Oh, and one more thing for Wall Street–skeptical readers: This isn’t part of the border adjustment issue, but the GOP tax plan would also equalize the tax treatment of debt and equity. Currently, it's way more profitable for companies to borrow money than to raise it through investors, which has spurred the creation of the private equity industry and encouraged banks to borrow many times more money than they have. High bank leverage is one of the factors that led to the 2008 financial crisis, and a destination-based cash flow tax would encourage banks to borrow less and so help prevent a repeat of that catastrophe.

Why border adjustment isn’t a tariff

Exchange rates at a London Bureau de Change
Exchange rates would rapidly adjust to counteract any effect of border adjustment on trade.
Bruno Vincent/Getty Images

“That’s all well and good,” you might be thinking. “But this looks like it’s still a tariff! It’s taxing imports that didn’t used to be taxed! Worse than that, it’s subsidizing exports, too, by not taxing those! How is this not going to drive up the price of avocados?”

It’s a fair question, and the fact that border adjustment looks like a tariff is a major reason Republicans in Congress like Ryan and Brady are embracing it. They wanted a way to tap into the anti-trade message of the Trump campaign, which appears to have resonated with voters in deindustrialized Upper Midwest states that blame free trade for eliminating good manufacturing jobs. Border adjustment offers them something that looks like a Trump-friendly tariff, but free market Republicans feel comfortable embracing it because most economists don’t think, at the end of the day, that it will boost exports and discourage imports at all. That appears to have played a role in getting Steve Bannon, an avowed “economic nationalist,” to support the idea.

The reason is that the dollar and most other currencies are floating: Their value fluctuates with the market. And most economists think currency markets would adjust relatively rapidly in response to a border adjustment tax being enacted.

The new tax on imports would reduce demand for imports from US consumers. When they buy imports, consumers provide foreigners with dollars; doing less of that means fewer dollars being exchanged, and a lower supply of dollars means the value of the dollar, relative to other currencies, will increase.

The tax change also subsidizes exporters. That means US exporters will be able to drop their prices to better compete internationally, increasing demand for exports. That means foreigners buying US exports will need more dollars, which increases demand for dollars and increases the value of the dollar still further.

According to textbook economic theory, this increase in the value of the dollar should totally offset the effects of the import tax and export subsidies. A stronger dollar makes it more expensive for foreigners to buy US goods (since they’re sold in dollars, which now cost more) and less expensive for Americans to buy foreign goods (since they’re sold in other currencies, which now cost less). The former effect offsets the export subsidy by making US exports costlier, and the latter offsets the import tax by making imports to the US cheaper.

Of course, the real world is more complicated than the simplest textbook model, and the currency adjustment process might not always be smooth. But even a more nuanced analysis reaches similar conclusions. “Under more realistic assumptions, a border adjustment could have some economic effects, but those effects would still not include a permanent increase in exports or a permanent reduction in imports,” AEI’s Alan Viard, an economist focused on tax issues, wrote in 2009.

This is why the World Trade Organization allows value-added taxes (or VATs, the form of sales tax used in Japan, Canada, Australia, and every European Union nation) to border-adjust in exactly this way; the WTO believes the adjustment doesn’t give them any trade advantage. Indeed, the destination-based cash flow tax proposed by House Republicans is nearly identical to a VAT, both because of the border adjustment and because it lets companies deduct all their capital investments (stuff like buying machines and factories) immediately rather than over the course of several years.

VATs, being sales taxes, are meant to tax domestic spending, so they’re calculated by taking the money that companies have coming in from domestic sources (that is, excluding money earned from exports) and subtracting the money they pay out to domestic suppliers. Companies can’t deduct imports, because the foreign companies they’re importing from haven’t paid domestic VAT, but the domestic suppliers they buy from have. That means that in the end, imported and non-imported goods are taxed exactly the same.

A destination-based cash flow tax is a VAT with one crucial difference: Companies can deduct wages and other compensation to employees, whereas under a VAT they can’t. Taxing wages is the thing that makes VATs regressive, hitting poor consumers the hardest; not taxing them means that a border-adjusted cash flow tax is actually more progressive than the current corporate tax, which is already one of the most progressive taxes the US has. Of course, cutting the corporate tax would make the overall tax code more regressive, but that’s not due to border adjustment.

There are good reasons to worry about a border adjustment tax

World Trade Organization leader Roberto Azevedo in Geneva
WTO Director-General Roberto Azevêdo.
Fabrice Coffrini/AFP/Getty Images

So the corporate tax reform Paul Ryan and Kevin Brady are considering — and that Bannon is embracing — would make it harder for corporations to evade taxes, would raise a ton of revenue, and would, all else being equal, make the corporate tax modestly more progressive. What’s not to like?

Well, a number of things. First, it’s an open question whether border adjustment would be allowed at the World Trade Organization, or whether it’d be ruled discriminatory. It’s allowed with VATs, sure, but normally not with corporate taxes. This is somewhat arbitrary. A destination-based cash flow tax is basically a border-adjusted VAT (which the WTO is fine with) combined with a wage subsidy (which the WTO is also fine with). But when you put the two together, it becomes sort of sketchy.

That’s why some analysts, like the Peterson Institute’s Caroline Freund, prefer the approach of literally adopting a VAT but simultaneously abolishing payroll taxes for Social Security and Medicare. That would have a very similar impact (it’d be more progressive, in fact, since a VAT would hit wages above $127,200 but Social Security taxes don’t) but be on much more solid legal ground.

Border adjustment could also have some major consequences on markets abroad. AEI’s Stan Veuger notes that by making the dollar more valuable and making every other currency less valuable, the change would create a ton of wealth for foreigners with assets valued in dollars in the United States, and destroy a ton of wealth for Americans with assets abroad denominated in other currencies. A decent estimate is that about $2.5 trillion in American wealth overseas would be wiped out, on net. That includes foreign stocks owned by pension funds that teachers and policemen and other workers rely on for retirement, as well as, say, golf courses in Scotland owned by former reality TV show hosts turned politicians.

Veuger has pointed out a few other big losers from the plan. One would be US companies that rely on business from foreigners but aren’t “exporters” in a traditional sense. Hotels and real estate companies rely heavily on business from foreigners coming to the US, and a stronger dollar would make their products more expensive for non-US customers. While traditional exporters like, say, Boeing, would get tax-free exports to offset the stronger dollar, revenue earned from a foreigner staying in a US hotel room wouldn’t be tax-free. So hotels and real estate companies that sell houses to foreigners could find themselves worse off in absolute terms.

This same type of problem would affect all exporters as the new tax is phased in, Veuger notes. Currency markets would probably react to the mere passage of a law like this by making the dollar stronger. That would hurt exporters before they have tax-free exports to offset the shift. Finally, Veuger notes that a lot of middle and low-income countries could be hurt by a stronger dollar, as companies in those countries tend to borrow heavily in dollars. A more expensive dollar effectively means those countries' debts would become harder to pay off, potentially hurting growth in countries that need it most.

All these concerns have to do with the “destination-based” part of “destination-based cash flow tax.” But the “cash flow” part is important too. That means that rather than “depreciating” investments — that is, deducting the cost of big purchases of equipment or machinery over the period of years that it’s used for — companies can deduct investments from their tax bill immediately. Proponents think this would encourage investment, but NYU tax law professor Lily Batchelder has argued that it would in fact do the opposite, because of how businesses in practice adjust to tax changes.

The tax reform plan being considered by Congress also involves huge rate cuts, which would swamp any progressivity benefit of the new tax design and mainly benefit the rich. That’s not a necessary feature of any destination-based cash flow tax, but it’s a feature of the one Congress is actually weighing.