The combination of a Republican president and Republican-controlled Congress in 2017 has breathed new life into the possibility of US tax reform. The starting point for the legislative effort in the House is expected to be the House Republican Blueprint for Tax Reform (the Blueprint) released this past June, which includes a provision for border adjustments. The border adjustments would exclude US exports from the tax base while including imports. While this represents a major departure from the current corporate income tax, this provision would transform the consumption-based tax Blueprint plan to a destination-based tax on domestic consumption and significantly affect exporters, importers, consumers and trade. The following Q&A provides an overview of the proposal and related policy considerations.

Q. What are border adjustments?

A. Countries with value-added taxes (VATs) typically include border adjustments, which refund (or credit) taxes paid on business purchases used in the production of exports, and tax imports. Border adjustments are included in VATs to transform the tax into a destination-based system that taxes domestic consumption. Most developed countries and all major US trading partners have a VAT and include border adjustments as part of the VAT system. It is the international norm for VATs to be levied on a destination basis — goods and services are taxed where they are consumed — where border adjustments are simply the mechanism used to transform the tax base in this way.

Q. Why are border adjustments pertinent now?

A. Border adjustments are an important feature of the Blueprint. Some supporters of the Blueprint, which, if enacted, would shift the US income tax towards a consumption-based tax, view border adjustments as a way to improve US competitiveness and the US balance of trade.

For example, under current US tax law, a US exporter must pay an import tax on products sold in a foreign country where there are border adjustments (paid via the foreign country's VAT). A foreign exporter, in contrast, has no VAT liability; instead it receives a tax rebate under its border adjustment and pays no import tax to the United States.

While in the near-term, a country that adopts border adjustments could see a temporary increase in exports and decrease in imports (and a corresponding increase in revenue), the longer term effects of border adjustments are likely to be very different. Most economists think that the real price level would adjust to offset the effect that border adjustments might have on trade - with changes in currency values (e.g., exchange rates, repegging) the primary mechanisms for the adjustment.

Q. Which industries would pay more or less tax with border adjustments?

A. While the ultimate effect of the Blueprint's proposed border adjustments will be determined by their final structure, Figure 1 shows how select industries would fare under the proposal as currently outlined in the Blueprint.

Figure 1. Estimated change in tax liability from border adjustments under the Blueprint, by select industry

Billions of dollars | Taxes as a share of industry GDP

Source: US Census Bureau’s USA Trade; US Bureau of Economic Analysis; EY analysis.

Because border adjustments exempt exports from tax while subjecting imports to tax, industries with a relatively high ratio of imports to exports would expect to see the largest increase in tax liability. These industries may respond in the short term by increasing their export volume or purchasing more intermediate inputs from US businesses.

Economists have long held, however, that border adjustments would have little long-term effect on the balance of trade because of offsetting changes in real price levels occurring primarily through changes in exchange rates. Most economists suggest that, once international price levels fully adjust, businesses' real after-tax incomes would generally be unaffected by border adjustments.

Q. Do multilateral trade agreements place any restrictions on border adjustments?

A. There is significant uncertainty over whether the border adjustments as proposed in the Blueprint would be allowed under the multilateral trade rules negotiated as part of the General Agreement on Tariffs and Trade under the World Trade Organization (WTO). WTO rules allow for border adjustments under indirect taxes (e.g., VATs), but not for direct taxes, such as income taxes. The border adjustments as proposed in the Blueprint would, in effect, be administered as an income tax, making their viability under WTO rules questionable. The case for the Blueprint's border adjustments being permitted is that they move the US income tax system considerably towards being a consumption tax (vs a direct tax).

Q. What steps can businesses take now?

A. As Congress begins to address tax reform, border adjustments and their revenue implications will likely be an important part of the discussion. Businesses can get a head start by looking closely at the border adjustments provision included in the Blueprint and modeling its effects on their company, industry and markets. In addition, monitoring the course of the discussions in Washington DC will allow businesses to prepare for the possibility of change and to educate policymakers about the potential effects of the Blueprint and other tax plans as the debate evolves.

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