By Stanley H. Hartt, June 26, 2017
Canadians should be very concerned about a scheme emerging from the politics of “Make America Great Again” called the Border Adjustment Tax. What is being described as a Value Added Tax on consumption will in fact be an assault on the established order of trade and taxation.
To understand why, it’s useful to remember how Canada came to adopt our Value Added Tax, the GST (now harmonized with the sales tax regimes of most provinces and known as the HST) in the first place.
What is being described as a Value Added Tax on consumption will in fact be an assault on the established order of trade and taxation.
Prior to the GST/HST, we had a massively outdated form of federal sales tax known as the Manufacturers’ Sales Tax (MST), which was designed in an era when the supply chain was much simpler. Canada adopted the GST when we entered into the Canada-US Free Trade Agreement because, like all consumption taxes in the Value Added Tax model, it is impossible to hide subsidies or disguise tariffs in it. To understand what a Border Adjustment Tax, proposed by some Republicans, means for Canada, the starting point is to realize that the Border Adjustment Tax is not a consumption tax at all but rather a rejiggered income tax scheme which is designed to accomplish precisely the opposite, namely to build subsidies for exports and tariffs against imports into the US system of corporate business taxation.
In Canada, under the MST, a raw materials supplier sold his product to a manufacturer who produced goods that were then sold to wholesalers or distributors. If a manufacturer needed to purchase something from another manufacturer, because such inputs were tax exempt, he was given a licence to “quote” to his supplier which exempted him from the MST. Everyone else paid the applicable rate of tax which, at its demise, had risen to 13 percent.
The only problem was that as the economy became more complex, the structure began to produce anomalous results: manufacturers began buying things elsewhere than solely from other manufacturers or suppliers of raw materials. If a manufacturer acquired a computer at an office supply store or online, the tax that he never intended to pay became inextricably hidden in his inputs with no mechanism to remove it.
On the other hand, imports were being subsidized because the MST was assessed at the border, before significant costs for transportation, warehousing, marketing and distribution had been incurred, creating an advantage over Canadian-produced manufactured goods.
So Canada looked at what the European Union had done at the origins of its customs union and internal free trade zone: the elegantly simple solution was to require that every member state structure its consumption taxation in the VAT model, at a rate of no less than 15 percent. Free trade was facilitated by the principle that the exporting country’s VAT came off at the border and the importing country’s VAT was imposed when the article (or service) was sold within the borders of the importing state.
A Value Added Tax (VAT) is designed to tax consumption of goods and services while permitting producers and suppliers to claim credits for taxes paid on their inputs, thus passing the effective tax burden on to their customers, and, ultimately, the final consumer. In the world of sales taxes, it has the distinct advantage of avoiding complex mechanisms to relieve businesses of unintended taxation of their inputs while targeting the act of consumption as the source of the intended revenue. As long as the rate of taxation is appropriately fixed and the VAT operates in conjunction with an income tax regime which is used to raise the bulk of the government’s budgetary resources, it can even be structured to be progressive in its application as between lower and higher income earners.
A VAT is different from a traditional sales tax because it is not imposed on a particular class of goods or services and operates best when there are no, or very few, exceptions to or exemptions from its application. In short, it enables the legislator to ensure that the tax burden is borne precisely where it was intended to be borne with no unintended consequences.
The United States of America does not have a VAT system for consumption taxation. US sales taxes are a hodgepodge of national sales taxes on particular goods and services, while all but five states operate general sales taxes at differing rates and, in some cases, permit municipalities and counties to add on their own sales taxes.
This is important when analyzing the rationale being offered by American commentators in defence of the so-called Border Adjustment Tax. Several notables on the Republican side of the Senate and House of Representatives appear to be angered by what they see as a significant disadvantage for the US in its various trade agreements. They are advocating what appear to be isolationist and protectionist, beggar thy neighbour, policy stances. And they have argued for a taxation system that penalizes imports and rewards exports to improve the balance of trade position of their country.
Originally developed by academics, notably Alan J. Auerbach at the University of California, Berkeley, and included in the policy paper prepared by the leadership of Republican Party in 2016 titled “A Better Way – Our Vision for a Confident America”, the “destination-based cash flow tax” (DBCFT) is a form of Border Adjustment Tax that would change how profits are calculated. Firms would no longer be able to deduct imports as costs while exports would no longer be included in the calculation of revenues. Imported goods purchased and consumed domestically would be subject to the tax while goods produced domestically and sold internationally would be exempt.
The proponents of this system plan to couple it with a reduction in the rate of taxation applicable to corporate profits from 35 percent to 20 percent. This feature will be important when we come to analyze the legality of the proposal under international trade law and its impact on businesses and consumers.
But it is important to note that, while the DBCFT is said to be modeled after the pure VAT systems operated currently by all OECD countries and some 160 other nations, it is in fact no such thing. Apart from the feature of taxes coming on at the border for imports and off for exports, it would be misleading in the extreme to compare the DBCFT to a traditional VAT. It does not propose to emulate the cascading of taxes imposed, billed and collected on and by businesses, matched by credits claimed for taxes paid on inputs until the good or service reaches the ultimate consumer.
Most importantly, there is no relationship between how imported goods and services would be taxed compared with goods and services produced and consumed domestically. Under the EU VAT tax system, the removal of an exporting country’s consumption tax at the border is a simple matter of parity – the good or service arrives in the importing country free of tax from the exporting country so that the importing country’s own rate of tax on goods and services of the same description can be imposed instead, thus creating a level playing field for competitors regardless of where the goods or services were produced.
The effects of the DBCFT look more like a combination of an import tariff with an export subsidy, both of which elements would violate the international trading arrangements binding on the US. Moreover, it is not only protectionist but also discriminatory – not all classes of goods and services would be treated the same way: industries with multinational markets for proprietary products would be massively subsidized while industries that rely on imported inputs would be hurt, perhaps irreparably, by this structure.
The proponents unabashedly defend the DBCFT by arguing that these discriminatory impacts are intentional, that the US has for too long been willing to sign and live with trade agreements that condemn it to procuring needed goods and services from abroad instead of encouraging their production at home. This ignores the very purpose of free trade arrangements which is to increase the standards of living of the populations of all trading partners through the operation of the theory of comparative advantage, namely to allow production to take place where any particular article of commerce can be produced more efficiently and to trade for what the other economies can produce at less cost.
It is hard to believe that the US considers itself to be comparatively disadvantaged when it is the locale of most breakthrough and innovative technologies. Being self-sufficient does not produce more economic welfare for anyone, even a fortress America hiding behind bad analogies with how the rest of the developed international community deals with commodity taxation issues.
Some of the vehemence behind the DBCFT proposals arose from the spate of “tax inversion” transactions where American companies merged with foreign entities as a way to relocate their headquarters to foreign jurisdictions, beyond the reach of the US taxman. It may be a legitimate goal to find ways to moderate the number and size of those transactions, but violating international trade law is not a way to tackle that problem.
Perhaps most vexing is the argument used by Auerbach and others to defend against the distortions the DBCFT would cause in international trade. They argue that the border adjustment tax of 20 percent applied to imports, and the removal of exports from the corporate tax base, would cause the US dollar exchange rate with all trading partners to appreciate by some 25 percent. The stronger dollar would keep domestic consumer costs lower in spite of the 20 percent corporate income tax being applied to imported goods consumed domestically, effectively cancelling out the higher tax on imports and making the border-adjustment tax value-neutral.
While there is no doubt that the dollar would strengthen as a result of this tariff cum subsidy regime, there can be no guarantee that the forces at play would drive the currency to this new equilibrium either swiftly or ever. Trade and investment forces are not the only factors which influence the exchange rate. Any failure of the predicted increase to materialize in the short term could materially hurt low income households disproportionately by raising the cost of the things they buy.
Most importantly, it is astonishing how little reaction the DBCFT proposals have generated among business leaders in the US’s largest trading partners, in order to condemn this contortion of how a VAT operates into a justification for a “Buy America” infringement of the basic principles of established international trade law.
Think tanks and observers have indeed taken issue with the self-serving structures endorsed by the adherents of the DBCFT, but many business leaders have been noteworthy not only for their silence in railing against such an initiative but in adjusting their business plans to take account of the possibility that it might actually happen. In this era, where foreign political leaders appear to be playing toady to the bullying tactics of President Trump, lest they offend the new international Sherriff in town, it is time that someone stood up and called this Border Adjustment Tax out for what it is.
Hopefully, Canada will be wise and strong enough to do so in the context of the recently announced renegotiation of NAFTA which the US, Mexico and Canada have undertaken.
Stanley Herbert Hartt, OC, QC is a lawyer, lecturer, businessman, and civil servant. He currently serves as counsel at Norton Rose Fulbright Canada. He has also served as chairman, president and CEO of Campeau Corporation, deputy minister at the Department of Finance and, in the late 1980s, as chief of staff in the Office of the Prime Minister.