A Primer on Border-Adjusted Taxes

In June 2016, House Republicans introduced the outline of a tax reform proposal (a.k.a. the blueprint).  The blueprint includes significant changes to how business income would be taxed. In particular, corporate taxation would move toward a cash-flow tax (CFT).

In their most basic form, CFTs tax income based on where the income ultimately flows.  In contrast, income tax liability currently depends on where a company is headquartered, where it generates income, and a multitude of other factors.  A country may decide to directly address international transactions by “border adjusting” the tax.  In these cases, tax liability is either based on where a product is consumed or where it is produced.  These are known as destination-based and origin-based CFTs, respectively.

The House GOP plan calls for a destination-based CFT that would base a firm’s income tax liability on where its products or services are sold.  This system would tax imported goods and exempt exports.  Ways and Means Chairman Kevin Brady succinctly explained the basic function of this border-adjusted tax (BAT) in a recent address to the U.S. Chamber of Commerce:

“At the end of the year businesses will add up export sales and disregard them—they aren’t taxable. And at the same time you’ll add up import costs and disregard them—they aren’t counted as deductible expenses.”

Arguments in Favor

House Speaker Paul Ryan and House Ways and Means Chairman Brady reason that the border adjustment provision puts an end to what they call the “Made in America” tax.  They claim that America’s exports are at a tax disadvantage because foreign competitors adjust their value-added taxes—which the U.S. does not impose—at the border.

Arguments in favor of the BAT include:

  • Exchange rates will adjust to fully account for the tax, in which case neither the purchase prices of imports nor the sales prices of exported goods would change in real terms.
  • It would boost exports and decrease the trade deficit.
  • A BAT provides revenue ($1.2 trillion over 10 years) needed to lower income tax rates.

Arguments Against

Two properties of the proposed BAT have drawn the most criticism from opponents.  Import-reliant firms take issue with the facts that:

  • Companies would not be able to deduct the cost of imports when calculating taxable income, and
  • Income attributable to exports would be exempt from income tax via a rebate.

Other publicized concerns of critics include:

  • Economy-wide prices would increase.
  • The tax design may breach World Trade Organization rules.

Potential Impacts on the Housing Sector

A quick glance at the value of building materials imported each year is indicative of the possible effects that a border adjusted tax could have on the housing industry.  Wholesalers, retailers, and distributors imported $32 billion worth of building materials in 2016.

American building materials producers have historically lacked the capacity to meet the growing demand of home builders during periods of sustained, cyclical growth.  Imports have increased every year by an average of 12.6% since 2009.  During the same period, the average annual increase in housing starts was 9.8%.  The same relationship held during 2001-2005, evidenced by the graph below.

The prices of finished goods, particularly electrical appliances and components, are as important to home builders as raw materials.  Nearly $11 billion worth of electrical equipment and household appliances imports were used in residential construction in 2015.  That equates to roughly $10,000 per single- and multi-family housing start, on average.  A 10% increase in the real cost of those imports would result in a home price increase equal to $1,000.

Conclusion

The GOP blueprint is a novel approach to reshaping the tax code as we know it.  The plan includes several provisions that positively affect both housing demand (through increased disposable income) as well as supply (resulting from lower business income tax rates).  As tax reform legislation continues to evolve, builders have incentive to pay close attention to the fate of border adjustability.  While it is theoretically possible for exchange rates to fully offset the tax, should they not, costs will rise for any producer that requires imported goods to complete production.



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