US Tax Reform, Border Adjustment Taxes, and International Trade Law

The border adjustment raises concerns about protectionism and the consistency of U.S. tax reform with international trade agreements.
April 26, 2017 • Commentary
This article appeared in Cayman Financial Review on April 26, 2017.

With the Republicans now in control of the U.S. Congress and the White House, tax reform is high on the agenda. One of the proposals being discussed is a shift away from a traditional corporate income tax, towards what has been called a Destination Based Cash Flow Tax (DBCFT). In essence, this plan attempts to collect tax in a way that focuses on the location of the business sales. To achieve this, the measure involves a “border adjustment,” through which exports are exempt from the tax, while imports are subject to it. In this way, the tax applies to “cash flow” in the United States.

The border adjustment raises concerns about protectionism and the consistency of U.S. tax reform with international trade agreements. Exempting export income from tax could be deemed an illegal export subsidy; imposing a border tax on imports could violate rules that limit import taxes and require that internal taxes be nondiscriminatory. However, there is a long and complex legal and diplomatic history that needs to be taken into account when evaluating the proposed measures under international trade rules, and in the end politics may be as important to this discussion as the law.

Basics of a border adjustment tax

The idea behind border adjustments is that, in some instances, imports need to be taxed to create equivalence with how domestic products are being taxed. To understand the issue, consider three common types of taxes: sales taxes, income taxes, and value added taxes (VAT). As explained below, no adjustment is used for the first two, but an adjustment is usually applied for the last one.

A sales tax is imposed on a product at the point of final sale to a consumer. The national origin of the product is irrelevant in this regard, as taxes are applied regardless of whether the product was made domestically or abroad. Thus, no adjustment is needed. It would not make sense to exempt imports from this tax, as it would be burdensome to do so and would give imports a price advantage over domestic products.

Income taxes are generally calculated based on the profits (revenues minus costs) of a company. Tax rates vary by country, but so do government services. As a result, the cost and benefits of taxes are roughly the same for companies across countries, so there is no obvious reason to make an adjustment at the border.

The situation of the VAT is more complicated. With a standard “credit invoice” VAT, this tax is collected from companies at each stage of the production and distribution process. It is passed on to consumers in the final sales price, but it is not collected directly from them, as with a sales tax. A problem therefore arises because the VAT cannot be collected on imports at the point of sale. The solution has been to impose a tax on imports at the border, so as to collect an amount equivalent to that collected on domestic products, thereby ensuring that domestic and foreign products are treated the same. In this way, the VAT functions somewhat like a sales tax.

While sales taxes are often fairly low, some VAT rates are as high as 20–25 percent. It is the combination of the high VAT rate and the border adjustment for imports that created a concern about these taxes in the trade arena, and discussion of these issues has a long history in the GATT/WTO.

Border adjustment tax discussions at the GATT/WTO

To fully grasp the trade policy implications of a border adjustment tax, it is important to understand exactly how and why trade obligations apply to tax measures. In order to prevent domestic laws from being used as a means of disguised protectionism, international trade obligations impose constraints on the use of both domestic taxes and regulations. Broadly speaking, such measures may not be used to favor domestic producers over their foreign competitors.

With regard to tax measures, there are three core trade obligations that are relevant for the issue of border adjustments: (1) Border taxes are generally prohibited, unless specifically allowed in the Schedules of Concessions that governments sign (GATT Article II); (2) internal taxes must be nondiscriminatory (GATT Article III); and (3) tax exemptions for exports are prohibited (GATT Article XVI and Subsidies Agreement). As we will see later, the border adjustment tax imposed on imports could be a problem under the first two, while the tax exemption for exports could be a problem on the third one.

Also of relevance to this discussion is that trade rules draw a distinction between direct and indirect taxes. Direct taxes are imposed on income and property, whereas indirect taxes are defined as “sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and import charges.” Thus, as currently drafted, WTO obligations classify sales taxes and value added taxes together as “indirect taxes.” As we will see, this grouping has implications for which kinds of taxes may be adjusted through a border tax.

Discussions of the legality of border adjustment taxes at the GATT be traced back as far as 1955, when Germany proposed an interpretation that would allow its “turnover” tax (in which a charge is imposed at each stage of production) to be considered a product tax. As a product tax, the argument went, a corresponding border adjustment tax could be imposed. No conclusion was reached at this time, but in the ensuing years, as additional countries adopted similar measures, in the form of a VAT, the GATT debate heated up. By the late 1960s, it had become one of the most contentious trade issues, and a special working party was established to examine it.

On one side of the Working Party discussion was the United States. In the U.S. view, because border adjustment taxes were only being applied to product taxes, there was a fundamental imbalance between countries that collect most tax revenue from income taxes and those which were relying heavily on product taxes. The use of border adjustments by countries with a VAT meant that U.S. companies paid their own income taxes but were also affected by foreign country border adjustment taxes. By contrast, a company from a VAT country paid its domestic taxes, but was exempt from these taxes on exports and also did not pay foreign income taxes.

On the other side were many countries using a VAT and a corresponding border adjustment. In their view, the value added tax with border adjustment was a simple non‐​discriminatory application of a product tax, no different than a sales tax.

In a report issued in 1970, the GATT working party noted the views of both sides and offered a brief analysis which seemed to endorse these border adjustment taxes in the context of a VAT. However, it was not a formal ruling by a neutral third party arbitrator of the kind that today’s trade adjudication would provide. As a result, there remains some legal uncertainty on these issues, and it is not entirely clear how a challenge to border adjustments related to a VAT would be treated if a WTO complaint were brought today.

Over the years, the United States continued to look for political solutions to this issue, but never had any success.


Into this long‐​standing debate comes the DBCFT, with a border adjustment tax of its own. First developed by some economists in the early 2000s, the DBCFT has gained traction in recent years, and in 2016 leading Congressional Republicans began supporting it. In the context of the general economic nationalism of Donald Trump, along with the specific concerns still being expressed about border adjustment taxes imposed by other countries related to their VATs, there is a possibility that the United States may begin imposing a border adjustment tax of its own.

The key features of the specific DBCFT currently under consideration are: a lower tax rate; full write‐​off of capital investments; no tax on profits earned abroad; no deduction of interest; and a border adjustment. Through the border adjustment, the DBCFT is said to be “destination‐​based,” in the sense that “the tax is levied based on where the good ends up (destination), rather than where it was produced (origin).” Specifically, as the Tax Foundation has explained, “if a business purchases $100 million in goods from a supplier overseas, the cost of those goods would not be deductible against the corporate income tax,” while “if a business sells a good to a foreign person, the revenues attributed to that sale would not be added to taxable income.”

As currently envisioned, however, the DBCFT will almost certainly violate WTO obligations, due to its deduction for wages. If these deductions are included, the measure would not treat imported and domestic products the same, as the deductions would apply to domestic products but not to imported ones.

The more interesting question is whether a revised version of the measure that removes this deduction would be consistent with WTO obligations. Note that if the measure were to be found in violation in its current form, the United States would have a chance to revise it before any retaliatory measures were authorized.

Normally, a border tax would only be permitted if a government negotiates for it, and specifically identifies it in its WTO Schedule. A border adjustment tax that is not mentioned in the Schedule would violate Article II of the GATT. However, there is an exception for border taxes that are “equivalent” to an internal product tax. For these taxes, the applicable provision is Article III, which requires that the taxes on imports and the taxes on corresponding domestic products be equal. Thus, if the border adjustment tax imposed in conjunction with the DBCFT is equal to the tax imposed on domestic companies, there is an argument that the measure does not violate WTO obligations.

On the export side, the situation is more challenging for the DBCFT. Normally, a tax break for export sales would be considered an export subsidy. However, there is an explicit carveout in GATT/WTO rules for “[t]he exemption of an exported product from … taxes borne by the like product when destined for domestic consumption, or the remission of such duties or taxes in amounts not in excess of those which have accrued.” Such exemptions “shall not be deemed to be a subsidy.” This provision clearly applies to typical value added taxes, which are taxes on products “destined for domestic consumption.” But it is less clear whether it applies to the DBCFT, which is not a tax on products in the same way.

On both the import and export sides, a key issue will be whether the DBCFT and related border adjustment are close enough to an “indirect” product tax to be treated like a VAT. The standard VAT used by most countries involves a “credit invoice” approach that is similar in nature to a sales tax on products. At each stage of production and distribution, a tax is collected on the sale of the product, which is reflected in the final sales prices. However, there is also a “subtraction method” approach that is less closely tied to products. With this kind of VAT, the tax base “is computed as the difference between the business’s taxable sales and its purchases of taxable goods and services.” WTO rules do not specify one or the other, simply referring to “value added taxes” as an example of an indirect tax. Arguably, then, either such method falls within the category of an “indirect” tax on products, and therefore a border adjustment tax is permitted for both. If the DBCFT can be framed as similar to a subtraction method VAT, as it sometimes has been, then perhaps a border adjustment would be permitted here as well.

However, the nuances of WTO obligations are unlikely to provide much of a check on whether the DBCFT is adopted. The House Republicans have said they believe the DBCFT border adjustment tax is consistent with WTO obligations. It is not clear if they mean the DBCFT as currently envisioned, or if they anticipate revising the DBCFT after an initial adverse ruling. Regardless, their confidence is probably misplaced, as the consistency of the DBCFT with WTO rules is, at best, very uncertain. At the same time, in the current atmosphere of economic nationalism being expressed by the Trump administration, perhaps the DBCFT border adjustment tax is better than the alternatives, which might include tariffs that are blatantly protectionist and clear violate the rules.

Of course, if the United States turns its income tax into a DBCFT with a border adjustment tax, other countries might, instead of bringing challenges at the WTO, deal with their trade concerns in another way: They could decide to adopt a DBCFT/​border tax of their own. If this were to occur, any supposed advantage to the United States from switching to a DBCFT would disappear. More broadly, if business taxes around the world include an import tax component, trade tensions could escalate, as differences in rates could be deemed “unfair” by one side.


The conventional wisdom has been that border adjustments for a VAT are legal under WTO obligations, perhaps because the VAT seems closer to a sales tax than it is to an income tax. But with this new kind of tax coming onto the scene — one that has features which perhaps bring it closer to a value added tax, at least in the sense of its “destination” focus — perhaps a rethinking of these tax categories is appropriate, as the economics of a border adjustment applied only to product taxes were always suspect. Perhaps a border adjustment is justified for both the DBCFT and the VAT; maybe it should not be applied to either one.

One way to test these ideas is through WTO litigation, through which both sides challenge each other’s measures. But this is a time consuming and costly endeavor, which may not offer much in the way of a practical solution. It has been suggested that a finding that the DBCFT violates WTO obligations would allow the rest of the world to retaliate in the amount of $385 billion. That figure is highly speculative, but nevertheless a trade war is not likely to be helpful here. A political effort may be more useful in this regard. Rather than a narrow legal ruling, a broader solution developed by tax and trade experts could be a better approach.

At this stage, it is very hard to predict how the trade issues will play out in relation to the DBCFT and the border adjustment tax. The current discussion sometimes suggests that the border tax could escalate trade tensions. But with the future of the DBCFT clouded by domestic politics, and alternative tax reform suggestions out there which would be much less likely to lead to trade conflict, at this point we can only wait and see how things progress.

About the Author
Simon Lester

Associate Director, Herbert A. Stiefel Center for Trade Policy Studies