Caleb Brown: This is the Cato Daily Podcast for Friday, January 13, 2017. I am Caleb Brown. How we tax imports and exports may be the most substantial fight Congress has over trade policy during the Trump administration. The Cato Institute’s Dan Mitchell and Dan Ikenson discuss the so-called border adjustment tax and what it means for free trade.

President-elect Trump has been threatening all manner of tariffs on goods imported from around the world. House Speaker Paul Ryan has said that comprehensive tax reform with, in his words, a border adjustment tax, which is something House Republicans are talking about, could achieve Donald Trump’s goal without sparking some kind of trade war. So let’s unpack what that actually means. What is a border adjustment tax and how does that work within our system of trade internationally?

Daniel J. Mitchell: The House tax plan, called the Better Way Plan, introduced by Paul Ryan and Kevin Brady, does a lot of things that tax reformers have always wanted. A lower rate, full expensing of business investment, territoriality, death tax repeal, lots of good pieces, but in order to try to make the numbers add up, they put in place a big tax on imports coming into the country. But not in a classic sort of protectionist this is a tariff, they changed the rules of business taxation to say that exports from America will no longer be in the tax base. In other words, they wouldn’t be taxed, and imports coming into America would no longer be deductible, which is the same as saying they would be taxed. Now the Republicans say that’s not protectionist, it is simply turning our business tax base from income or production in America to a tax base of consumption in America and they say that it is equivalent to European value-added taxes, which are border adjustable, so that they claim that they are doing something that is compliant with trade rules, although that is a very big, open question.

Caleb Brown: Okay, so Dan Ikenson — a related question to that. As you like to point out and as I think all of our trade people should be pointing out every opportunity they get, about half of the stuff that is imported into the United States from other countries is stuff that Americans use to make other stuff. So what is the impact there?

Daniel J. Ikenson: The impact is potentially very adverse to U.S. manufacturers and other kinds of producers who rely on imported components and raw materials and things like that. And it looks like right now the way K Street is lining up, you see companies and industries that are export-oriented seeming to be supportive of this plan at this nascent stage. Companies that rely on imports tend to be registering opposition. Now, under international trade rules, most import taxes are forbidden, most export subsidies are forbidden. But international trade rules also require something called national treatment. So imports, foreign companies, are supposed to be afforded the exact same treatment in your economy as you afford to your domestic companies. And that extends to tax policy. So in countries where there are VATs where there are consumption-oriented taxes, what you will see is when a company is about to export a product, the government will rebate the VATs that they have already paid. And then they export the product to another economy that has the VAT, and a new VAT, the prevailing VAT in that economy, is assessed on those imports. So what that does is it means the playing field is level in both economies. The companies that are — products that are being sold in France are subject to the same taxes as products sold in Germany. Those are two companies both with VATs. So adjusting at the border, to me, is not really protectionism. It is about preserving this idea of national treatment. We don’t want policy to tilt the playing field against foreigners.

Caleb Brown: Okay, to you, Dan Mitchell — you don’t like value-added taxes as a practical matter, you don’t oppose them in theory, but what do you make of Dan Ikenson’s argument here?

Daniel J. Mitchell: Well Dan is pointing out that there is a trade argument dealing with whether or not — that you have some form of neutrality, and there’s actually two different types of neutrality. There is origin-based taxation, and there is destination-based taxation. And European VATs and the plan put forth by House Republicans is based on destination-based taxes. I prefer origin-based taxes, because origin-based taxes are more consistent with tax competition. I want consumers, I want workers, I want investors to have the ability to shift their economic activity from high-tax jurisdictions to low-tax jurisdictions, so I don’t like destination-based taxation as a matter of theory. And as a matter of fact, the academic who is most associated with this idea that House Republicans have adopted, Alan Auerbach, when he wrote a paper for the Left-wing Center for American Progress on this tax, his very first subheading in his paper was “Ending the Race to the Bottom,” because people on the left think it is terrible when governments have to compete and can’t have a cartel to squeeze more money out of other taxpayers. So there’s the issue of what is the proper design of a tax system, origin or destination, and I like origin for purposes of tax competition, but then what about the value-added tax you are asking about? Well, if this plan of House Republicans is approved, and if it gets taken to the WTO, as it certainly would be taken, and if my colleague Dan Ikenson is correct that the WTO has this distinction between direct and indirect taxes, what happens when the WTO rules against this House Republican tax plan? The simplest way to fix it, in my fearful nightmares, is to simply make wages non-deductable and thereby turn it into a subtraction method VAT, and at that point we are just off to the races with government getting bigger and bigger, financed by little incremental increases and its VAT, which is of course what we saw in Europe between 1965 and 85.

Caleb Brown: So in an effort to try to avoid a trade war, House Republicans are considering a border adjustable, border adjustment tax, but the fear is if the WTO opposes that, then all businesses in the United State are going to have is a loss of further deductions. Is that about right?

Daniel J. Ikenson: I don’t know if it comes down to that. I mean I think Dan’s concern is that if we end up with this destination-based, VAT-oriented tax, that the tax base is now captive. Right now there is tax competition, which is driven by the fact that the base is producers. And producers can move around. And that, I think, disciplines bad policy. If the tax base is consumers, it is going to be much more difficult to rein in wayward tax policy.

Caleb Brown: Because producers can presumably make bigger decisions about, or make a decision that involves a lot more potential revenue, whether it be produced here versus there, whereas individuals don’t as often make that kind of decision.

Daniel J. Mitchell: Capital is much more mobile than labor. And labor is more mobile than consumption. So politicians and academics who like destination-based taxes usually like those takes because it is a way of giving the government more latitude to increase the tax burden. And by the way, we see a very clear analogy. The whole issue of the so-called Marketplace Fairness Act inside the United States, this issue of whether or not there should be a state sales tax cartel, that’s all being driven by people who want a destination-based sales tax regime inside the United States so that consumers in high sales tax states wouldn’t have the freedom to go online to buy products from merchants in low sales tax or no sales tax states. So again, the common theme is that if you are a politician who favors bigger government, if you are a special interest group that favors bigger government, you want a destination-based tax system because you don’t want taxpayers to have the ability, or at least you want to make it much harder for them, to escape increasing onerous demands from government.

Daniel J. Ikenson: In some sense you are thinking one step ahead, because many economists would agree that a consumption tax, the value-added type tax, is less distortive than the kind of corporate income tax system that we have. So if you were assured that that wouldn’t happen, that there wasn’t this — it wouldn’t impede tax competition, wouldn’t you say that a value-added, destination-based tax is less distortive than the one we have?

Daniel J. Mitchell: Well I think there’s — something very important to understand is that there is the choice between the current type of tax structure which has all the double taxation of saving and investment, what public finance wonks sometimes call a comprehensive income tax base, then there is a consumption base. And a consumption base can be a value-added tax, it can be a national retail sales tax, or it can be an income tax like the Hall-Rabushka flat tax, because there is no double taxation. That’s all consumption base means, is no double taxation of income that is saved and invested. Now, once you make the decision, and you should, that a consumption-based tax is better than a so-called Haig-Simons or comprehensive income tax, then you have a second decision. Do you want it to be destination-based or origin-based? So I want the consumption-based tax, at least compared to what we have right now, and then, once we make that choice, I want it to be an origin-based system, not a destination-based system. The European Union chose to have credit invoice VATs be destination-based because they didn’t want their consumers to have the freedom to buy, or they wanted to make it harder for them to buy, where taxes were lower.

Daniel J. Ikenson: So right now what is being considered in Congress is still a direct tax, it’s still primarily a corporate income tax-driven system with border adjustability. But that is likely to run afoul of WTO commitments. We have tried stuff like this in the past and I’m wondering whether — we’ve been having discussions in the Trade Center about whether it would make sense for the Europeans to challenge the United States on that. Some people are suggesting that focusing on border adjustability and the tax code is going to keep Trump out of mischief on trade policy. And this is something that could address all of the protectionist rhetoric that he has been doling out for the past year, and then he wouldn’t have to do much else. And the distortions on the trade front would be small enough to preclude the Europeans from bringing a case and challenging us and then opening up a whole new Pandora’s box. So that is something to consider.

Caleb Brown: Dan, you and I spoke earlier this week about the president’s authority delegated to him by Congress to make mischief in the trade realm and presidents have broadly not done a whole lot of that historically, but with Republicans who are generally free trade and Democrats who, if you will recall, Nancy Pelosi did not want to give Barack Obama fast track authority. Is it possible that Congress could decide together we want to take away a lot of authority from this president with regard to trade, because it meets with both of our interests? One, on one hand free trade, and the other hand preventing the president from controlling trade. Is that a possible bargain that could be struck?

Daniel J. Ikenson: It is certainly under consideration. There is legislation that is being crafted right now to restrain the executive, so since 1930 Congress has been delegating more and more of its authority to the Executive Branch under certain laws. So usually there’s some statutory benchmark that needs to be met, there needs to be injury to a domestic industry, there needs to be a national security threat, there needs to be a balance of payments crisis. There are at least a dozen statues in which the president can sort of act unilaterally. Underway right now are efforts to craft legislation to tie his hands a little bit more or to make him go through a few extra hoops before acting unilaterally. The question is under what political circumstances will we have two-thirds of both chambers supporting the veto override?

Caleb Brown: Dan Mitchell, to you — is it possible that Congress could simply lower the corporate income tax to the point that a lot of this doesn’t matter?

Daniel J. Mitchell: That would be the ideal result. If we simply had a very low, say 15% corporate tax rate, which Trump has embraced as part of his tax plan, then a lot of these concerns that people have I think would be mitigated. And if we do the expensing of new business investment that Republicans in the House have talked about, that also would make America a much more attractive place to invest and to create jobs. So there are solutions to the things that worry people about jobs in America, just stop shooting ourselves in the foot with bad class-warfare tax policy. There is one other wrinkle in this whole issue that we should raise to people, and that is that if you accuse the House Republicans of being protectionist for wanting to levy a tax on imports while exempting exports, they will say no, no, we’re not protectionist because there is going to be an adjustment in currencies. And in theory I think that would be the tendency for exchange rates to adjust somewhat, but then that raises a whole separate issue. If the House Republicans and Trump agree on a plan that lowers the corporate tax rate, that puts in expensing, that fixes a lot of the warts we have on our tax system, not withstanding my concerns about this destination-based business system, one effect will be that foreigners will want to invest more money in our economy, which means that they are going to want more dollars to make those investments with, which means that our trade deficit necessarily will go up. So when we are thinking about these second and third-order effects of what is going on now on tax policy, just keep in mind that anything we do to strengthen the American economy is going to result in more foreign investment in our economy, which is a good thing, but that is going to get the trade deficit paranoid people all agitated and upset.

Caleb Brown: And to you, Dan Ikenson — I remember years ago Larry Kudlow saying this phrase: “I love trade deficits because they create current account surpluses.” And very quickly explain the problem with that kind of thinking.

Daniel J. Ikenson: Well, it’s the flipside of the trade deficit, of the current account deficit, is the capital account, surplus, right? So we are purchasing more goods and services from foreigners than they purchase from us. So what? To the tune of about $700 billion. That means there’s about $700 billion, almost to the penny, of net foreign investment in the United States. And when we talk about trade deficits which we’ve run for 42 straight years now representing some sort of leakage or creating job loss, we haven’t really seen that at all. And one of the reasons we haven’t is because the investment that comes back into the United States, whether it is stock market equity investment, corporate debt, government debt, foreign direct investment, it undergirds value-added creation and it creates jobs. And in fact oftentimes that investment that comes back in is better than the loss of economic activity attributed to the trade deficit. If U.S. companies go out of business, well, they’re on average, they’re an average company or they’re below average. What we are getting coming back in is foreign direct investment from world-class companies in Europe and Japan and elsewhere, so that’s a good thing.

Caleb Brown: Dan Mitchell is a senior fellow at the Cato Institute. Dan Ikenson directs trade policy studies at the Cato Institute. Subscribe to and rate this podcast at iTunes and Google Play, and follow us on Twitter, @CatoPodcast.