Will the US implement a border adjustment tax (BAT)? When the proposal was first mooted by the Republicans last June in the House of Representatives as part of a comprehensive tax reform package it appeared unlikely to many. The election result on November 9 put it firmly on the agenda, with House speaker Paul Ryan a strong supporter and the concept of BAT under review in Congress. It appears increasingly likely that BAT will be enacted in some form as part of a new US tax code.
That doesn’t necessarily mean that BAT is necessarily well understood, with many critics misrepresenting it as a 20% levy on all imports into the US. Fortunately it differs considerably from Europe’s value-added tax (VAT), which it can be argued immediately increases the price of all the UK’s imported goods. BAT ingeniously exempts all imports and exports from any taxation; indeed describing it as a border adjustment tax isn’t strictly accurate.
Indeed, were US politicians to seriously consider abolishing corporate tax in favour of a new regime of VAT all Europe would support the change. VAT across Europe is a substantial source of financing for every government. While many contend that it is paid by consumers rather than companies, every European company works as tax collector as far VAT is concerned and the work involved is significant.
When VAT is introduced all prices have the potential to increase by the amount of the tax, which is simply added to the invoice. If the price before VAT is imposed is €100 then after the introduction of VAT of, say, 20% the price will be €120. BAT is a superior concept in offering the same advantages as VAT without being burdensome, bureaucratic and immediately penalising consumers with a price hike.
As currently proposed, BAT envisages a reduction in the US corporate tax rate from 35% to 20% with exported and imported goods exempted from taxation. Since imports are normally costs, exempting these costs leads to higher taxable profit and critics of the BAT concept describe it as a 20% tax on imports. However, this isn’t the case as BAT would treat imports and exports in the same way by exempting them from taxation. Interestingly the tax which treats exports and imports differently is VAT, which is charged on – and is true tax on – all imports while exports are exempt. Unfair, you could justifiably claim.
Time magazine commentator Haley S. Edwards says that BAT is not only a new tax rate but would burn down the current tax code, replacing it with something totally new. BAT would no longer tax company profits but corporate cash flows. It would no longer matter where the company is located, where its goods are produced or where intellectual property is housed; what would matter is where the company sells its products.
If the company sells and produces its products in America it pays 20%; if they are sourced from abroad it will not be able to deduct the costs for imported goods for tax calculation purposes. If it sells products abroad, it does not pay any US corporate tax but foreign taxes will certainly apply. The BAT simplifies the deduction of many items; as outlined, it is based on corporate cash flows. Any investments in machinery can be deducted immediately – no need to create special depreciation tables for each machine or capital item. However it is no longer possible to deduct interest expenses, asset depreciation (already deducted in the year of purchase) and the cost of imported goods. To analyse the impact of BAT on various companies it is helpful to use simplified financial statements and brief tax calculation.
Table 1: Situation before the introduction of BAT:
Table 1 represents the current situation – where US corporate tax rate amounts to 35%; purchased goods can be expensed independently where they were purchased; capital expenditure has to be calculated annually according to the depreciation; and interest of debt can be deducted. The net profit on US$100 in sales amounts to US$17.88 in year one and US$18.20 in year two. The difference results from lower interest expenses in year two, because of debt reduction. Interest for debt is assumed to be 5%.
Table2: BAT goods purchased and sold in the US
Table 2 reflects the situation where all goods are purchased and sold domestically. The first two columns reflect the tax calculation; we use two years because of the different treatment of capital expenditure. In this example all machinery was purchased in year one, so can also be expensed in year one.
The financial statements assume that the economic life of the company’s machinery is five years and therefore we expense it over that period, with 10 per year. Tax calculation leads to taxable profit for year one of minus US$10 (sales minus costs of goods sold, labour and capital) and US$40 in year 2. A tax credit of US$2 is received in year one and US$8 taxes paid in year two. This information is used to create the financial statements, whereas taxes appear as calculated according to tax rules and then results in net profit of US$29.50 in year one and US$20 in year two. We see now a dramatic improvement to the pre-BAT tax regime, where profits in year one amount to US$17.88 and in year two to US$18.20. US business will be substantially more profitable under BAT.
The change to the BAT tax regime, with a 20% tax rate means a substantial increase in profitability for US corporations, which sell their products on the US market. There is no incentive to increase prices. Imagine how much the domestic prices would have to increase if the US was to implement a 20% VAT tax. Since capital expenditure can now be written off immediately the additional impact on increased employment through higher capital expenditure can be expected. It would be interesting to see how the profitability of the company changes if, instead of purchasing in the US, it imports products from abroad.
Table 3: BAT goods imported and sold in US:
This situation is shown in Table 3. When a US company imports goods from abroad under BAT import expenses are not deductible for tax purposes calculation. Therefore the taxable profit in year one is US$30 and in year two US$80. The company would need to substantially increase its capital expenditure to offset this negative effect.
When a company imports all its products and sells them exclusively on the US market, profit in the first year amounts to US$21.50 and in the second year to US$12. Before implementation of BAT the profit was US$17.88 and US$18.20. So although profit increased in year one we have in year two a decrease of financial profit in amount of US$6.20, or 34%. What can a corporation do to mitigate this deterioration? It could try to raise the price – an increase of US$6.20 would offset the negative effect resulting from the non-deductibility of imported goods for tax purposes.
However, bear in mind that were the US to introduce VAT rather than BAT all prices would rise by 20%. If a company could increase substantially capital expenditure – for example by 28% in year one to US$32 and year two also by US$32, then financial results would be the same as before the implementation of BAT. With US$32 capital expenditure in both years one and two, profits would amount to US$17.90 and US$18.40 respectively.
Furthermore, the company could try to take up exporting. If it could increase sales by 10% through additional exports – assuming the same cost structure, capital expenditure excluded – then using the imported goods profit would increase by US$4.40 and using domestically produced goods would increase by US$5.20. So on a small volume of new or additional exporting any US company could offset the negative effect from BAT, even if it exported nothing before the implementation of BAT. We see from this that BAT is a terrific policy instrument, which not only simplifies taxation but also boosts the trade balance. Every company will try to begin, or step up their exporting. Everybody will try to become an exporter!
Table 4: BAT goods produced in the US and exported
BAT will encourage US production and US exports, as Table 4 evidences. We see here the highest increase in profits. The net profit increases in year one to US$49.50 and in year 2 to US$40, versus the case pre-BAT where it is a very high increase of US$31.60 in year one and US$21.80 in year two. So even without the capital expenditure, the increase is almost 120%. This is a tremendous incentive to produce and export US products; companies such as BMW, which export vehicles produced in the US, will be thrilled.
Table 5: BAT on all goods imported and exported
Table 5 shows the case where a company importing goods into the US market potentially makes some modifications/improvements, then sells them to abroad. All goods will be exported, BAT does not count imports and exports and therefore the taxable profit will be always strongly negative. The company is receiving quasi money from the government for just having a presence in the US; an incentive to open a shop in the country. While net profit is not as high as when the goods are produced in the US, nevertheless profit in year one amounts to US$41.50 and in year two to US$32.00. These are the second- best results and will encourage companies to open facilities in the US, or just bring re-invoicing to the US.
BAT not only will have a strong incentive to produce in the US and export as much as possible but also import and export business will thrive. Any company will be motivated to open a warehouse in the US, bring goods to the US, make potentially some modifications and export them for as high as possible a profit. Since exports will not be taxed, the US will enjoy an export bonanza similar to Ireland’s but to a substantially greater effect and we might see the BAT tax regime spread around the world. If Europe’s VAT tax system could be exchanged for BAT all of above-described advantages would apply to Europe as well. The burdensome and bureaucratic VAT system would disappear and millions of VAT tax collectors employed and paid by businesses, could move to more productive work.
Let us summarise the results so far in Table 6.
Table 6: Summary of the results
Should the US introduce BAT the attractiveness of doing business in the country will substantially increase. Table 6 shows that before introduction of BAT under our assumption the company could expect to make a profit of US$18 for US$100 sales – so let’s say 18%. Using the same assumption we have changed only the tax regime and tried to answer the questions of how profitable the same corporation will be when BAT is introduced. In most cases, profitability increased strongly.
Companies which produce goods in US and export them will see the highest increase; however those which produce and sell in the US will do better. Companies which import goods into the US and export them later will profit also handsomely. We see a profit reduction for companies that import goods for the US market. However we showed as well that these companies can offset the profit reduction through a combination of different measures, such as additional capital expenditure, moderate price rises and exporting a proportion of their imported goods.
The discussed question in connection with BAT are foreign exchange rates. How will the US dollar react to the implementation of BAT? It is difficult, perhaps impossible, to predict FX rates in the short term. When one takes into account that FX cash flows resulting from import and export activities amount to less than 2% of the daily FX turnover, then the direct impact of BAT on FX cannot be strong and can be easily overcompensated by other factors. However in the long run BAT will be very positive for the US economy. BAT can lead to:
- Increased capital expenditure, as everything can be expensed immediately.
- Tax compliance and calculation will be much easier.
- The tax procedure is much easier than under the VAT regime.
- Incentives to bring business into the US, import/export companies, re-invoicing centres, warehousing etc.
- Profits under the new BAT tax regime at a 20% rate are substantially higher than before.
So in the long term the competitive advantage of the US will increase, and the value of the dollar can rise as well. It can also be expected that BAT will be introduced in other countries; especially those that currently have VAT, which could switch to BAT and create a significantly more efficient tax system than VAT, keeping advantages of VAT system (I mean here promote export activities), without condemning all companies to be VAT tax collectors.
VAT is a tax that imposes levies on all imports and asks importers to collect these levies and pass them to the government. BAT does not impose any levies, nothing has to be collected and passed to government. Simply imports and exports are excluded items by tax calculation. The end effect is the same, but the procedure is much simpler and does not penalise consumers for whom VAT is not a passing through item.