USA-VAT? Understanding Trump's Exporter-Friendly Tax Proposal

In the last three weeks we’ve covered Donald Trump’s proposals to increase tariffs, on China, on essential goods, and potentially on all imported goods. The effect of these policies will be to increase the cost of imported goods in the United States by increasing customs revenue. However, in former President Trump’s second term trade policy, this increase in duties is paired with a decrease in taxes on domestic producers. Today I want to consider how this may be achieved.

The blueprint for how the US may reduce taxes on its domestic producers is provided in Robert Lighthizer’s book, No Trade is Free. It is presented as follows:

In 2016, Speaker Paul Ryan, Ways and Means Chairman Kevin Brady, and their Republican colleagues in the House proposed tax legislation (referred to as the “House Blueprint” proposal) that would have solved most of the problems that arise from the US not having a VAT. They proposed: 1) converting our current business income tax to a 20 percent tax on cash flow, which allows for expensing of capital expenditures for plant and equipment and a deduction for labor; and 2) making the tax “border-adjusted” by disallowing as a deduction the cost of imported products, intangible property, and services and exempting from the tax all revenues from the export of products, intangible property, and services. Essentially the proposal would tax cash flow instead of domestic corporate profits but only allow a deduction for domestic inputs and not allow one for foreign ones. To simplify, this proposal would mean that (1) cash flows from American produced goods and services that are exported are not taxed, (2) cash flows from American-produced goods and services consumed domestically are taxed at 20 percent with essentially full deductibility of costs, and (3) cash flows from imported goods and services are taxed at 20 percent with no deduction for foreign production costs.

A missing piece from the above is that the increased tax revenue generated from this cash flow-based tax system would allow the government to lower corporate profit taxes. The beneficiaries of this new tax system would be US exporters, whose overseas revenue would be untaxed while benefitting from lower profit taxes alongside other US businesses. Therefore we realize in this case the Trump team's “producers” is really shorthand for exporters.

As referenced by Ambassador Lighthizer, the above is a way of making the US resemble a country with a 20% value added tax (VAT). It is worth considering why the US is unable to have a true VAT. I believe this is due to the US’s relatively unique system of separate tax collection at the federal, state, and local level. The closest current analog to VAT in the United States is sales tax. However, given the larger revenues that can be collected through VAT, along with the need for a standardized, nationwide deduction system and refunds on export, it would make most sense for this sort of tax to come from the federal level. However sales tax has historically been a tool of state and local government. Implementing a true VAT system would cross historical lines, and perhaps constitutional ones if there were challenges when applying a federal VAT to intrastate commerce.

The benefit of this new tax system would be to support US exporters and domestic production, theoretically evening the playing field between US and foreign businesses in global markets. A downside of this system would be the inherent challenge of all US businesses switching to a new method of taxation and accounting. One imagines a significant amount of friction, with businesses figuring out what counts as domestic and foreign sales and inputs and how to correctly calculate. A second challenge highlighted by Lighthizer would be an initial shock as the price of domestic and imported goods increased while the price of US exported goods decreased in global markets, which would have the net effect of increasing the value of the US dollar, reducing the advantage afforded to exporters while creating pain for consumers.

It is also worth considering how this proposed system will be different from a traditional VAT system. One way it will be different is it will be less labor intensive and easier to operate, as participants will not need to provide official VAT receipts to their customers or to the government or to apply for refunds on export. This may also make the system more susceptible to fraud and manipulation. Another difference will be that we assume this tax will only be collected from companies after the fact, through quarterly or annual filings. This differs substantially from how VAT is collected on imported goods in most countries, with importers having to pay VAT up front at the time of entry along with any duties. To my reading, this policy will create a loophole where individuals will be able to import goods themselves and avoid this VAT-like tax. If true, this will only exacerbate the existing Section 321, $800 de minimis loophole that is already being exploited to avoid Section 301 duties on Chinese goods. I would go so far as to say that if this new tax scheme comes into effect, the Section 321 loophole will need to be closed or at least significantly altered.

A second Trump Administration will clearly be a good time to be a US domestic manufacturer, and in particular an exporter. Not only will these companies benefit from a new competitive advantage created by increased tariffs, but they will potentially receive a second gift in the form of a new rewarding tax system. It is worth considering what these firms will do with their newfound wealth, whether reinvesting and hiring or distributing profits to owners and shareholders.

As always, if you or your company could use help thinking through the trade policy of a second Trump term, I hope you will reach out to me at [email protected].