Why Lord Lawson's right about tax reform

Ex-Chancellor Lord Lawson appeared on Sky News yesterday and backed abolishing Corporation Tax and replacing it with a 'Trump style border-tax'. Perhaps he read the ASI's 2017 Budget Wishlist where I called for exactly the same thing.

This might all sound rather surprising. Indeed, reading Sky News' write-up, which makes reference to Trump using the tax to make Mexico pay for the wall, you might think that Lawson was advocating a tariff. Far from it. He was actually backing the House Republican corporate tax reform plan, which effectively abolishes Corporation Tax as we know it, and replaces it with a kind of sales tax like VAT (with a few caveats).

There's another nit to pick – despite it being described by some as 'Trump' style, we don't actually know if he supports it. He seems to use the term border tax interchangeably to mean either an protectionist tariff or the border adjustment that's part of Ryan's plan.

The main objective of the Ryan plan is to replace the current system of corporation tax, which discourages investment lowering long-run GDP. That’s why economists like Alan Auerbach and Larry Kotlikoff (as well us at the ASI) are backing the plan.

The Ryan plan contains three major changes to the status quo.

1. It lets you deduct the full cost of capital investment immediately. In order to calculate their taxable corporations currently have to work through a plethora of complex rules and depreciation schedules. The Ryan plan simplifies this by allowing for the immediate full expensing of capital investment.

This is why it's known as a Cash Flow Tax, instead of navigating depreciation schedules and deducting interest costs – firms simply pay tax on their cash flow (Revenues-Expenses).

Beyond saving on paperwork, this has two major benefits. First, it will increase investment, boosting productivity and ultimately workers' wages. When Estonia brought in a Cash-Flow Tax, they saw investment surge compared their neighbours. The Tax Foundation points out that "between 2000 and 2004, Investment growth in Estonia was 39 percentage points faster than neighboring Latvia and Lithuania."

Second, it fixes one of the biggest and most pernicious distortions that exists in both the UK and US tax systems – the debt equity bias. The status quo treats investments funded through debt much more favourably than investments funded by raising money from investors (equity). This is a problem because debt (and not equity) tends to attract government bailouts.

2. It's Border-Adjusted. In other words, the taxes are paid based on where the final transaction happens - in tax jargon it's 'destination based'. As I mentioned before under this system firms calculate how much tax they pay by subtracting their expenses from their revenue. But border-adjustment complicates that slightly.

Imported inputs no longer count as deductible expenses and exports no longer count as taxable revenue. This is typically the most controversial part of the proposal. Its opponents have painted it as a protectionist move that will push up costs at shops like Walmart and hit ordinary Americans hard. If they were right, the tax would be a terrible idea. But I (and many other economists) think they’re mistaken.

It's worth looking at why you'd want to make a tax border-adjustable. It's all about the base . The tax base, that is. It shifts the tax base from domestic production to domestic consumptionIf it’s implemented then companies will never be able to reduce their tax bill by moving overseas, effectively giving America the lowest corporate tax rate in the world—zero. That makes the US incredibly attractive for foreign investment.

It’s nuts to attack firms for following the rules of the current system, but where there is a problem with tax avoidance—Base Erosion and Profit Shifting—the solution is fixing the underlying rules. Dylan Matthews over at Vox has a really nice explanation:

"Right now, the US taxes companies on their profits, both those earned in the US and those earned abroad that are brought back into America. But because foreign profits aren’t taxed until they’re brought back to the US, companies have a big incentive to make US profits look like foreign profits to avoid taxes.

For example, suppose that a car company — let’s just call it, uh, General Motors — makes $1 billion in profit manufacturing cars in the US and selling them domestically and exporting them to subsidiaries abroad. That would normally subject it to about $350 million in taxes, since the US has a 35 percent corporate tax rate. But GM could instead have its foreign subsidiaries pay $1 billion less for the cars they buy from the US branch of the company. That wipes out GM’s US profits, leaving it with no US tax liability and shifting the profits to the subsidiaries abroad. If those subsidiaries are in countries with a low or nonexistent corporate income tax, that could wind up being a very good deal.

Same goes for companies that import goods. Imagine a company — call it Chiquita Banana — that has subsidiaries in Latin American countries, buys up bananas from banana farmers, and then sells them to the US branch for resale. Suppose it, too, makes a $1 billion profit doing this. It could then just have its Latin American subsidiaries charge $1 billion more for the bananas, leaving the US branch with no profits and shifting them to Latin America."

Border-adjustment makes schemes like these redundant. Why undercharge a foreign subsidiary when your exports already don't count as taxable revenue? And why overcharge for imported inputs when you can't deduct your imports as costs.

So why are people opposed?

Opponents worry this will impose a huge tax increase on importers. In essence, they object that this is a protectionist measure aimed at deterring overseas trade. Indeed, with supporters like Trump describing it as a big border tax, it's hardly surprising many people have got that idea.

But it turns out that almost all economists believe that the border-adjustment won't have any effect on the overall balance of trade.

Simultaneously taxing imports and and effectively subsidising exports by letting firms exclude export revenue from their taxable income should cause the US dollar to appreciate to the amount that'd make it trade neutral.

The import tax would raise the cost of imports and cause fewer imports to be demanded. This means that foreigners are getting fewer dollars, increasing scarcity and driving up the value of the dollar. At the same time, the export subsidy side of things would make US goods cheaper, the US would then sell more goods overseas and this would drive up the demand for the dollars you need to pay for them.

Martin Feldstein, who served as President Ronald Reagan's top economic advisor (and long overdue for a Nobel Prize), explained it an article for the Wall Street Journal:

"Since a border tax adjustment wouldn't change U.S. national saving or investment, it cannot change the size of the trade deficit. To preserve that original trade balance, the exchange rate of the dollar must adjust to bring the prices of U.S. imports and exports back to the values that would prevail without the border tax adjustment. With a 20% corporate tax rate, that means that the value of the dollar must rise by 25%.

With a 25% rise in the value of the dollar relative to foreign currencies, the $80 net price of U.S. exports would rise in the foreign currency to the equivalent of 1.25 times $80, or $100, and therefore back to the initial price. Similarly, the 25% rise in the value of the dollar would reduce the real import price to the U.S. retail customer back to $125/1.25, or $100, as it is without the border tax adjustment."

Now there are admittedly a few concerns here.

Some are worried that the currency adjustment wouldn't happen immediately and would hurt American importers in the meantime. I'm sceptical of that fear. For example, look at the Mexican Peso the morning after Trump was elected or the pound after the Brexit vote. Big currency moves can be priced in even before a policy change has been formally announced.

Others are concerned that the currency wouldn't fully adjust because of the third element of the Ryan plan.

3. It'd make wages a fully deductible expense. So far there's very little to differentiate the destination-based cash-flow tax I'm describing to a VAT. But the wage deduction is what sets it apart. It'd allow firms to fully deduct wage costs from their taxable income, which they can't under the current system. This makes the proposal more progressive than a similar VAT.

It's essentially equivalent to a big cut to payroll taxes like national insurance or social security. Indeed, economists at the (truly excellent) Tax Foundation looked at the distributional impact of the plan and found that it's more progressive than existing corporation tax set-up. This is because part (about 25% in their example, maybe more according to ASI research) of the burden of corporation tax falls upon labour and corporation tax deters new investment which depresses productivity lowering wages.

But the wage deduction is probably the biggest obstacle overall. First, some have argued that it'd make it hard to past the WTO. The WTO allows border adjustments for indirect taxes like VATs but doesn't for direct taxes like corporation tax. Without the wage deduction it'd be very straightforward to get it passed the WTO, but with it another nation might argue that it distorts trade in a way that a VAT doesn't. If the WTO were run by economists this argument would get short shrift, but sadly lawyers still run the world and this could become a hiccup. It'd hardly be the end of the world as the US could simply replace the wage deduction with a big-league cut to payroll taxes and push it through.

Second, some have argued that the wage deduction would impede the currency adjustment because wages are deductible for domestic production but not imported inputs. I'm sceptical of this argument because the wage deduction wouldn't cancel out the effect of large payroll taxes that hit domestic producers but not necessarily importers. And I doubt that those objecting to this move would object to an economy wide wage-subsidy as protectionist.

That's it, in a (rather large) nutshell. I think Lawson and the House GOP are right to back this move. It removes large impediments to investments within the corporate tax system, it'll boost GDP and wages, and effectively gives the US (and Britain if we follow) most competitive business tax system in the world.

It’s really important for us in the UK to follow this debate, for two reasons. The first is because after Brexit we need to make our tax system as efficient as possible to encourage growth. But the second is because if the US does go ahead with this reform plan then we will have little choice but to follow suit if we want to remain competitive.