Will Paul Ryan’s Tax Reform Set Off a Trade War?

The Issue:

Many international economists and legal scholars believe that the Border Adjustment Tax (BAT) at the core of the corporate tax reform plan pushed by House Speaker Paul Ryan violates World Trade Organization (WTO) rules.  If the U.S. implements this plan, America’s trading partners can – and probably will – retaliate. Recent analysis by Chad Bown, an economist affiliated with the Peterson Institute for International Economics, suggests this retaliation could cost U.S. exporters as much as $385 billion annually in lost export revenue.

If the U.S. implements Speaker Paul Ryan's corporate tax reform proposal, America’s trading partners can – and probably will – retaliate.

The Facts:

• The tax reform proposed by House Speaker Paul Ryan and House Ways and Means Committee Chair Kevin Brady includes a provision that changes the way the U.S. taxes imports and exports, which would likely be considered in violation of international trade agreements.  The proposal would replace the current corporate income tax system with a destination-based cash flow tax (DBCFT). The new tax would include a “border adjustment,” that would apply a new lower tax rate of 20 percent to all goods consumed in the U.S.—including imports—but exempt goods produced for export from the levy. Border adjustment, per se, is not a violation of WTO principles (see this EconoFact memo).  But the proposed tax violates the principle of “national treatment” which is that once a good has paid a tariff to get across a border, domestic tax laws (as well as other laws) should not treat foreign goods and domestically produced goods differently.  The violation of national treatment occurs because United States companies would be allowed to deduct their wage costs from the cash flow against which the tax is assessed, whereas foreign firms are not.
• The new border adjustment tax could spark retaliation if it is seen as violating World Trade Organization (WTO) rules.  Trade partners could retaliate to the decrease in their sales to the United States by limiting American exports to their markets.  Under WTO rules, the retaliation would need to be proportionate to the lost exports.  Chad Bown has conducted the following calculation to provide a rough estimate of the possible magnitude of this retaliation: If the U.S. imposes a 20 percent border tax and labor costs are, on average, 50 percent of cash flows, then the discriminatory part of the tax is 10 percent, because local firms can deduct the 50 percent associated with labor costs, but importers cannot. If we assume that a 10 percent discriminatory tariff reduces U.S. imports by 10 percent then, at current import levels, our trading partners could levy retaliatory measures that reduce our exports by $220 billion per year.  Furthermore, because the new border tax system also subsidizes U.S. exports, a similar calculation suggests that the export subsidy would be 10 percent per year.  This subsidy could be cited as a reason to impose additional restrictions on our exports equal to 10 percent of our annual exports, or $165 billion per year.  Therefore, total trade retaliation could sum to $385 billion per year.
• The $385 billion estimate may overstate the amount of retaliation.   In advance of actual WTO litigation, it is impossible to predict with absolute certainty whether the WTO will conclude that the DBCFT actually violates international trade rules, nor is it possible to predict with certainty the exact “damages” the WTO will associate with any WTO-illegal aspects of the proposed reform. Some nations may choose a retaliation option that is less than what might be allowed, in the hopes of reaching a quicker and better resolution with the United States.   Also, acts undertaken as retaliation against WTO-illegal practices must be approved through the WTO’s Dispute Settlement Understanding, which can take years; any retaliation can only be pursued after the dispute resolution process; and the retaliation cannot be retrospective (see this for more details).   Nations that wish to retaliate before this lengthy process has run its course have another, faster option.  To the extent that they believe the U.S. reform functions as a WTO-illegal export subsidy, they are empowered under international law to initiate Countervailing Duty (CVD) investigations under their own domestic trade laws, and could apply CVDs to U.S. exports as soon as their own laws allow.  In many cases, these retaliatory CVDs could be in place within months of the U.S. enacting its reform.  However, these retaliatory measures would only apply to the export subsidy component of the tax reform, not its import tariff component.  But even if full retaliation falls short of Bown’s $385 billion estimate in the short run or the long run, it would still be very damaging for U.S. exporters.
• Revenues from the Destination-Based Cash Flow Tax are an important component of the Republicans’ broader tax reform.  The current statutory corporate income tax rate is 35%.  Martin Feldstein, a professor of economics at Harvard who advocates corporate tax reform, states that lowering the corporate income tax rate to 20% could lower corporate tax revenue by as much as $190 billion per year.  The proposed border tax, which taxes imports and exempts exports, could raise $120 billion per year because the United States runs a substantial trade deficit.  This would cover two-thirds of the lost corporate tax revenue, and provide Congress and the White House with a freer hand to cut taxes elsewhere.  Herein lies the dilemma for reform proponents:  without the border tax, broader corporate tax reform becomes a much harder sell, because it widens the deficit.  But the version of the border tax in the House reform package could lead to widespread retaliation against U.S. exports.