Most change in public tax policy is conducted at the margin to minimize disruption to ongoing commercial activity. This will not be the case if the U.S. Congress’ proposed sweeping corporate tax reform and destination-based cash flow with border adjustment is implemented. In short, it would be the most significant change to the U.S. tax code since at least 1986, and quite possibly since the 1913 inception of the income tax.
In one swift move, the plan would substitute a tax on cash flows for corporate entities for the current tax on income, and reduce the corporate tax to 20 percent from its current level of 35 percent. This carries significant implications for middle market businesses with exposure to the global supply chain across industrial sectors. The destination-based cash flow tax (DBCFT) would apply to all businesses including, we assume, all firms — whether they are pass-through entities or not.
Whether the border adjustment becomes law or not, the idea of such a radical shift in the tax code presents an opportunity for middle market businesses to get reacquainted with their supply and value chains, which may be disrupted and distorted in the aftermath of any border tax implementation or the imposition of selective trade tariffs.
The goal of the border adjustment tax is to create the conditions for a quicker pace of economic growth (current U.S. trend growth is 1.9 percent) in the near-term and to make room for rising productivity, currently at 0.4 percent per year. The reform would also simplify the tax system and make it more transparent while protecting the integrity of the U.S. tax base.
Corporate tax revenue today is equal to about 2 percent of U.S. gross domestic product (GDP), so the proposed tax reduction would be equal to 1 percent, or approximately $190 billion. This should serve as an incentive to increase capital expenditures on the part of domestically based firms and encourage the repatriation of corporate profits held abroad, while serving to stop corporate inversions designed to take advantage of lower corporate tax jurisdictions overseas. Moreover, it would make the United States a more attractive corporate tax location and act as a magnet for new investment and capital flows.
Taxing cash flows rather than income significantly reduces incentives to engage in tax avoidance, therefore broadening the U.S. tax base. Aligning the incentives to both source materials and produce goods domestically would tip the tax code in favor of domestic firms with little or no exposure to the external sector. Moreover, it would give preference to an immediate depreciation of investment on capital expenditures and incentivize the development of intellectual capital. This favors risk taking by small and middle market businesses by permitting them to take immediate advantage of business opportunities rather than the current system’s unintended consequence of encouraging firms to spread out risk and costs over time.
From an economic point of view, the substitution of a cash flow regime for an income-based regime represents a shift to what is essentially a value-added tax with deductions for wages. This shift carries with it the capacity to pay for about two-thirds of the $190 billion-dollar corporate tax cut, from 35 percent to the GOP’s proposed 20 percent, on a static basis. Given the probable growth in the economy that would follow from the tax cuts, it would likely pay for much more. If the border adjustment tax were set at 30 percent, it would likely pay for itself.
Without the anchor of the border tax arrangement, the current tax reform proposal would likely either flounder in Congress, or if enacted, create far larger deficits than are currently assumed by the Congressional Budget Office, the GOP or the White House. There is simply no amount of dynamic scoring that could be employed at the Congressional Budget Office that would bring the corporate tax rate far below 30 percent without significantly altering the budget outlook in a negative fashion.
What Is A DBCFT With Border Adjustment?
The current proposal would effectively abolish the corporate income tax in favor of a value-added approach that would be easy to administer and would likely generate substantial revenue during the next decade. The DBCFT should generate about $1.2 trillion in revenues over the next decade at the proposed 20 percent rate.
In theory, a DBCFT should treat equity and debt equally, given the elimination of interest on debt as a deduction. That said, with favorable treatment of debt stripped from the tax code, firms would likely move toward issuing equity as a form of raising capital. This would likely boost private equity and venture capital firms during the first few years of implementation.
The DBCFT is not a de facto trade policy. If currency markets adjust perfectly (an estimated 25 percent), a border adjustment tax will not reduce the trade deficit nor will it alter the price level in the economy. Rather, imports and exports would face paired and equal adjustments that, ideally, would create a level playing field for both domestic and external competition. If the U.S. dollar did not adjust perfectly then, at least in the near term, the DBCFT would favor exports over imports.
Tom Rourick is the audit practice leader and Managing Partner of the Houston office at RSM US LLP.