Less than one week into office, President Donald J. Trump issued an executive order indicating U.S. intent to build a wall on the border with Mexico. The next day, White House Press Secretary Sean Spicer stated the administration might pay for the wall by levying a new, 20 percent border tax on U.S. imports from Mexico.
A significant diplomatic fallout erupted. New confusion also suddenly arose due to the apparent shift in Trump’s policy priorities.
The Trump administration needs to tell the truth about this 20 percent border tax adjustment. Further obfuscation elevates the risk that any U.S.-imposed border tax adjustment would lead to an immediate trade dispute, that the United States would lose that dispute and that the U.S. would face internationally sanctioned retaliation.
Worse, further U.S. rhetoric and escalation could even force trading partners to seek vigilante justice. They could address their own trade problems in ways that lead everyone into an inadvertent trade war. This would result in considerable economic pain to U.S. companies and U.S. jobs.
Trump’s first motivation for a border tax: wall financing.
President Trump’s first motivation for a border tax arises from his campaign promise to stem the flow of immigration into the United States. Trump’s executive order indicated his explicit intent to “secure the southern border of the United States through the immediate construction of a physical wall on the southern border, monitored and supported by adequate personnel so as to prevent illegal immigration, drug and human trafficking, and acts of terrorism.” Cost estimates for border wall construction and maintenance run into the tens of billions of dollars.
During the presidential campaign, Trump indicated he not only wanted the wall, but he wanted Mexico to pay for it. Mexican leaders have adamantly refused.
And yet in the days immediately after the inauguration, appearances were that U.S.-Mexico relations might be warming. President Trump publicly described, somewhat amiably, an upcoming meeting he had scheduled with Mexican President Enrique Peña Nieto. Trump indicated that, while the meeting would involve “negotiations having to do with NAFTA,” Peña Nieto had been “amazing” and Mexico had been “terrific.”
But then the administration published the executive order that formally announced their plan for building the wall. Peña Nieto responded by cancelling his planned meeting with Trump.
This appeared to catch the Trump administration off guard. It almost immediately responded by stating that a new 20 percent border tax on imports from Mexico could be used to pay for the wall. Even putting aside Mexico, Trump’s announcement surprised domestic observers as it signaled a potentially major policy shift. For only days earlier, Trump had given an interview with The Wall Street Journal in which he seemingly dismissed this particular type of border tax as “too complicated.”
Trump’s second motivation for a border tax: addressing NAFTA “problems.”
The second impetus for a border tax on Mexico is based on the notion that such a tax could rectify perceived problems with the North American Free Trade Agreement.
NAFTA is a long-standing agreement cutting import tariffs to zero between the United States, Canada and Mexico. Trump has frequently derided NAFTA as one-sided, claiming Mexico benefits by stealing companies and jobs from the United States. He routinely points to the U.S. bilateral trade deficit with Mexico — that is, that the U.S. imports more goods from Mexico than it exports to Mexico — as indisputable evidence of a bad deal.
Economists generally do not agree with the idea that bilateral trade imbalances are a useful barometer by which to evaluate trade relations or trade agreements, especially for the U.S. economy. And the measure is particularly misleading when characterizing the health of the U.S.-Mexico trade relationship. The biggest problem is its failure to account for the large share of U.S. imports from Mexico that are filled with U.S.-produced content and value added.
Take the example of a “Mexican” automobile exported to the United States. In the export statistics used to construct traditional trade balance measures, Mexico is assigned the full value of any car assembled south of the border that is sent to the United States. Not included in those statistics is that under the hood of that Mexican car there are engines, seats and software that were made by U.S. workers on U.S. soil in U.S. factories that had been exported to Mexico for final assembly.
Indeed, when taking these factors into consideration, the corrected “value-added” measure of the U.S. bilateral trade deficit with Mexico is only half as large as the numbers to which U.S. politicians refer. The problem is with using the bilateral trade deficit statistic to guide policy — not Mexico or NAFTA.
To the extent that a particular U.S. worker or community is displaced by changes in economic activity — whether due to increased trade with Mexico, or because of automation, robots, artificial intelligence or simply a change in the types of goods that consumers want to buy — the more appropriate government response is to fix U.S. labor market policies, not a trade agreement.
This potential tax on imports from Mexico is only part of a broader border-tax adjustment plan.
The 20 percent border tax adjustment that the Trump administration was seeming to reference is but one part of a major U.S. tax reform proposal under debate in the Congress.
The current U.S. tax system involves a complex web of levies that generate the federal revenue used to finance government spending programs. In addition to the corporate income tax, there is a payroll tax, personal income tax and capital gains tax, amongst others. Comprehensive U.S. tax reform has long been a priority.
In June 2016, Republicans in the House of Representatives published what has become known as the Ryan-Brady Blueprint, after House Speaker Paul Ryan and Ways and Means Committee Chair Kevin Brady. One of its main features is to replace the current corporate income tax with an alternative business tax that is referred to as a destination-based cash flow tax, or DBCFT.
The DBCFT has similarities with the value-added tax, or VAT, regimes employed by more than 150 other countries around the world, including Mexico. It also has at least one important difference.
The Ryan-Brady Blueprint would be equivalent to a 20 percent VAT, but with a wage allowance that permits only sales from companies producing in the United States to deduct their U.S. labor costs from their tax bill. The details of this last part are potentially important, as they are what makes this plan distinct from the “pure” VAT.
Normally, a border adjustment does not act as a discriminatory tariff.
Most any VAT regime — including the Ryan-Brady Blueprint variant — contains a border tax “adjustment.”
Consider two different cars that are both purchased in the United States. The only distinction is the country in which each is produced. A U.S.-made and consumed car would face a 20 percent tax. The foreign-made car that is consumed in the United States would also face the 20 percent tax.
So far, each car is being treated the same. However, since the 20 percent tax on the foreign car is new to the trading partner, this may be where the confusion arises. By itself, this looks just like a newly imposed 20 percent import tariff.
Yet, if the rest of the tax burden between the U.S.-made car and foreign car were the same, then claims that the DBCFT were an import tariff would be incorrect. The tax would be nondiscriminatory and apply equally to all cars consumed in the United States, regardless of where they were produced.
It is also important to point out that this border tax adjustment is not discriminating against Mexico. It would apply not only to cars imported from Mexico, but also to U.S.-bought cars from Canada, Germany and Japan.
Importantly, Mexico would not be singled out by a normal border tax adjustment.
However, there are additional wrinkles.
Under the current proposal, there is at least one important distinction that could introduce elements of discrimination. Recall, for example, that the company making the car in the United States also gets to deduct its labor costs. So, its effective tax rate is less than 20 percent.
The foreign-produced car — whether made in Mexico, Canada, Germany or Japan — is not eligible for the deduction, so it is still liable for the full 20 percent border tax adjustment. If prices and the value of the U.S. dollar relative to foreign currencies do not fully adjust to offset this difference, the Ryan-Brady DBCFT could end up discriminating against the imported car relative to its American counterpart.
This possibility needs to be considered.
Discriminating against foreigners increases the likelihood the DBCFT runs afoul of international trade agreement rules, including NAFTA and the World Trade Organization. Mexico, Canada, Germany, Japan and any other country adversely affected by the discrimination could seek redress.
But to be clear, the source of this differential treatment between the imported car and the U.S.-made car is not the border tax adjustment itself. It could potentially arise because of tax allowances granted to U.S.-based production that are not accessible to foreign production.
There are potential fixes to the discriminatory elements of the DBCFT proposal.
Of course, the Ryan-Brady plan is only a blueprint. If it is discriminatory, repairs could be made.
One proposal has been to eliminate the wage allowance for U.S. produced goods. A second and more difficult to implement alternative would be to keep the U.S. wage allowance, but to permit foreign producers to deduct their labor costs as well.
Even the border tax adjustment is but one element of the Ryan-Brady Blueprint
While border tax adjustment has received disproportionate political coverage, it is only part of the overall package of the Ryan-Brady Blueprint for U.S. tax reform. Other important elements of the proposal require honest and informed public scrutiny, and they are getting lost with a singular focus on border tax adjustment.
Tax reform could lead to efficiency gains for tax collection and reduce current disincentives for saving and investment that ultimately benefit U.S. productivity and economic growth. Also important is that the border tax adjustment component could eliminate existing incentives for U.S. multinational corporations to abuse transfer-pricing rules and undertake corporate “inversions” simply to reduce their tax burden.
However, there are also alarming elements to the Ryan-Brady proposal. First is controversy over the proposed rates. Without getting into details, there is apprehension that the plan would not be revenue neutral and could thus further exacerbate the federal budget deficit. Second, any shift from a corporate income tax to a VAT-type (or DBCFT) system raises regressivity concerns and the potential exacerbation of trends in U.S. inequality. Such worries could be allayed if accompanied by a major transformation of U.S. social policy on the spending side — for example, redistributive programs favoring the working poor — but those are largely missing from the Blueprint.
Political theater presents new problems.
The knee-jerk inclination by Trump as well as Congress to frame a border tax adjustment politically as either a punitive import tariff or revenue raiser directed at Mexico is unfortunate. It introduces a new host of concerns.
First, inaccurate characterization of the tax only serves to muddy an important U.S. debate over the merits and implications of fundamental tax reform. The DBCFT is still at the proposal stage. If the Ryan-Brady plan is shown to likely result in discriminatory effects on imports from all sources, including from Mexico, it could still be fixed.
Political escalation tends to harden positions prematurely and may foreclose the opportunity to get the policy right.
Second, stating that the purpose of the policy is to punish a country or to raise revenue to fund a single infrastructure project both antagonizes trading partners and, as a tactical maneuver, weakens the U.S. legal position in future negotiations.
Claims by Trump and other U.S. politicians that the DBCFT is designed to discriminate against Mexico or any other trading partner would, under the best-case scenario, result in a trade dispute. Partners could use the rules-based trading system to challenge the policy and help resolve the controversy. Ironically, even if the ultimate tax reform did not have much discriminatory effect in practice, countries could point to how the United States motivated the tax reform politically to make their case for them.
The worst-case scenario has Mexico and other countries feeling politically compelled to take matters into their own hands. President Peña Nieto and other world leaders have their own domestic politics to navigate. The Trump administration’s lack of tact and the breakdown of quiet diplomacy increases the political pressure that other nations act outside of the comforts provided by the constraints of trade agreements.
The most under-appreciated part of today’s trade agreements is its formal dispute settlement system. These are designed to depoliticize trade issues. Consider even the end compensation in any given case — it is a firm limit to the amount by which a trading partner is permitted to retaliate. It is this retaliatory limit that contains the fallout and prevents a trade war.
Working outside of the trade agreement system, retaliation and counter-retaliation could result. A self-defeating trade war could erupt. Just like the 1930s, this could have devastating implications for all the economies involved.
There is little to gain and much to lose by motivating a border tax adjustment as either a punitive import tariff or a policy designed to finance the construction of a border wall. Short-term gains from political theater are mostly short sighted. They are more likely to both torpedo the best-intentioned efforts at tax reform and reverberate negatively on the U.S. economy.