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News Release

United States Should Reform Tax System and Adjust All New Business Taxes at the Border

January 25, 1996

Contact:    Gary Clyde Hufbauer    (202) 328-9000

Washington, DC—Proposals for fundamental tax reform have reached the forefront of the policy debate. As the United States gears up for the 1996 presidential election, tax policy will attract even greater attention. Fundamental Tax Reform and Border Tax Adjustments, a new study from the Institute for International Economics by Gary Clyde Hufbauer and Carol Gabyzon, makes two basic recommendations:

  • that the United States should replace its current federal income tax system, as applied to business firms, with a new tax on business activity (TBA system); and

  • that the new tax should be imposed fully on all imports and rebated fully on all exports.

The US Congress is actively considering three major TBA systems: a national retail sales tax, an Unlimited Savings Allowance Tax (USA Tax), and a flat tax. This book provides a useful primer on the three systems, pointing out their similarities and differences. The authors find two strong arguments in support of all such systems:

  • TBA systems would promote private saving and investment. Unlike the present corporate tax system, saving and investment would not be taxed at all, or would be taxed at lower rates.

  • TBA systems would simplify the very complex US Internal Revenue Code now applied to corporations and other firms. Simplification could save tens of billions of dollars in administrative costs.

Reasons for Border Tax Adjustment

If and when the United States reforms its tax system, the authors argue that the new tax should be adjustable at the border on internationally traded goods and services. Adjustment at the border means that the TBA tax would be imposed on imports and remitted on exports (or exports would be exempt). These tax adjustments should apply to trade in both goods and services. The authors support the principle of border tax adjustments for the new TBA system because border adjustments will facilitate the transition to a new tax system. Many US firms will pay higher taxes with a new tax system, inasmuch as they now pay little or no tax. Firms whose taxes increase will be concerned about their ability to compete with foreign firms, both in the United States and foreign markets. Border tax adjustments will lessen the legitimate concerns of these US firms. Border adjustments will also answer the fears of workers that some US firms will try to escape the new tax net by relocating abroad and shipping goods or services back to the United States (the "runaway plant'' phenomenon).

The authors emphasize that fundamental reform of the US tax system will promote both saving and investment. However the two will not necessarily be promoted to the same degree. Consequently, tax reform may either enlarge or reduce the US current account deficit: if saving rises more, the deficit will be reduced; if investment rises more, the deficit will be enlarged.

The authors do not believe that border tax adjustments—as distinct from fundamental tax reform itself—will significantly affect the US current account position. Instead, in macroeconomic terms, border adjustments will work as an adjunct to the exchange rate changes that will inevitably accompany fundamental tax reform.

Rules for Border Tax Adjustments

The new book analyzes the intellectual history and practice of border tax adjustments in the European Union, Japan, and the United States. It examines the international rules on border adjustments established in the General Agreement on Tariffs and Trade (GATT) and the General Agreement on Trade in Services (GATS). The authors highlight three major asymmetries in the current international rules on border tax adjustments:

  • Direct taxes (such as the corporate income tax) cannot be adjusted at the border, whereas indirect taxes (such as the value added tax) can be adjusted.

  • The rules applied to border adjustments on exports are not the same as the rules applied on imports.

  • Moreover, while the international rules are highly articulated as to permitted border adjustments on goods, they are vague as to permitted adjustments on services.

In the last chapter, the authors focus on the three most popular TBA proposals—the national retail sales tax advocated by Representative Bill Archer and Senator Richard Lugar, the Unlimited Savings Allowance income tax system (USA Tax) designed by Senators Sam Nunn and Pete Domenici, and the flat tax proposed by Representative Richard Armey and Senator Richard Shelby. The authors argue that a GATT/GATS case can easily be made for border adjustability of the national retail sales tax. Further, under current GATS rules, all three TBA systems can be adjusted on trade in services. But they find it is more controversial whether, under current GATT rules, the business component of the USA Tax or the flat tax can be adjusted at the border on traded goods.

Both the USA Tax and the flat tax differ from the value-added tax and other indirect taxes, which can be adjusted at the border under current GATT rules. Because of these differences, important trading partners, such as the European Union, may contend that border adjustments are not permitted for the USA Tax or the flat tax. The authors argue that a strong case can be made for border adjustments for the USA Tax, given the structural similarity between European-style VAT systems and the USA Tax. The authors also believe that a case can be made for border adjustment of the flat tax, but that case is harder to sustain.

Possible Change in Gatt Rules

The authors go on to argue, on policy grounds, that the GATT rules should be revamped if the current rules are in fact interpreted to preclude border adjustment either for the USA Tax or for the flat tax. In their view, the current GATT rules make an artificial distinction between indirect and direct taxes (the former are adjustable, the latter are not). This distinction does not correspond to the economic impact of different tax systems. Moreover, in light of the historical evolution of permissible border adjustments, the authors contend that it would be reasonable for the GATT system to permit adjustments for a new US tax system.