The unintended consequences of a Trump’s proposed tax reform

By Justin Hatherly
AIMS on Campus Fellow

Most observers agree that the corporate tax system of the United States needs reform. At present, at 35 percent, the US has one of the highest nominal rates of tax on corporate profits in the industrialized world. This high rate of tax has deterred investment, stifled economic growth and led to trillions of corporate cash being held overseas. At the same time, even with the high rate, some firms pay only a low effective tax rate on their profits due to the proliferation of preferences and exemptions that litter the corporate income tax code.

Since assuming office, President Trump has promised address the situation. Republicans in Congress (who hold the majority in both houses) seem to be coalescing around the idea of replacing the corporate income tax with a flat rate, border adjusted, cash flow tax.

Under the Republican proposals, the corporate income tax would be abolished and a 20 percent tax on domestic cash flow would be imposed. Under the plan, a firm would be taxed on its revenue minus its costs with regards to domestic activity. Exporters would have the tax rebated to them, while imported goods would be included in the tax base. In contrast to the existing corporate income tax, firms would be able to fully expense capital investments immediately instead of depreciating them over a several years.

In essence, taxes would be levied on transactions in the United States. Imports consumed in the US would be subject to the same taxation as domestic goods and services. Exports, consumed abroad, would not be subject to domestic taxation. This would remove incentives for corporations to shift production abroad based on tax considerations, as imported goods would be included in the tax base.

However, despite its initial attractiveness, there is reason to think that the cash flow tax might actually be detrimental to the world economy. Upon imposing such a tax, the United States would likely see a sharp appreciation in the value of the dollar. This is because the tax rebates for exports could help make American exports initially appear cheaper to foreigners. The increased demand for American exports would put upward pressure on the value of the dollar. Moreover, the fact that sales of imported goods would now be taxable would reduce the attractiveness of imports to American consumers. This would lead Americans to supply fewer dollars on foreign exchange markets, which would further increase the value of the US dollar.

A stronger dollar sustained by the tax change would likely wreak havoc with the rest of the global economy. Many firms and consumers in developing nations borrow in US dollars. However, since they earn incomes in domestic currency, this means that they must engage in foreign currency exchange to service their debts. Thus, a sudden, sharp increase in the value of the US dollar would increase their debt service obligations, as they would need more domestic currency to service existing dollar denominated debts. In other words, a stronger dollar could trigger a global financial crisis, as it would lead to a surge in real debt burdens globally. Canada would not be immune from such a policy shift, as many of our firms engage in cross border trade and have US dollar-denominated liabilities.

While the proposed tax shift may be appealing to many, the possibility of negative unintended consequences suggests that US policy makers should proceed with caution.

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