Planned US border tax would most likely violate WTO rules

The border adjustment tax mooted to improve the US trade balance may fall foul of WTO rules, but whether this will compel the US to scrap the controversial plan is another matter.

by Martin Khor

As American lawmakers and the Trump administration prepare the ground for introducing a border adjustment tax, many controversial issues have emerged, including whether such a measure would go against the rules of the World Trade Organization (WTO).

The border tax is part of the overhaul of the US corporate tax system proposed by Republican Congressional leaders and appears to have the support of President Donald Trump.

If adopted, the tax measure is sure to attract the opposition of the US’ trading partners, as their exports to the US will have the equivalent of a 20% tax imposed on them, whereas the exports from the US will be exempted from a 20% corporate tax (see TWE No. 632).

The tax on US imports, without the same being applied to US-made products, discriminates against foreign products, while US exports being exempted from taxes is tantamount to being an export subsidy.

How will this be taken at the WTO, the guardian of the multilateral trading system?

US Congressman Kevin Brady, chairman of the House Ways and Means Committee, and the plan’s main advocate, is convinced the plan is WTO-consistent, but has yet to explain why.

On the other hand, many trade and legal experts think the plan violates the principles and rules of the WTO, although they caution that a final opinion is possible only when the language of the law is known.

Their general view is as follows: Firstly, the inability to deduct import expenses from a company’s tax (while allowing deductions for locally sourced products and services and wages) discriminates against imports vis-à-vis domestic products, and violates the “national treatment” principle of the WTO and the rules of the General Agreement on Tariffs and Trade (GATT) which specify that imports must be treated no less favourably than similar locally produced goods.

Secondly, the exemption of export revenues from taxable income would be most likely assessed as a prohibited export subsidy under the WTO’s subsidies agreement.

The renowned international trade expert Bhagirath Lal Das says that there are two separate issues to be considered:  the differential treatment of domestic and imported materials, and the differential tax treatment of income based on whether the product is domestically consumed or exported.

Says Das: “It appears that the proposal is to deduct the cost of domestic input (product) from a company’s income while computing the tax, whereas there is no such deduction if a like imported input is used in the production. If this be the case, such a provision will clearly violate the principle of national treatment contained in Article III of GATT 1994.”    

Under that article, imported products must be accorded treatment no less favourable than that given to similar domestic products in respect of laws and regulations.

Adds Das: “If the use of the domestic product results in tax reduction whereas the use of the like imported product does not get similar treatment, clearly the imported product will get ‘less favourable’ treatment. And that will violate the principle of national treatment, and it can be successfully challenged in the WTO on this ground.”

On the second issue, the proposal is to differentiate between the earning from domestic sale and that from export in the matter of taxation in respect of a product.

Das comments: “Here it would appear that the exemption of the tax is conditional on export. This practice will clearly qualify for being categorized as export subsidy which is prohibited under Article 3 of the WTO’s Subsidies Agreement.”

Das cites the case of a particular type of American company, the domestic international sales corporation (DISC), where a portion of its profit which was engaged in export was tax-free. The European Economic Community raised a dispute in the GATT forum in 1973. The matter was delayed for a long time until a panel at the WTO ruled in 1999 that the US practice was in fact an export subsidy and was prohibited.

“This case may not be exactly the same as the currently anticipated proposal, but it does point to the fallibility of providing government benefit contingent on export,” says Das.

Das was formerly Chairman of the General Council of GATT, Indian Ambassador to GATT, and subsequently Director of Trade in the UN Conference on Trade and Development, and has written many books on the WTO and its agreements.

According to another eminent expert on the WTO, Chakravarthi Raghavan, whether the US law is considered “legal” depends on the language of the law and its actual effects. “There is little doubt that the ‘pith and substance’ of the Republican border tax proposal or ideas will be in violation of Articles II and III of GATT and Article 3.1 of the Subsidies Agreement.”

Raghavan, Editor Emeritus of the South-North Development Monitor (SUNS), has closely followed and analyzed the trade negotiations of the Uruguay Round and of the WTO for years.

Limits to taking action at the WTO

Countries can challenge the US at the WTO, and if they succeed, the US has to change its law or face retaliatory action. The winning party can block US exports to it equivalent in value to the loss of its exports to the US.

However, there are many shortcomings with the WTO dispute system. Few countries have the courage or financial resources to take up cases against the US. If some countries do take up cases, it takes as long as three to four years for a case in the WTO to wind its way through panel hearings and to a final verdict at the Appellate Body, and for the winning party to get the go-ahead to take retaliatory action. During that period, the US can continue with the laws and practices in question.

If the US loses, it need not pay any compensation to the successful party for having suffered losses.   Moreover, based on past experience, when it loses cases at the WTO, the US has typically not complied with the orders made on it. Even if it does comply, it needs to do so only in respect of the parties that brought the action against it; it need not do so for other parties.

If it does not comply, the complainant countries are allowed to take retaliatory action by blocking US goods and services from entering their markets up to an amount equivalent to the losses they have suffered. This retaliatory action can only be taken by those countries that successfully took up the case.

Thus, the US may decide to implement the border adjustment tax and wait two to four years before a final judgment is made at the WTO and, if applicable, before retaliatory action is allowed by the WTO. It can meanwhile reap the benefits of its border tax measures.

Another possibility is that Trump may make good his threat to leave the WTO if important cases go against the US. That would cause a major crisis for the WTO and for international trade.

With regard to the WTO process, Raghavan said: “Apart from the difficulties of taking up cases in the WTO, including costs, the lengthy process and no retrospective damages when any WTO member raises a dispute, the onus of proving the violation is on them.

“To the best of my knowledge, in none of the rulings against the US requiring changes in law or regulations has the US implemented them, and even major trading partners have been chary of taking retaliation action.

“Countries that are affected could act to unilaterally deny the US some rights, but they cannot justify that this is retaliation until there is a ruling in their favour.”

Is the border tax similar to

value-added tax?

American advocates of the border adjustment tax plan have claimed that it is similar to a value-added tax (VAT), which is considered by the WTO to be a legitimate measure, and thus that the border adjustment tax would also be compatible with the WTO.

Almost all major developed countries have instituted the VAT system, with the notable exception of the US. The Republican Congressional leaders and Trump have argued that this places the US at a disadvantage in its trade relations because the VAT system imposes a tax on imports whilst allowing companies to obtain a refund for taxes paid on their exports. They claim the border tax would correct this disadvantage and that the WTO should similarly recognize the border tax as legitimate.

However, several well-known economists and lawyers are of the opinion that there are important differences between the VAT and the border tax.

There are two parts to their arguments. Firstly, the VAT imposes taxes on both imports and locally produced goods and services, and therefore does not discriminate against imports; whereas the border tax system imposes a tax on imports whilst excluding domestic inputs and wages from tax, which therefore discriminates against imports. Secondly, the VAT system does not subsidize exports, whereas the border tax system does.

In a 1990 paper, economists Martin Feldstein and Paul Krugman found that the VAT does not improve the trade competitiveness of countries using it. They said: “The point that VATs do not inherently affect international trade flows has been well recognized in the international tax literature … A VAT is not a protectionist measure.”

Krugman, in a recent blog post, reiterated that “a VAT does not give a nation any kind of competitive advantage, period.” But a destination-based cash flow tax like the border adjustment tax has a subsidy element that “would lead to expanded domestic production.”

In another paper, Reeven Avi-Yonah and Kimberly Clausing from Michigan Law School and Reed College respectively analyzed the difference between the VAT and the proposed border adjustment tax and why the former is WTO-consistent whereas the latter would violate WTO rules.

They said: “US trading partners are likely to be hurt in several ways. The effects of the wage deduction render the corporate cashflow tax different from a VAT, and these differences have the net effect of increasing the incentive to operate in the United States.

“In addition, such a tax system would exacerbate the profit shifting problems of our trading partners, since the United States will appear like a tax haven from their perspective.”

Economists also agree that the border tax will raise the value of the US dollar but there is a debate as to how long this will take and by how much it will rise. If the dollar appreciation is significant, this may have an adverse effect on countries that hold debt in US dollars, as they would have to pay out more in their domestic currency to service their loans. This would include many developing countries with substantial dollar-denominated debts of the public or private sectors, and some of them may tip into new debt and financial crises.   

According to former US Treasury Secretary Lawrence Summers: “Proponents of the plan anticipate a rise in the dollar by an amount equal to the 15 to 20 per cent tax rate. This would do huge damage to dollar debtors all over the world and provoke financial crises in some emerging markets.” (IPS)           

Martin Khor is Executive Director of the South Centre, an intergovernmental think-tank of developing countries, and former Director of the Third World Network.

Third World Economics, Issue No. 633, 16-31 January 2017, pp13-14