Corporate tax reform, the perennial bridesmaid of Washington’s crowded and contentious policy agenda, may finally move forward over the next few months as the new Trump administration and Republican majorities in Congress attempt to fulfill top 2016 campaign commitments. Although there have been a number of studies and proposals over the years, insiders expect that House Ways and Means Chairman Kevin Brady’s and House Speaker Paul Ryan’s ambitious but heretofore relatively obscure “Better Way” plan of June 2016 will play a major role in the current discussion due to its potential for affecting international trade, another key Trump priority. If enacted, this complex proposal would have a profound impact on all American businesses that are part of an international supply chain. This column attempts to tease out some possible implications for New Jersey.
Although the Better Way plan contains many interesting features, one provision in particular has sparked an intense and growing debate: a proposal to replace the current 35 percent federal tax on worldwide corporate income with a 20 percent tax on net income arising from the consumption of goods or use of services inside the United States. To equalize the treatment of domestic and foreign producers/service providers, the Better Way plan would apply the new 20 percent tax to imports as a “border adjustment.” For simplicity, we’ll refer to the entire scheme as a “border-adjusted tax.”
Got it? If not, don’t panic, you’re in good company. Luckily, for our current purposes we can fast-forward to the summary headline: a border-adjusted tax would effectively exempt U.S. taxpayer corporations from any U.S. tax on foreign earnings or exports while imposing a 20 percent tax on all imports.
Proponents argue that this new tax structure would be more efficient and fairer to U.S. companies that compete on a global scale — indeed, most “rich” countries do not tax foreign corporate earnings — and ultimately promote U.S. production while obviating many current tax-avoidance (tax-sheltering) strategies.
On the face of it, however, a border-adjusted tax looks like a major tax break for export-oriented companies and an equally huge protective tariff on imported goods and services. Everything else being equal, a 20 percent border adjustment would mean that Amazon, Walmart, Target, and other retailers would have to pay 20 percent more for the mostly foreign-made products they sell in the U.S. That sounds like a potential disaster for retail margins and American consumers.
Of course, everything else may not be equal. Standard economic theory asserts that the new tax structure would fuel a dramatic rise in the value of the American dollar against foreign currencies, making imports cheaper and exports more expensive in dollar terms. In theory, this anticipated change in the exchange rate would exactly offset the economic impact of both the 20 percent tax on imports and the new tax exemption for foreign earnings, leaving all producers and service providers, both domestic and foreign, in the same position as now.
Standard economic theory or not, many major retailers are extremely dubious and have launched a furious lobbying effort against the Better Way plan’s border-adjusted tax. (Memo to former Obama administration staffers: It is a very good time to be a tax or trade tax lobbyist in Washington, D.C.)
So, what does all this have to do with New Jersey?
In general, a border-adjusted tax’s impact on any one state will depend on that state’s particular economic characteristics. For an import- and logistics-oriented state with a high immigrant population like New Jersey, the effects could be profound.
Assuming no change in exchange rates, a border-adjusted tax regime would plausibly boost New Jersey’s manufacturing base. Trouble is, New Jersey has less manufacturing compared with the rest of the nation. According to the National Association of Manufacturers, manufacturing accounted for about 8.7 percent of the nation’s nonfarm employment in 2015 but only 6.1 percent of New Jersey’s nonfarm employment. More significantly, New Jersey’s 2.1 percent share of the nation’s manufactured goods exports (by value) is both small relative to its 2.8 percent share of the nation’s population and surprising in light of the state’s strategic coastal position.
Meanwhile, of course, New Jersey-based manufacturers that import components, consume services, or license intellectual property from abroad would face a substantial increase in nondeductible costs under a border-adjusted tax. Similarly, reduced demand for more expensive imports would negatively impact New Jersey’s substantial and relatively well-paid transportation, logistics, and distribution sector linked to Ports Elizabeth and Newark. In 2015, this sector provided 11.2 percent of the state’s private-sector jobs, compared with 8.8 percent nationally. Even if the border-adjusted tax ultimately boosted U.S. exports, there is no guarantee that New Jersey would grab a proportionate share of the resulting economic activity or that the shift would not be hugely disruptive.
Speaking of disruptive, a switch to a border-adjusted tax at the federal level would force a major retooling of state revenue systems, especially in states like New Jersey, which maintain a state corporate income tax with strong links to the federal corporate income tax. Although New Jersey’s Corporate Business Tax, the state’s third-largest revenue source, is overdue for a major overhaul, adjusting the CBT to a fundamentally new federal tax regime would be extremely complex and fraught with unanticipated risk.
But the largest potential impact would be on New Jerseyans as individuals. Absent a surge in the dollar, they could face much higher prices for everyday consumer staples imported from China and other countries. However, if the dollar does surge as economic theory predicts, one impact would be a dramatic reduction in the dollar-denominated value of assets (i.e., wealth) that American firms and individuals hold abroad. For a state with the third-highest ratio of foreign-born residents (over 21 percent as of 2012), many with close economic ties to their country of origin, this could have a profound adverse impact.
Although a border-adjusted tax is intriguing as national policy, the bottom line for New Jersey compared with other states appears to be less potential upside reward coupled with more downside risk. Unless you believe that academic theories and models always prove out in the ultra-complex real world economy, caution and further analysis seem warranted.