Wharton's Ann Harrison and Penn Law's Michael Knoll discuss the proposed border adjustment tax.

The Republican proposal for a border adjustment tax was a contentious issue when President Donald Trump met with CEOs of eight major retailers last Wednesday. Retailers fear the tax would significantly increase the cost of their imports, which could hurt consumers’ wallets, depress demand and threaten retail industry jobs.

During a recent discussion on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111, Michael Knoll, a professor and co-director of Penn Law’s Center for Tax Law and Policy, and Wharton management professor Ann Harrison explained the potential implications of a border adjustment tax. Knoll said the proposal could gain wide acceptance if it was styled similar to Europe’s value-added tax. But Harrison warned that a protectionist tax could trigger retaliatory action from other countries.

Here are key takeaways from their discussion (listen to the full podcast using the player at the top of this page):

Shock Waves Within and Beyond the U.S.

Knoll explained that the Republican proposal for a border adjustment tax would exempt exporters’ profits from taxes and remove existing tax deductions for what importers purchase from foreign countries. It will mean “a dramatic change overnight” and it is “likely have significant effects throughout the economy,” he said.

The effects on imports and exports will not necessarily cancel out each other at the firm level because many companies have exposure overwhelmingly on just one side of the equation, said Knoll. For example, retailers like Walmart that expect their after-tax costs to rise substantially are upset, while big exporters, including technology companies and large industrial companies like General Electric could have nil or even negative tax liability, he said. Indeed the chief executives from 16 companies, including GE, Oracle and Pfizer, sent a letter to congressional leaders this week in support of the GOP tax plan.

The Dollar Effect

Knoll said the border tax would mean an “awfully high” value-added tax of 20% coming in overnight. Retailers are expected to pass on those increased costs to consumers, but those higher costs could be mitigated if the dollar strengthens, he explained. That would happen because U.S. demand for costlier imported goods would fall, and reduce the flow of dollars to exporters in foreign countries. Demand for the dollar would rise in such a scenario, pushing up its value, which means importers would get more supplies for every dollar they spend.

“If the dollar rises, it will eliminate a lot of the aimed benefits [of the tax proposal],” said Knoll. “But it will also produce other large-scale effects.” For example, U.S. entities with foreign assets will find their assets devalued, while non-US entities owning dollar-denominated assets will find the value of their holdings increase. A stronger dollar would also increase the size of dollar-denominated liabilities of many countries. However, he added that no empirical evidence exists on whether the border adjustment tax and the currency adjustment it could trigger would indeed cancel out each other.

A Tool to Fund Corporate Tax Cuts

The intentions behind the tax move were legitimate, according to Knoll. A major impetus for the border tax is “to address the current corporate tax system, which is an utter mess in the way it encourages companies to flee the U.S., it encourages them to shift income outside and it also discourages production in the U.S.,” he said. “The design for this tax was meant to respond to some of those problems and eliminate some of those concerns by essentially taxing consumption where it takes place.”

The border adjustment tax would help fund the corporate tax cuts the Trump administration wants to implement as part of its overall tax reforms. If the corporate tax rate falls from the current peak of 35% to 20%, it would cause a $1.2 trillion hole in the government’s tax revenues over 10 years, according to an analysis by the Tax Foundation. “That’s a big hit to government revenues, and they need to find a way to finance it,” said Harrison. “Taxing imports at the rate of 20% would definitely make up the shortfall.”

The border adjustment tax could collect up to $1 trillion in fresh revenue, comfortably funding the revenue gap, said Knoll. Its advocates find that tax proposal attractive “because it raises a lot of money as our exports are far smaller than our imports,” he added.

Knoll suspects the reported move by the Trump administration to change the way it calculates the trade deficit is a ploy to make that deficit bigger, and thereby drum up popular support for higher taxes on imported goods. The proposed recalculation of the trade deficit would exclude re-exports, or goods imported and exported after value addition in the U.S.

Retaliation Likely

Harrison noted that there is a difference between what Trump proposed during the campaign and the border tax that is now being considered. While Trump had proposed selective measures to target what he saw as unfair competition from Mexico or China, the border tax currently on the table would apply to all countries and all goods. “So it is a much more dramatic and massive proposal,” she said.

“A lot of countries around the world could get very angry, and they could then try to hit us back.”  –Ann Harrison

As a consequence, both Knoll and Harrison expected retaliation from other countries if the border adjustment tax takes effect, in the form of higher taxes placed on imports from the U.S. “A lot of countries around the world could get very angry, and they could then try to hit us back,” said Harrison. “So this could escalate, and that is a major concern about the way the border adjustment tax has been designed.”

The border tax would also be “in violation of World Trade Organization (WTO) rules that try to prevent countries from engaging in beggar-thy-neighbor, protectionist and mercantilist policies,” Knoll said. The issue will likely go before a WTO panel for resolution. “I don’t see any way the U.S. can win that [case],” he noted. Other countries will retaliate, even though “it doesn’t make sense for them to do so,” Knoll added. “It isolates the U.S.”

Back home, the tax plan could also “face a big uphill battle,” said Harrison. “It’s unlikely that it will pass because it is such a radical change from our current tax code.” Some groups like this idea, like the President’s voting base, Harrison noted – but they might feel differently if it became reality. “If you had to pay 20% more for imported energy, then all those rural voters who rely on cheaper gas are the ones who will feel the effect,” she added.

A European-style Alternative

“The original idea, which came from the concept of a value-added tax, is a good one,” said Harrison. “In theory, if it’s done correctly, it should be neutral [in its effects] in that it doesn’t favor one group or another.” But the version presented in Congress is protectionist, she added. One alternative for the U.S. is to move to a European-style value added tax, said Harrison. “[The U.S.] version does discriminate against imports in a way that the French value-added tax does not,” she added.

The U.S. could also try boosting tax revenues elsewhere such as focusing on getting U.S. companies to bring back profits they retain overseas in more tax-friendly regimes, said Knoll. He also called for “comprehensive” tax reforms instead of piecemeal actions.