Many academic economists argue that a destination-based tax, such as a value-added tax (VAT) or cash-flow tax, will not have competitive effects due to offsetting changes in exchange rates. Many businesses are concerned about the economic effects of a destination-based tax that includes a “tax on imports.”
An old paper by Martin Feldstein and Paul Krugman, “International Trade Effects of a Value-Added Taxation”, helps explain some of the disconnect between the thinking of academic economists and business. Academic economists generally assume that a VAT would apply to 100% of final household purchases. In fact, few VATs are comprehensive. The most recent OECD Consumption Tax Trends publication reports that only 56% of final household purchases are subject to VAT in OECD countries with a VAT. Thus, a VAT causes distortions across products, services, and industries, plus any exchange rate adjustment is not fully offsetting the tax paid by importers.
A destination-based cash-flow tax (DBCFT), similar to the House Ways and Means Republican’s A Better Way tax reform proposal, would introduce another reason why exchange rates would not adjust for the full tax rate. Unlike a VAT, a DBCFT provides a deduction for origin-based employment compensation. While an imported good would be taxed on the full sales price (or not deducted by an importer), a similar domestically produced good would only be taxed on the non-labor value added. Again, the academic argument is that exchange rates will offset the difference, but since labor intensity differs across products, services and industries, an exchange rate offset may occur on average, but with differing effects across products, services and industries.
Thus, similar to most tax reforms, there will be winners and losers depending on the specifics of the actual tax design. For instance, a comprehensive VAT, similar to New Zealand’s, will have fewer distortions than the typical VAT. It should be noted, that the typical credit-invoice method VAT prevents a zero-rated or exempt activity earlier in the supply chain from reducing the final tax on household consumption goods or services. A subtraction method VAT, similar to a DBCFT with a deduction for labor, however, results in differential final good prices depending on the amount of exempt or zero-rate activities in the value-chain. In addition, tax losses to exporters are often not refunded fully, and the differential effect of the taxes or spending replaced, will also differ by industry.
Businesses should focus on both the positive and negative economic effects of a destination-based tax, since exchange rate changes are unlikely to fully offset non-uniform features of the tax. Academics are correct in noting that some of the effects will be offset by a change in exchange rates, but an ideal tax is unlikely to be the tax businesses will have to live with, and there will be winners and losers.