Testimony:  The Rebate of Value Added Taxes at the Border and the Competitive Disadvantage for U.S. Small Business  
Maya MacGuineas

For the House Committee on Small Business
July 7, 2005

Summary:  Comprehensive tax reform would be a far better way to address the problems created by repealing trade subsidies than the targeted tax relief Congress is currently considering.


Good afternoon, Mr. Chairman and members of the Committee. My name is Maya MacGuineas and I am the Director of the Fiscal Policy Program at the New America Foundation. I am also the Executive Director of the Committee for a Responsible Federal Budget, which is now housed at New America, and the Chair and Co-founder of Centrists.Org. Thank you for the opportunity to testify.

 

As you are all well aware, it is the case that while European exporters benefit from rebates at the border on their value-added taxes, parallel tax relief for U.S. companies has been ruled illegal by the World Trade Organization. This is due to the distinction international trade law draws between the value-added taxes used by most nations and the corporate income taxes that U.S. firms are subject to. Accordingly, FSC/ETI benefits for U.S. companies appear to be on track to be repealed.

 

There is considerable debate about whether border adjustments affect the competitive trading positions of nations. On the one hand, general economic theory holds that in a system of floating exchange rates, changes in tax levels are offset by changes in exchange rates. Under this line of thinking, even for countries without floating exchange rates, rebates are not believed to make a difference in the long run.

 

On the other hand, were this true, it would not matter to our trading partners whether their VATs were rebated at the border – and yet it does matter and they are rebated. In the real world, exchange rate movements can be quite sticky. Not only are relative exchange rates affected by a variety of economic factors, the timing of such changes can be quite unpredictable.

 

So, as is so often the case when it comes to theoretical predictions, we cannot know for sure whether the economic relationship between border adjustments and exchange rates holds true, nor can we know for sure the extent to which U.S. companies will actually be harmed by the WTO ruling.

 

Either way, the current tax bill making its way through Congress is premised on the belief that U.S. companies will be severely disadvantaged by the change and the bill therefore includes compensatory measures. It is true that the corporate tax bill does little to help small businesses in particular, which are less able to absorb general overhead costs and do not benefit from economies of scale that many of their larger competitors do. From the perspective of the Committee, that may well be problematic. Similarly, it is true that the benefits of the bill are spread quite unevenly, with some sectors benefiting a good bit more than others.

 

No matter the extent to which U.S. companies will be harmed by the tax law change, I would argue that targeted tax relief as is included in the FSC/ETI bill is not the right approach to remedying the problem.

 

Already, the cost of the bill is quite expensive. And it is likely to be more expensive than current projections since many of the expiring provisions would undoubtedly be renewed. Since the costs will increase budget deficits, thereby decreasing government saving, the effect could actually be to worsen our trade balance.

 

Furthermore, the general approach of targeted tax relief de-levels the playing field between U.S. companies. Distorting the tax code to favor particular sectors of the economy may be politically appealing but it is not good policy, nor does it help American consumers or the economy.

 

Finally – and I will not mince words here – this bill has become an egregious example of how effective special interest lobbyists have become, filling the package with expensive, unnecessary and unjustified corporate handouts, and any pretense that this constitutes good tax policy was lost long ago.

 

But out of the need to alter our tax policy comes an opportunity.

 

The money saved from removing the illegal subsidy could be used to either reduce the deficit, or help sweeten a comprehensive tax reform deal along the lines of what we saw in 1986, which would include eliminating many existing loopholes and subsidies while lowering corporate income tax rates.

 

Another desirable option would be to introduce a consumption tax, which could be adjusted at the border, to replace income taxes. Consumption taxes have a number of benefits including of course, that they would increase national saving. If we want to improve our trade balance, not to mention longer-term economic performance, improving our national saving rate could play a critical role in that endeavor.

 

At the same time, most consumption taxes, such as sales taxes, tend to be highly regressive, whereas the existing income tax at both the corporate and individual level is quite progressive. Efforts to reduce the regressivity of sales taxes by exempting certain goods deemed necessities such as food, clothing and medicine can cause tremendous distortions in consumer markets.

 

However, it is quite possible to institute a progressive consumption tax that would maintain existing tax burdens (or even make them more progressive if desired) rather than shift the burden down the income scale.[1] My time here is short today so I will not go into the details of how this might work, but a progressive consumption tax is desirable not just with regard to tax treatment and trade issues, but in its ability to balance the oftentimes competing tensions of tax efficiency and tax equity.

 

I would be happy to follow-up with you on any of the issues I have raised here today. Thank you again for inviting me to testify, I look forward to your questions.

[1] For more details of a progressive consumption tax proposal, please see “Radical Tax Reform” by Maya MacGuineas in the Atlantic Monthly, January 20, 2004 and “A Tax Plan for Kerry” by Maya MacGuineas and Ted Halstead in the Washington Post, May 24, 2004. While this proposal focuses on using a progressive consumption tax to replace payroll taxes, the tax could instead be substituted for income taxes, or both income and payroll taxes.

Links:
Centrists.Org The FSC-ETI Bills Highlight the Need for Tax and Budget Reform (revised July 6, 2004)  The Senate-passed FSC-ETI bill includes a  tax reform commission to begin the process of simplifying and rationalizing the tax code, especially for corporate and international taxation.

Centrist Policy Network Some Bigger Ideas for the Presidential Race (January 26, 2004)