The US Congress and the Trump Administration agree that the US corporate tax system is a drag on the competitiveness of American companies and the American economy. Tax reform is therefore a top priority for 2017.

Under current law, corporations are taxed on their income earned worldwide and the U.S. top rate of 35 percent is the highest among advanced economies.

But the United States is the only industrial economy to maintain a worldwide system, which encourages American corporations to move their headquarters operations out of the country (inversions), and discourages them from bringing their foreign-earned profits home for re-investment.

Previous reform proposals pushed for a territorial system, taxing income where it is earned. Territorial systems commonly used by major economies are more efficient and eliminate the incentives to move legal headquarters. Territorial taxation can, however, be subject to attempts to shift profits to low-tax jurisdictions, known as “base erosion.” Consequently, such proposals are usually accompanied by rules that attempt to limit profit-shifting activities.

Shifting to Destination-Based Taxation

House Republicans have developed a tax blueprint called a “Better Way” that would enact a destination-based tax on cash flow.

Instead of taxing worldwide income (the current law) or taxing income in the jurisdiction where it is earned (a territorial system), the House plan would tax companies’ cash flow where their goods and services are sold, regardless of where production, management, or income is located.

Further, the destination-based system proposed is border-adjustable. In simplest terms, the destination-based cash flow tax would impose a flat 20 percent tax rate on earnings from sales of output consumed within the United States.

How does this affect companies? Since the tax falls only on output consumed in the U.S., the cost of imported materials would no longer be deducted from taxable income (as part of the cost of goods sold), while all revenue from exports would be deducted and therefore not subject to federal tax.

It’s All About That Base

Why are House Republicans proposing this change? First, this approach eliminates the distortions of a worldwide system without needing new rules on base erosion.

Second, and probably more important, the cash flow tax broadens the tax base dramatically. Because the U.S. currently runs a trade deficit of about $500 billion per year, border adjustment would generate nearly $1 trillion in additional revenue over a ten-year period.

Broadening the base is critical to achieving lower tax rates, from 35 percent to 20 percent, (and a range of other pro-growth reforms like expensing of capital spending) while staying close to revenue neutral. A conventional tax on income does not offer enough base-broadening measures to deliver a large rate reduction.

The House “Better Way” proposal is likely the starting point for a debate on tax reform, and a change of this magnitude may or may not survive the legislative process.

Back to Trade Policy

Individual firms will do their own assessment of the effects on their business. Exporters will probably find a cash flow tax beneficial. Importers including retailers, oil refiners, or apparel companies will probably see the proposal as a major tax hike.

The fact that differently-situated companies will face different effects may divide the business community, cutting into the nearly unanimous support for pro-growth tax reform.

Moving away from income taxation to something closer to (but not precisely) a tax on consumption is clearly a substantial policy change. It’s also one that is big enough to affect trade flows, and therefore likely to spark trade controversy.

Is an Adjustable Border Tax Protectionist?

Proponents say, “no,” that the tax is neutrally applied based on where the good or service is consumed.

But there would be an incentive to import less. Also, in the near term, the change may boost inflation, as importers raise their prices to suppliers and consumers to maintain margins.

Medium-term, currency exchange rates will likely adjust to absorb some of the impact, which would lead to an even stronger U.S. dollar.

Does an Adjustable Border Tax Square with US Trade Obligations?

WTO rules permit border adjustments for indirect taxes, such as credit-invoice value-added taxes (VATs). But the House plan operates like a direct tax, and it’s a near certainty that it would be challenged by trading partners.

Many of us recall the 2002 WTO case in which a US provision regarding tax treatment for Foreign Sales Corporations was found contrary to trade rules, leading to a change in U.S. tax law. The United States could be vulnerable to losing a WTO case on border tax adjustability. The Trump administration and Congress would have to make some decisions that could include repealing border adjustability, or turn the cash flow tax into a subtraction-method VAT, or ignore the WTO ruling altogether, which would give other nations the right to retaliate.

Stay closely tuned to forthcoming policy debate. The plan raises important issues about tax competitiveness, but also broader U.S. economic engagement with the world.

Scott Miller is a senior adviser and holds the William M. Scholl Chair in International Business at the Center for Strategic and International Studies. Miller was previously the director for global trade policy at Procter & Gamble.