Are markets predictable enough for a border-adjusted tax to be revenue neutral?

The first shot of the modern “Showdown at Gucci Gulch” was fired on June 24, 2016. That’s the day Republicans in the U.S. House of Representatives released their tax reform “Blueprint.” A keystone of the Blueprint is the DBCFT, or destination-based cash flow tax. This is known publicly as the “border-adjusted tax.” The tax is an inventive VAT-esque plan that would essentially replace the U.S. corporate income tax. It would allow business taxpayers to immediately expense capital assets instead of deducting them after amortization. It would also eliminate the interest deduction. But the completely new aspect of this tax would be to deny corporate tax deductions for imported goods or services while exempting corporate revenues from exports; hence the “border-adjusted” moniker.

Mainly through op-eds, scholars such as Martin Feldstein, Paul Krugman, Alan Auerbach, Douglas Holtz-Eakin and Michael Devereux have touted the tax as a simplification that should appeal to Republicans and Democrats alike. Their starting point is that the U.S. corporate tax system is broken and the border-adjusted tax is the solution. They have been persuasive in addressing criticisms of the tax from various camps, including importers, progressives and free-market advocates.

What they do not address in general are the market predictions necessary to make the tax revenue neutral. Many of these same economists predict the value of the U.S. dollar increasing 25 percent relative to foreign currencies almost immediately after instituting the tax. If the dollar experiences the 25-percent boom, there will be no price increases as a result of the tax’s enactment.

That’s a big “if.”

Assuming the linear analysis is sound from “tax plan” to “dollar increase” in a paper model, what about the system of tax compliance in between these two points? There is evidence that we should regard tax compliance as a “wicked system;” one beyond merely the simple, complicated, or complex. Wicked systems are highly unpredictable in that results from controlled inputs often deviate from expected outputs that would otherwise result from linear systems. This in turn can collapse an entire enterprise. For example, if we place the initial condition X into a wicked system and our reasonable, linear expectations are that we get Y as a result, it is very possible that we will instead get Z (or more importantly, not Y). If we are depending on getting Y as the output that made developing X in the first place rational and cost-effective, getting Z might be disastrous for our project.

This notion of a wicked system springs from the now-ubiquitous concept of a “wicked problem.” First introduced as a label in 1967 by West Churchman’s publication discussing Horst Rittel’s articulation of management problems without generally-applicable solutions, Rittel further developed the characteristics of wicked problems as they apply to social planning and policymaking with co-author Melvin Webber in 1973.  In this paper, the authors note that every solution to a wicked problem is a “one-shot operation” since there is no opportunity to learn from trial and error. Also, wicked problems do not have well-defined solutions that one can list out or accurately calculate. A wicked system, then, is a social structure that generates systemic wicked problems.

To be clear, it is not the tax reform plan to have a border-adjusted tax that is the wicked system. It is tax compliance that is the wicked system in that the actions taken in between the tax reform plan’s launch and its linearly-analyzed results can send these results wildly off course. Consequently, the best that we can predict in instituting the tax as policy is that certain results will take on various measures of probability, but all of the results will be far from certainty.

Another wicked system that has a similar aim of tax reform in that it attempts to solve a large-scale problem is cloud seeding. Cloud seeding is similar to tax reform in that the analysis from initial silver-iodine seeding to final precipitation yield (or hail intensity reduction) can be modeled linearly. Yet, it is the “in between” system of the weather that is the wicked system that can take the seeding as input and generate an output quite different than that expected from the models. In fact, it was our early attempts to control the weather after World War II that led to the discovery of what we now call chaos theory. Simple models that generated highly-predictable results changed wildly if the inputs differed, not significantly, but at the nth decimal place. Recognizing this, the cloud-seeding industry no longer seeks to predict the precipitation yield with anything close to certainty. In fact, the investment is profitable if the yield is only 10 percent of the projections.

Can we conclude the same about the border-adjusted tax as cloud seeders do about their precipitation yields? Most likely not. The economic analyses that predict the immediate 25-percent increase in the dollar fail to include the effects of the wicked system known as tax compliance; that “in between” reality of aggregate human action that is as (un)predictable as the “in between” weather systems for cloud seeders. The difference is that cloud seeding remains a profitable venture if the precipitation yield is only a fraction of the model’s projections. Can the border-adjusted tax venture still produce revenue-neutrality if tax compliance reduces economists’ projections to a fraction of the 25-percent increase in the dollar’s value? Tax policy drafters have the public duty to at least ask and attempt to answer this question before implementing the new tax; especially since significantly different economic results can prove ruinous for the current tax reform project.

Proponents of the tax are correct in stating that our corporate tax system is broken. Still, it would seem wiser for tax policy makers to realize from go that long-term market results will most likely look different from a model’s forecasts. We must be confident not in the economic predictions, but in the high probability of the realization of the tax reform plan’s objectives even if/when these economic predictions prove inaccurate. This is true even under a White House “Plan B” that tweaks the proposed tax. Any Plan B will also face the same wicked tax compliance system if its constituent parts are enacted regardless of its exclusion of the border-adjusted portion.

The solution? By definition, that’s not easily articulated. But finding a solution begins by neither rationalizing nor justifying any part of tax reform as “revenue neutral” based on the prediction that markets will respond to tax stimuli in a linearly-predicted fashion. Can we pay for the border-adjusted tax without a relative value increase of 25 percent in the U.S. dollar? In other words, can we pay for this tax in a way that doesn’t rely on the market’s actions (which include the wicked system of tax compliance) to be linearly predictable, much like the cloud seeding industry has done? If so, then the proponent economists are correct that the border-adjusted tax very well might fix the broken U.S. corporate tax, at least in part, by making U.S. corporations more competitive globally. But if the success of the tax depends on the 25 percent increase, the wicked compliance dynamic might very well deliver a drastically different result to the U.S. dollar’s relative value. We would then have a new broken system to fix.

Given tax compliance as a wicked system, the choice between tax reform Plans A and B with a dependence on a very specific market reaction is most likely to result in Plan 3. The question that policymakers must attempt to answer is whether the Plan 3 result will still make the initial plans revenue neutral. If not, then we need to face the fact that the border-adjusted tax might very well increase the U.S. deficit.

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Jack Manhire

Jack Manhire is a faculty member at the Treasury Executive Institute in Washington, DC, which is part of the U.S. Department of the Treasury. Some of his prior positions include Chief of Legal Analysis for the IRS Office of Professional Responsibility, Director of Technical Analysis & Guidance (Policy and Procedure) for the IRS Taxpayer Advocate Service, and Attorney-Advisor (Tax) to the National Taxpayer Advocate. Before entering government service, he practiced law privately for over a decade, primarily in the field of federal tax controversies.
Jack lives in Virginia with his wife and nine children. He enjoys weight lifting, scotch and cigars with good friends, the intersection of theology and cosmology, anything nautical, and singing really loudly to classic rock on the car radio.
 

 Jack Manhire
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Treasury Executive Institute

The Treasury Executive Institute (TEI) provides continuous learning and growth opportunities that meet the learning needs of Treasury Department executives, executive development candidates, and senior managers. TEI brings executives to the marketplace of ideas by exposing them to best practices in leadership models, new technologies, and executive competencies. TEI programs have provided both education and knowledge sharing opportunities among executives throughout the Treasury Department since its creation in 1983. 

 

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