Trump's border-adjusted tax: how Europe would react.

• Author: Fuest, Clemens

U.S. President Donald Trump has repeatedly warned that he is no longer willing to tolerate trade deficits with countries such as China or Germany. To bring down those deficits, he wants to punish foreign companies which distribute their products in the United States, but do not produce there. He wants them to pay an import tax of 35 percent. He has not yet explained how he plans to implement this tax.

There are, however, strong indications that he may adopt a reform plan put forward by Speaker of the House Paul Ryan (R-WI). Instead of customs duties, the plan outlines far-reaching reforms in the taxation of corporate profits. Interestingly, the tax plan is an academic idea. It is based on a proposal developed by the Oxford-based economics professor Michael Devereux called destination-based cash flow tax (DBCF tax). If implemented unilaterally, the effect of the reform is similar to the effect of introducing a tariff. This would have adverse consequences for both U.S. trade partners and the United States itself. The reform could even trigger a trade war. In contrast, if the new tax is implemented internationally, the plan would revolutionize the global tax system. The new system would have a number of advantages compared to the existing system. However, it would also have significant redistributive effects.

How does the new tax system work? The reform would bring about a number of changes, including immediate write-off of investment goods, rather than depreciation over a longer time period. The core of the reform, however, is a border tax adjustment that has only existed in value-added tax to date, but not in taxes on income or corporate profit. Let's look at the example of exporting a vehicle from Germany to the United States. The exporting company incurs production costs of [euro]30,000 in Germany, gives the vehicle an export value of [euro]40,000, incurs [euro]5,000 in distribution costs in the United States, and demands a sales price of [euro]50,000. To date the company has been taxed on profits of [euro]10,000 in Germany. In the United States, it makes a profit of [euro]5,000, which corresponds to the sales price minus the costs of the imported car and its distribution. According to the new U.S. tax system, the costs of the imported car would not be tax-deductible any more, so the taxable profit on the car in the United States would amount to [euro]45,000, leading to a huge increase in the tax burden.

A key question is: how might...