Op-Ed: Decoding Tax Reform and the Border Adjustability Dynamic

They tell us that three things are inevitable in life: death, taxes and change.

This year, if the political pundits are right, we can add a fourth certainty: tax reform.

Updating the U.S. tax system—which has been characterized as burdensome, complicated and antiquated—has become a unifying principle of the leadership in Congress and the incoming Trump Administration. Just about everybody agrees that tax reform needs to get done, just about everybody agrees the political climate is ripe for it to get done, and just about everybody agrees on why it should be done.

But there is widespread disagreement over exactly what tax reform should entail. Moreover, as is often the case in Washington, such commonsense endeavors can become a Trojan Horse for proposals that are controversial. The 2017 tax reform discussion is no exception.

Back in June, when House Republicans unveiled their tax reform blueprint, they included a proposal known as border adjustability. The goal of the proposal was noble. The drafters want our tax system to remove disadvantages created by other countries’ tax systems, to enable U.S. companies to be internationally competitive and to close loopholes that allowed U.S. companies to move taxable income offshore.

Closer inspection reveals a terrible price to pay—one that would be disastrous for most footwear, apparel and accessories companies given our industry’s dependence on imports (where 97 percent to 98 percent of all clothes and shoes are made offshore) and tight margins. Importers lose the right to deduct their cost of goods sold (COGS) as a business expense. Yes, you read that right.

Under the “A Better Way” blueprint, overall taxes would drop to 20 percent (or 25 percent for “pass through” companies) down from the current 35 percent. Sounds great. And revenue associated with exports will be entirely exempt from taxation. Sounds better. But all COGS associated with imports will no longer be eligible to be deducted from a company’s income. This means that companies will end up paying an extra 20 percent tax on the cost of all their imports, including those originating from free trade areas or those that contain U.S. content.

 Let’s look at an example to see how this works.

Suppose “Company Z” made $250 million in revenue, which it earned by reselling $200 million in imported shoes and clothes. Currently it can deduct the overhead costs—say $20 million—as well as the import costs, paying tax on the remainder. In this case it would pay tax on $30 million, or about $10.5 million at a 35 percent tax rate. After tax profit is about $19.5 million.

Under the “A Better Way” plan that includes border adjustability, the $200 million cost is no longer subtracted before the income taxes are assessed. Although the tax rate drops to 20 percent, this rate is assessed on the much higher income base of $230 million (total revenue minus overhead). The resulting tax is an astounding $46 million, more than four times the previous example and much more than actual profits.

And this isn’t even an extreme example. Under border adjustability, a company with a high import bill that lost money in a single year would still have to pay a huge tax bill. That doesn’t seem right.

Border adjustability proponents argue that these examples are misleading because a strengthening dollar combined with the natural changes in supply chains will offset any price increases. They also believe that the overall gains will outweigh any losses in the long term as the U.S. economy becomes more competitive and adds more jobs. But those explanations provide little assurance, especially since most apparel and footwear imports are purchased in dollars.

To that point, our recent experience with the dollar’s appreciation over the past two years didn’t generate the kind of savings those economists’ models would have predicted. The more likely scenario is that this change causes profound disruption in global supply chains with adverse pricing and employment effects being felt throughout the United States. In other words, retail prices increase sharply and people lose their jobs.

Our trading partners may have something to say about this too. They are unlikely to sit idly while the U.S. attempts to change the terms of trade. In the short term, countries may exact counter measures in the form of tariffs on U.S. exports. In the longer term, the U.S. is likely to see a challenge in the World Trade Organization (WTO), since this plan would appear to violate several key WTO principles.

If successful, a WTO challenge would enable other countries to legally impose punitive tariffs on U.S. exports. This would be especially damaging to the U.S. textile and apparel industry, which is usually singled out for such punitive tariffs. Of course, some countries may not wait for the WTO in the face of aggressive action by the United States, taking retaliatory action right away.

Next steps for the border adjustment concept are murky. Although the House Republican leadership has proffered this proposal, it has not been embraced by others in the Congress. President-elect Trump has signaled skepticism with Border Adjustability, although some proponents argue it is consistent with his Make America Great themes.

Probably most importantly, there are few details on exactly how this proposal will work. Yet the questions are many. For example, will there be a transition and if so, for how long? Will import duties be included as part of the COGS (meaning there could be a double tax situation where one will pay an income tax on the tariff it paid)? Some of these may be answered soon. House Republican leaders are hoping to unveil draft language in the coming months.

 So where does this leave the industry? Back in June the House Republican leadership asked for input when it released its plan. “We will be listening,” they declared, adding, “House Republicans believe it’s time for a change. It’s time, America, to let your voice be heard.”

Our industry needs to answer that call. Loudly and insistently. Now is the time to speak up to ensure that tax reform is done in a way that benefits our companies and our industry.

Otherwise, changes in taxes might be the death of us all.