With Donald Trump now as the president-elect and Republicans controlling both houses of Congress, a tax reform is looming in the United States.
It is expected that the tax reform will cause a shift in global trade, something which is of grave concern to countries trading with the US, such as Malaysia, but the impacts could be greater than expected, depending on how the reform is undertaken.
One main theme of Trump’s campaign is jobs and growth. To deliver his election promises, Trump is expected to kick off a major tax reform, once he is sworn in as president on Jan 20 next year, to spur economic growth and attract US companies to move production lines onshore.
There are currently two tax reform proposals on the table, one is by the Trump team and another is by the Republicans in the Congress. Although both call for massive tax cuts, they are different in many respects, particularly in regard to corporate tax.
Trump’s plan for tax reform is rather a conventional one. It is basically Reaganomics. It promises a cut to corporate tax from the existing 35 percent to 15 percent.
At the same time, it would also provide a one-time tax holiday to US firms to repatriate earnings held overseas with only a 10 percent payment, rather than the usual rate of 35 percent
Through such measures, it is hoped that trillions of dollars now parked overseas would be instantly brought back into the US economy (One estimate puts the figure of US firms’ unrepatriated overseas earnings at US$2.6 trillion).
Then, the trickle-down effect to the economy would kick in – more domestic investments by US firms and thus more jobs for US citizens.
‘Border adjusted’ tax
The congressional Republicans plan is, however, far more aggressive. It would possibly rewrite the US corporate tax system and have far-reaching implications on global production patterns.
The crux of the plan is a destination-based cash flow tax, which would replace the existing corporate tax regime.
This new form of corporate tax has been discussed by academicians and economists for some time, but only grabbed public attention recently when it was introduced as part of the tax overhaul proposed by the congressional Republicans in June.
Like the Trump plan, the congressional Republicans plan proposes a massive cut to corporate tax rate, from the existing 35 percent to 20 percent. But, the destination-based cash flow tax would also overhaul how corporate income is taxed in US.
A key feature of the destination-based cash flow tax is that the corporate tax is to be “border adjusted”. It means that corporate income would now be taxed only at the place of consumption (destination), rather than the place of production (origin).
In other words, US companies would only be taxed when their products are sold for domestic consumption. They would no longer need to pay corporate tax if their products are exported to other countries.
On the contrary, any proceeds from US imports would be liable to corporate tax. Any company that exports its goods and services to US customers would have to pay 20 percent of its profits to the US tax authority.
The easiest way to understand the new tax is to think of value-added tax (VAT). Both are similar in principle – they are levied at the destination, rather than the origin. But, the working mechanism is totally different to the VAT.
For VAT, the source of inputs has no bearing to its calculation. Regardless of whether the goods or services are produced domestically or in overseas, the tax you pay should be theoretically the same. But, this is not the case for the destination-based cash flow tax.
Discriminatory to offshore production
In calculating the taxable profits for destination-based cash flow tax, the input costs would also have to be “border adjusted”. It means that only those costs from local inputs would be deductible against corporate income and all costs from foreign inputs would be excluded.
This is where the impact on global trade would kick in, with greater economic advantage for domestic production in the US.
For example, assuming one US company imports product A from overseas at a cost of $70 and sells it in US market at price of $100, the taxable profit under the current corporate tax regime would be $30. But, under the new regime, the taxable profit would be higher, at $100, because the costs of foreign inputs would not be deductible.
This would mean that companies with productions offshore could risk facing a higher tax payment, even though the tax rate would also be reduced as per the plan.
As the costs of producing offshore increase, this would provide greater incentives for companies to move their production lines back to US.
As Adam Creighton of The Australianargues: “It might well be cheaper to make goods in China and export them to the US now, but it might not be when those costs of production are no longer tax deductible.”
This observation applies to goods currently produced in Malaysia as well.
There already are concerns that the Trump presidency would spark a trade war and the new destination-based cash flow tax will only intensify it.
Critics have already pointed out that the tax might violate World Trade Organisation (WTO) rules, particularly the national treatment principle, as it discriminates companies that produce offshore.
Given Malaysia’s integration into global value chain and with the US being in our top three trading partners, this process is something which we need to keep a close eye on.