One concern voiced about the destination-based cash flow tax (DBCFT) is that the border-adjustment feature may not be compatible with World Trade Organization (WTO) rules. Although much of the current discourse on the topic is muddled, the border adjustment feature of the DBCFT proposal is not intended to be trade policy (and, as we have discussed before, many economists believe that it should have no impact on trade). Instead, it is intended to be tax policy – i.e., a means to achieve territoriality within a cash flow tax-based system, taxing only cash flows associated with consumption in the United States.

It is on this basis that House Speaker Paul Ryan and House Ways and Means Committee Chairman Kevin Brady (R-TX) have repeatedly defended the proposition that the DBCFT is a consumption tax that meets WTO standards. So, why do critics think that the border-adjustment feature of the DBCFT may run afoul of WTO rules? And what are the implications if it does?

Why the Concern?  The WTO rules generally permit border adjustments for indirect taxes but not for direct taxes, but the distinction is not entirely clear.

WTO rules define “direct taxes” as “taxes on wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property,” and “indirect taxes” as “sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and import charges.” Past WTO/GATT reports have indicated that the distinction lies in whether the tax is levied directly on a product.  Taxes implemented as a credit-invoice VATs clearly fit within the definition of an indirect tax, but it is less clear where non-traditional consumption taxes, like the DBCFT, fall.

Japan’s border-adjusted “subtraction-method VAT” has been in place since the early 1990s without serious objection from WTO members, even though, like an income tax, it is imposed directly on corporate sellers (determined based on revenue minus purchases) and not on consumers. The DBCFT has been described as economically similar to Japan’s border-adjusted subtraction-method VAT, despite the hesitation by lawmakers to call the DBCFT a VAT. This similarity helps support the argument that the DBCFT is an indirect, not a direct, tax.

However, the DBCFT has an additional feature not found in Japan’s system – it permits a deduction for domestic wages in computing the cash-flow tax base. In addition to making the DBCFT look more like a direct (income) tax, the wage deduction feature of the DBCFT could also be viewed as an imbedded wage subsidy on domestically-produced goods that is not available for imports, potentially in violation of WTO rules in its own right.

Is WTO challenge a certainty?  Details of the House Republican proposal are still being hashed out, and it is conceivable that lawmakers will attempt to adjust the mechanics of the DBCFT to better withstand a WTO challenge. House Ways and Means Committee Chairman Kevin Brady recently stated: “This will be written in a way that is WTO-consistent and compliant. And we will prevail in any challenge that they bring.”

Notwithstanding Brady’s optimism, a number of commentators have argued that a successful WTO challenge is a near certainty. Interestingly, other commentators have suggested that WTO members might be reluctant to challenge a U.S. enacted DBCFT for fear that the U.S. response might be to threaten to withdraw from the WTO, which would blow up the WTO if other major economies follow suit. Others have noted that some disputes might just be too “big” for the WTO dispute settlement process. As an example, Gary Hufbrauer, a senior fellow at the Peterson Institute for International Economics recently noted that the United States chose not to bring a WTO challenge against China’s currency manipulation out of concern for the implications for monetary policy.

What Happens If There Is a WTO Challenge?  The short answer is nothing, at least for a while. The dispute resolution procedures adopted by the members of the WTO provide that members must first attempt to settle their dispute through consultations. If those fail, the complaining member can request a panel to examine the dispute and issue a report (i.e. a determination that a member’s policies do or do not violate WTO rules). The rules also provide for an appellate body to review panel reports and panels to determine if a defending member has complied with an adverse WTO decision by the established deadline. This process could take years.

A WTO finding that a U.S. law or practice violates WTO rules has no direct legal effect in the United States, and U.S. courts have treated determinations involving “whether, when, and how” to comply with a WTO ruling as within the purview of the executive branch. The WTO cannot unilaterally prevent a sovereign member from pursuing what it believes to be sensible policies.

But, if the U.S. were to enact the DBCFT, and the DBCFT were to be successfully challenged by another WTO member, and the U.S. failed to take measures to bring the DBCFT into compliance within established deadlines, the WTO could authorize the imposition of sanctions and other retaliatory measures against the U.S. (which the WTO otherwise prohibits). The average length of a dispute in which sanctions are approved is seven years.

Lessons from the Past.  To illustrate how a WTO dispute process might unfold, we created the timeline below which tracks the DISC/FSC/ETI controversy, sparked by the 1971 enactment of provisions that subsidized exports of U.S.-made goods through the Domestic International Sales Corporation (DISC) Act. Three months after Congress passed the DISC Act, the European Community (the precursor to the European Union) challenged the DISC as in violation of the GATT. The U.S. responded to adverse determinations by repealing the DISC legislation and enacting the Foreign Sales Corporation Act provisions (FSC), which were also challenged. The U.S. responded again by replacing the FSC provisions with the Extraterritorial Income Act provisions (ETI). Thirty five years later, the dispute ended with U.S. repeal of the final elements of the ETI.

Click here to view a pdf version of the timeline.