In June 2016, as part of Speaker Paul Ryan’s “Better Way” initiative, the House Ways and Means Committee rolled out its “Blueprint” for tax reform. This broad overview outlined Republicans’ talking points for the campaign trail and the anticipated showdown with the Clinton White House, if not a Democratic Senate majority.

After a false start with the ill-fated Camp Draft, expectations were tempered for legislative action. The topline items read as a veritable wish list of pro-growth provisions that were hailed by tax coalitions and trade groups alike. The tradeoffs were largely ignored, with any prospective pushback muted by dismal electoral expectations. After an initial burst of coverage, the Blueprint receded as Congress left town, leaving all eyes trained on an increasingly surreal presidential race.

Amid the aftershocks of the ensuing electoral earthquake was the realization that the Ways and Means Committee was suddenly armed with live ammunition. Lulled to sleep by six years of kabuki, the sleeping giant of tax reform had suddenly awoken. And as the House maintains sole constitutional authority to originate tax bills, the Blueprint now represents the de facto foundation for the best chance at a fundamental rewrite of the code in more than three decades.

What’s in the Blueprint?

First, it’s worth looking at the consensus positives. The Blueprint slashes marginal tax rates across the board for individuals and corporations alike. The most dramatic relief occurs on the corporate side, where the top rate would drop from a high of 35 percent to 20 percent. And for the first time, pass-through entities such as

S corps and LLCs would see their top rate on business income cut by a similar proportion, from 39.6 percent to 25 percent.

Beyond the rate cuts, it scraps the current depreciation schedule in favor of full, first-year expensing of capital investments. It fully repeals the death tax and the alternative minimum tax (AMT).

But to do all of this without exploding the deficit, even using a dynamic analysis that gives credit for significant growth, there must be a catch. The refrain is that the United States needs to lower rates while broadening the base. Everybody is for it in the abstract, until the base broadening starts to cut into their bottom line. This is where “border adjustability” comes into play.

The most novel and misunderstood—and arguably indispensable—aspect of the plan is border adjustment, or what tax professionals call a destination-based cash flow tax (DBCFT). Import-reliant retailers hate it, export-heavy domestic manufacturers love it and everyone else is still trying to decipher the acronym.

What a border adjusted system means in practice is that the corporate layer of tax is applied (or not) depending on where the goods or services in question end up. Receipts from the sale of imports and domestic products are treated the same for tax purposes, but only the cost of the domestic goods may be deducted. Export sales are exempt regardless of the origin. Put another way, the DBCFT ignores both foreign expenses and foreign revenues.

The point of the border adjustment element is not merely to raise revenue, though the $1.2 trillion it is projected to raise during the first 10 years certainly helps to finance some of the goodies. The adjustment represents a structural reform necessary to fix the international side of the code. By ignoring cross-border transactions and focusing only on where the consumption occurs, the DBCFT removes the incentive for profit-shifting and international gamesmanship by U.S. multinationals.

The Devil Is in the Details

If this all sounds very complicated, it’s because it is. None other than the president of the United States initially dismissed the idea as “too complicated,” leading House leaders to rebrand their idea and tailor their marketing and messaging to an audience of one. Instead of border adjustment, there’s talk of ending the “Made in America” tax, a nod to the fact that 160 other countries already have a similar tax in place on U.S. exports. In this telling, the DBCFT is simply a means of leveling the playing field.

Depending who you ask, border adjustment is being hailed as a panacea for America’s trade woes or cursed as a consumer apocalypse. The truth ends up somewhere in the middle, depending on the expectations of the economic effects. While this system puts a thumb on the scale for domestically sourced goods, especially those bound for other countries, it differs from a
tariff in important ways—not the least of which in that it would be permissible under the United States’ international trade obligations.

Further, any effects on the trade balance would be muted by the reaction of the currency exchange market. Inflationary pressure would mitigate the rise in prices for imports as the relative cost of foreign goods drops; the only question is how much and how fast. In classic economic theory, there will be no net change due to the immediate adjustment of the dollar. And if a business does have to absorb a hit on its import costs, a 40 percent cut in its income tax rate makes for decent medicine.

Ultimately, border adjustment is a simple, elegant and rather clever attempt to ease the various policy, political and regulatory tensions at play. Taken by itself, the policy may not be a winner, but it’s essentially the glue that holds the entire Blueprint together. To get the low rate, the expensing and the estate/AMT repeal, you have to accept the DBCFT or the whole thing unravels and you’re back to square one. Just like anything else, the devil is in the details, and it remains to be seen how the rules will apply under certain circumstances. But one thing is for sure: Border adjustment is here to stay in the House plan, and right now that’s the only locomotive coming down the track.