Why Mexico will pay for the wall and not mind doing it

In recent weeks, I have been doing presentations on the economy. I find that many of the people who come to these presentations share a similar problem. They have woken up that morning in a parallel universe in which Donald J Trump, billionaire, is President of the US and they want me to explain to them what he is doing.

Donald Trump campaigned for President on the platform that he would "Build a Wall" and "Mexico would pay for it". He recently signed a directive to begin planning to build the wall. Speaker of the House, Paul Ryan, said that this would be paid for by the US. Trump when interviewed, said rather that Mexico will pay for the wall because they would face "a big 20% import tax". What is Trump talking about?

When Trump ran for President he also promised to reduce company tax to 15%. Paul Ryan, in a more structured and planned program, released on the website abetterway.speaker.gov, promised to reduce company tax to 20%. Ryan showed an illustration that compared the corporate tax system as like a Swiss cheese. Various lobbyists had arranged to have big areas of tax deduction included in the tax code in return for campaign contributions. He argued that eliminating all of these tax deductions or "carve outs" would allow the corporate tax to decline from the current rate of 35% down to a much lower rate of 20%.

The Border Adjustment Tax

One of the tax deductions that Ryan wanted to remove (perhaps surprisingly to Australians) was a tax deduction on imports into the US made by corporations. If this tax deduction is removed, and the company tax rate stands at 20%, then businesses would face an effective 20% increase in import prices. This is called the border adjustment tax. This is the tax that Trump was talking about. We note that all countries exporting to the Unites States would face this, not just Mexico.

Although imports would no longer be tax deductible, all expenses involved in exporting products from the US would be tax deductible. The result is to push up import prices but subsidize export prices. Most economists believe that this would generate an improvement in the US balance of trade (see footnote).

Transfer Pricing

There is another important result of the border adjustment tax. Right now America has a problem with US companies moving outside the US and setting up in tax havens. Some tax havens have corporate tax rates as low as 12.5%. An example is the Irish Corporate Tax on Trading Income.

US Corporations may set up subsidiaries in tax havens and generate a high level of "value added" in the tax haven. They then export products back to the US, pricing those products to include the high level of "value added". The advantage is that the income generated is taxed in the tax haven. These high priced imports are then tax deductible to the US parent corporation. This whole process reduces US corporate tax receipts and increases tax haven tax receipts.

The incentive to engage in this process is removed by the Border Adjustment Tax, because imports into the US are not tax deductible. The incentive will be to import products or services into the US at the lowest possible price. This reduces the income that can be retained in a tax haven. Because the products are imported into the US at the lowest possible price, this maximises the income that is earned by the US parent corporation in the US and therefore maximises US domestic corporate tax collections.

The border adjustment tax firstly improves the US balance of trade. Secondly, it increases domestic tax receipts because it removes the incentive for US corporations to locate in tax havens.

Conclusion