Border Adjustment Tax – Control Knob for Free Trade

Last week we saw that unchecked free trade leads into the abyss of countries competing on how to better destroy country and people. 

How to fix it.

In the developed world we like to give things a price. At least we pretend to like that. Doubts? Look at your free-trader badge and give it a good polish. That’s better.

This pricing process in itself is fraught to be messy as no matter what the price is going to be, it will be an artifice. How does one measure the value of environmental destruction and the lack of respect for its own people?

And as this is never going to be a market-driven process but rather a political one, lets play.

In May 1997, the American Economic Review, a journal published by the American Economic Association released an article by Alan J. Auerbach. In it conceptualized the concept of a Border Adjustment Tax (BAT) for the first time.

It was a radical idea to prevent large, international companies to use different taxation rules in different countries to optimize and hence cut their tax bill.

How does it work?

Current taxation aims at the country of production when it comes to tax company profits. Example: a German company produces widgets in Tunisia which exports to France. Right now, the Tunisian subsidiary earns the profits and will pay taxes in Tunisia. That’s a very simple example. Reality gets way more complex but you get the concept.

Under BAT, as the country of consumption is France, the company would have to pay taxes on the profits it makes from the product it sells in France. This means that a Geman company that has no legal representation in France will have to pay taxes there as it sells products there.

Under BAT that would be the case.

It’s an interesting solution for the constant war against tax shopping and tax heavens. But taxation is one of the ways how those trading globally use and abuse distortions in the global trade fabric.

Before we go there, let’s shine a light on some tenets of free trade. 

When I was a much younger man, I was convinced that free trade would be something good. Borders should fall. Goods, services, money, and people should flow freely between all nations. Every country should do what its best at and all should enjoy an optimized world system.

Milk and Honey everywhere you look.

But as good as things look in theory, as nasty have been many of the consequences. Industries went to the cheapest and easiest countries. Tax and regulations shopping became staples for any multinational. American companies built factories halfway around the world to produce stuff that was sold in the US only. 

Jobs in the country of destination went up in smoke. Investment flowed out and whole regions and cities fell apart. The social fabric in many of those regions took immeasurable damage. All for the sake of cheaper iPhones.

Like it or not but the concept of a Border Adjustment Tax is potent to bring a semblance of balance to an unbalanced situation.

Imagine a country like the UK defines a certain set of standards it holds dear. They would be free to put into those standards whatever they deemed worthy. Any country that does not uphold those or similar standard would automatically see the BAT applied. And it would be applied to all things and services produced in that particular country.

Environmental standards too lax, labor standards a misery, harassment of religious minorities, or of people with off standard sexuality? There could be a factor for how much plastics a country or its fleets put into the sea. Or a factor for the destruction of natural habitat. Or for air pollution and even Human rights if a country determines that this is important for it. 

You will say, how will a country control how much plastic the vessels under its flag put in the sea? Well, how do developed nations do this? Because they do it. 

The importing country would be free to define its own set of values and give those that don’t follow it a price. There could be many levels of compliance and there could be a certification procedure every year. Or every five years. Pick your poison.

Politics will make this a monster I am sure. As they always do. But it puts a price on countries’ behaviors. There could even be a unified set of standards that certain free trade areas could adopt as theirs. Like a USMC BAT or an EU BAT. There could be agencies that define certain standards that countries would be able to elect as theirs for a time. Like a rating system. 

The concept lends itself to an incredible breadth of different methods enabling variety. And also ensuring an evolutionary factor within.

Countries are free to determine how they want to interact with the world. The tiny kingdom of Bhutan in the Himalaya between the Peoples Republic of China and the Republic of India is known to be rather isolated from the rest of the world. It’s self-chosen isolation. Not really in tune with much of the rest of the world but it’s their country so they must be free to do so if they think that this is in their best interest. 

So it is for all countries. 

Of course, this makes imports more expensive. Which means that there needs to be an offset. And it just so happens that there is one. Lower-income tax obligations on your residents and cash in on the BAT. This could be a formula so that taxpayers get a cheque for too much income tax paid if it turns out that BAT was higher than predicted for the year.

Lots of control knobs to play with. 

Manuel Lazerov defined the BAT in a discussion as follows: “Rudolf Huber better stated, the adjustment helps to neutralize certain competitive advantages, such as lax environmental rules and the exploitation of cheap labor, by imposing a tax equal to would it would have cost an exporter to produce goods, consistent with abiding by higher standards.” I loved this definition as it hits the spot.

If you produce wares in a country and want to export them to another country that raises a quite steep BAT on those wares, you will think twice if you want to invest. You might even lobby your own government to improve its own act and prove it to the target country to lower the BAT applied. Whatever that requires – the government of that country will be free to determine if it wants to go this way or forego exports into this country. 

Fair.

The whole BAT is nothing but a big incentive scheme for exporting countries to have decent standards. Standards that will, of course, cost money. Environmental protection costs money. Treating your working population in a decent manner costs money too which makes costs of production go up. This might drop the incentive to export but it also might not.

The way things work now is that the exporting country signals virtue without really doing something about problems. And the importing world takes it on the chin with very little leverage. 

Of course, it cuts both ways. If a country defines standards that will kill off all but some imports, the population will not appreciate in time and demand more variety. Its a pendulum. Not perfect but safe to assume that if the pendulum swings too much one way, it will come back the other way.

The BAT will preserve competition in the market of the nation enforcing it as there won’t be direct cash payments to companies. It’s still the survival of the fittest and not the survival of the politically connected. The developed world tends to be a net oil importer. This means that enforcing the BAT on oil imports would drive the international oil prices down. All while domestic ones go up a bit. But oil-exporting countries would not be able to cash in on it.

It increases pressure on countries’ intent to play the international oil market for their benefit. And it also preserves domestic jobs. That alone would be more valuable than the cost of higher prices altogether. 

Am I dreaming? Ms van der Leyen seems to think otherwise as she already talked about a BAT for CO2. Why not target the things that really hurt people instead of the gas that makes our world green?