By Greg Ip

The flaws in the U.S. corporate tax are legion: It encourages debt, outsourcing and tax avoidance while punishing investment.

Republicans in the House of Representatives may have found a way to solve all of this. They have an ambitious plan which, besides revamping individual taxes, would replace the current corporate tax with a tax on cash flow that exempts exports while taxing imports.

It faces the usual hurdles of any tax overhaul: losers such as importers who won't go quietly, losers, in this case importers, won't go quietly, and a potential hit to the budget deficit. It also has one unusual obstacle. Even though it's economically similar to, and probably better than, the value-added taxes (VATs) many other countries use, it may be illegal under World Trade Organization rules. An international clash over taxes is something the world can ill afford when protectionist sentiment is already running high.

The current U.S. corporate tax rate, at 35%, is the developed world's highest and is charged on profits earned abroad when they are repatriated (minus foreign tax paid). This incentivizes companies to rearrange their operations to book profit in low-tax countries like Ireland and avoid repatriating them. An alternative "territorial" system wouldn't tax foreign profits, but that also encourages outsourcing to low-tax countries since operations there won't incur U.S. taxes.

Under the House plan, companies could expense all capital investments immediately instead of over time, but no longer expense net interest, removing the current bias of debt over equity financing and old over new investment. A 20% tax rate would be applied to revenue minus costs such as labor and parts. Exports wouldn't count toward revenue, while imports wouldn't count toward costs. In theory, this "border adjustability" sweeps away the distortions that encourage companies to slash their tax bills to almost nothing by shifting profits and operations around the world, while other businesses pay the full rate.

"It became clear we needed border adjustability to eliminate all the incentives for companies to move jobs, innovation, and headquarters overseas," Kevin Brady, chairman of the House Ways and Means Committee, said in an interview.

The controversy is over whether border adjustability discriminates against trade partners. Legally, it depends. The VAT -- which is like a consumption tax -- is also border-adjustable. A Mexican-made car sold in Mexico carries VAT, as does an imported car. Mexico rebates the VAT when that car is exported to the U.S. The U.S. could slap its own VAT on it,so long as it does the same to American-made cars.

The problem is that while other countries finance a growing share of public services with a VAT, the U.S. relies on income and payroll taxes which aren't rebated on exports. In effect, the U.S.-made car shoulders costs that its Mexican-made competitor doesn't. The cash flow tax solves that problem. It would penalize imports but not if foreign countries adopt it, much as the discriminatory effect of a VAT would disappear if the U.S. had one.

Economically, it shouldn't matter. A trade deficit occurs when a country consumes more than it produces; a tax change won't eliminate the deficit unless consumption patterns also change. In theory, the dollar should rise to eliminate any tax-driven disadvantage for imports. A 2012 International Monetary Fund study found that outside the eurozone, a shift from payroll to value-added taxes had no impact on trade balances.

This might disappointPresident-elect Donald Trump, who wants a lower trade deficit. Not Mr. Brady: "Our focus is on economic growth; trade deficits aren't always an indicator of that."

Indeed, the House plan can raise gross domestic product by reducing both the incentive to move activity overseas and the after-tax cost of capital, boosting capital-intensive industries such as manufacturing. This raises workers' productivity and wages, some of which will be spent on foreign products, for example French wine or Mexican vacations. The result: higher exports and imports, but not necessarily a smaller trade deficit.

Unfortunately, the WTO operates not according to economics but trade treaties, which consider tax exemptions on exports illegal unless they are consumption taxes, such as the VAT. This drives economists crazy. Alan Auerbach, an economist at the University of California at Berkeley and an expert on the cash flow tax, says it's the same as combining a VAT with a lower payroll and no corporate tax. "How can a combination of changes, all of which would be WTO-compatible, when combined be incompatible?"

Mr. Brady says since the tax shares many features of a consumption tax, it should be WTO-compliant. But the U.S. has lost similar disputes before. In 1971 it introduced a tax break for exporters that, despite several revamps, the WTO ruled illegal in 2002.

That time, the U.S. changed the law. Mr. Trump and current Congresses might not be so agreeable and instead press ahead, betting that the rest of the world won't retaliate. One way to avoid such a confrontation would be to swap the cash flow tax for a VAT, but Republicans have ruled that out.

The other would be to persuade the rest of the world to make the U.S. tax legal. Then, "Other countries are going to say, OK, here's my list of things I want changed," warns one former U.S. trade negotiator. Perhaps the only thing harder to overhaul than the tax code is the WTO.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

December 21, 2016 16:59 ET (21:59 GMT)

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