The House GOP Blueprint for Tax Reform would replace the business income taxes with a 20% “destination-based cash-flow tax” (DBCFT) on goods and services sold in the United States.[1] This reform would pay for a significant rate reduction on business taxes, including a 20% taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. on corporate earnings. One of the features of the DBCFT is “border adjustment.” Export earnings would be exempt. Import sales would be subject to the tax, because imported goods would not be allowed as a deductible expense. Because the United States normally runs trade deficits,[2] this border adjustment would raise about $1.1 trillion over ten years, helping to pay for the business and individual tax rate reductions in the reform package.
Importing firms have objected that the border adjustment would force them to raise prices for U.S. consumers to pay the tax. In practice, this is unlikely. The border adjustment would initially discourage imports, lowering the U.S. demand for foreign currencies. This would cause the exchange rate of foreign currencies to fall (or that of the dollar to rise) by about as much as the tax differential, lowering the cost of imports and leaving the after-tax price about unchanged. Some opponents of the provision have expressed doubt that the exchange rate would or could move that much. In an earlier paper, we documented that the dollar has often moved as much, sometimes in response to similar types of tax changes.
A more recent argument takes the other side of the equation, focusing on the effect of excluding export income from the tax. Not taxing export earnings makes exporting more attractive to producers, who can increase their sales to foreign buyers by dropping the price a bit. The claim is that the advantage of exporting would divert U.S. production from being sold here, and send U.S. output abroad, raising the cost of these items here at home.
This concern again assumes that the exchange rate would not change. In practice, as explained, above, the exchange rate would move to offset the effect of the tax. The initial impetus to lower export prices to expand U.S. sales abroad would increase foreign demand for the dollar, causing the dollar exchange rate to rise by roughly the amount of the tax differential. The higher value of the dollar would offset the lower price of the exports, leaving the cost to foreign buyers unchanged. Therefore, the export surge would not occur, there would be no shortage of goods for sale in the U.S., and the result would be no increase in domestic prices.
This rather frantic reaction to the border tax loses sight of the fundamentally beneficial effects on producers and consumers of the lower tax rates in the proposal. Taxes are part of the cost of goods and services. They end up embedded in the prices we pay for everything. The reform plan would lower the corporate tax rate from 35 percent to 20 percent, and the top non-corporate business income tax rates from 39.6 percent to 25 percent. It would also lower tax rates on U.S. labor income. These steps would lower production costs and result in lower prices in the United States, other things being equal. That might not happen if the Federal Reserve were to ease money to keep prices from falling, but in the absence of some such shift in monetary policy, this type of tax reform is noninflationary.
[1] The tax on domestic goods would fall on sales less labor costs. The tax on imports would fall on total sales.
[2] The provision would raise revenue because U.S. imports normally exceed exports. This is due in large measure to the use of the dollar as the world reserve currency. People, businesses, and governments around the world use dollars as savings and precautionary reserves, and to transact world trade. As world commerce expands, foreign holdings of dollars expand. To earn additional dollars, other nations sell the U.S. additional goods and services. In effect, the additional dollars constitute a financial service provided by the United States that does not show up in the trade accounts. This imbalance would continue even if other factors, such as trade barriers abroad or faster income growth in the U.S. than in foreign nations, were to disappear.
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