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Tax Reform Bill Will Increase the Trade Deficit. Good or Bad?

7 min readBy: Stephen J. Entin

The Tax Cut and Jobs Act will boost investment, employment, and incomes in the United States. That’s the good.

And then there’s another outcome of the bill that may cause concern in some circles. The bill will temporarily increase the U.S. trade deficit and expand the current account deficit, which covers traded goods, services, and certain remittances and transfers, such as foreign aid. However, this should not be alarming, but instead be viewed as a positive sign that the world wants to invest in America.

The increase in the trade deficit will mirror the increased inflow of capital into the United States, which will speed the additional U.S. investment and capital formation triggered by the business 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. reductions in the reform bill. This will hasten the improvements in U.S. labor productivity and wages generated by tax reform.

Faster-growing economies experience larger trade deficits (or smaller surpluses)

Faster growth of output and income in the United States, especially compared to unchanged growth rates abroad, will increase the U.S. trade deficit. Our spending on investment will rise quickly, and, as incomes increase over time, our spending on consumption will rise too. Some of these added outlays will be on imports. With no change in foreign incomes, exports will be largely unchanged. The trade deficit will increase, at least for a time. When a trade deficit is the result of increased growth, rather than a drop in buying by foreign customers, it is not a drag on the domestic economy.

Adding physical capital takes resources

Adding physical capital – plant, equipment, office space, commercial and residential buildings, agricultural structures, and transportation infrastructure – requires additional production of these assets. Investment will rise significantly during the build-out of the capital stock. Once the additional capital is formed, investment will decrease slightly, but remain above old levels to maintain the larger capital stock.

Some of the added construction and additional production of equipment will be made possible by a larger supply of labor. Additions to the labor force are possible, even at full employment, either through more people entering the work force or current workers taking on longer hours.

Beyond that, producing more capital would require diverting some resources into investment and away from production of consumption goods and services. To some extent, the lost consumption output will be made up by increasing imports during the build-out of the higher capital stock. Some of the desired equipment may be imported, along with additional consumption goods and services. The imports reduce the short-run sacrifice needed to bring about the additional investment. We should expect an increase in the trade deficit during this adjustment to a new capital stock.

Financing the expansion from higher saving and a capital inflow

These potential additions to the U.S. capital stock, and the increase in the federal budget deficit, must be funded through additional saving. Some of that added saving will be done by Americans. The higher returns on capital will cause people to save more, to buy more American stocks and bonds, and to invest more in their small businesses. The corporate and individual tax reductions on business income, and the faster depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. permitted by expensing, will boost businesses’ saving directly by raising after-tax cash flow. A portion of the tax cuts on wages and salaries will be saved. However, these increases in domestic saving may not be large enough to cover the capital stock expansion and the increased federal borrowing to fund the deficit. For the remainder, we must look to international capital flows.

Global saving is enough to finance economic expansion

Global capital markets will have no trouble accommodating the expansion of the capital stock and the funding of the U.S. budget deficit following the Tax Cuts and Jobs Act. Global saving over the next decade will total about $250 trillion. An infinitesimally small portion of that world saving – about six-tenths of one percent – would be needed to fund the additional U.S. federal budget deficit. Even less would be needed if we look at total government borrowing, which is reduced by increases in state and local government surpluses that will naturally result from the base-broadening provisions in the federal tax bill and faster economic growth.

The redirection of global saving toward the United States will come from two sources. First, some U.S. saving that was flowing abroad will stay at home. U.S. residents (individuals and businesses) will buy more U.S. financial and physical assets and fewer foreign assets (lending more at home and less abroad). Second, foreign savers may increase their purchases of U.S. assets (lending more to the U.S.). Both shifts in behavior increase the net capital inflow into the United States.

The Economic Recovery Tax Act of 1981 illustrates this point. The law was phased in over three years and became a net tax cut toward the end of 1982. Between 1982 and 1984, economic growth accelerated. The annual federal budget deficit increased by about $100 billion. However, U.S. banks were more than able to finance the added deficit and additional private sector investment. U.S. banks reduced their annual lending abroad from about $120 billion in 1982 to about $20 billion in 1984. The lending stayed home instead of going to foreign projects. This redirection of bank lending was about as large as the change in the budget deficit. Later in the decade, some additional foreign capital flowed into the United States.

For every buyer there is a seller, and what flows out of the country must be equal in value to what flows in. As more U.S. saving and lending stays at home, and more foreign saving is lent to the United States, Americans receive more foreign exchange to spend on foreign goods and services. As foreigners seek to participate in the expanding U.S. capital formation, they must earn the dollars to buy the additional U.S. assets by selling us more of their output.

Any increase in the capital inflow coming to the United States will be matched by an equal increase in the U.S. current account deficits. Increased capital flows toward the United States mean an inpouring of foreign exchange seeking dollars. The dollar will rise until there is a corresponding increase in U.S. purchases of foreign goods and services to balance the capital inflow. The increased spending will be in part for investment goods to expand U.S. factories, and in part for consumption goods. These increased outlays will be over and above the rising levels of production in the United States, not a substitute or diversion away from U.S. production.

Economic gains will last as long as the tax cuts do; trade balance effects will be temporary

The capital inflow to assist in the additions to the capital stock will be temporary. There will be only a finite amount of additional capital to be built here. Once that capital has been funded, the capital inflow for that purpose will be complete, and international saving flows will return to normal, as will the level of the dollar and the current account (or trade) balance. In the short run, the capital inflow will boost the dollar and the current account deficit. In the medium run, foreigners will receive an increased stream of dividends and interest on their added U.S. assets, which will assist in reversing the capital flow, the rise in the dollar, and the current account increase. In the long run, U.S. savers will be earning more interest and dividends too, and the effects on the capital-flow will fade.

The temporary nature of the capital-flows can be best understood by noting that the new plant, equipment, and other structures must be paid for only once. After that, the added capital will pay its own way, earning enough to cover its maintenance or replacement.

As added capital is formed, American wages and employment will rise, and the total amount of saving done by Americans will rise. Over time, Americans will fund more of the expansion. As Americans add to their assets, some of the government bonds that may have been purchased by foreigners initially may be refinanced by Americans. Americans will increase their holdings of domestic or foreign stocks and bonds. In the long run, the holdings of domestic savers versus foreign investors will return to normal shares of the (larger) total stock of productive capital in the United States.


The Tax Cut and Jobs Act will boost investment and incomes in the United States, and make the country more competitive for production and employment. There will be a transitory rise in the trade deficit, but in the context of a stronger, faster-growing economy. The associated capital inflow will speed the expansion of U.S. industry and employment. Finally, the temporary increase in the trade deficit should not be misinterpreted as detrimental to the economy, a reason to rescind the tax reductions, or a reason to restrain trade.