Exchange Rates and the Border Adjustment

December 15, 2016

Over the last couple of weeks there have been a few questions raised regarding the economic impact of a border adjustment, which is a significant base broadener in the House GOP Blueprint. Specifically, import-heavy companies have raised concerns about a policy that no longer allows them to deduct a significant amount of their business expenses. This concern has been echoed in two recent research reports, one by Goldman Sachs and another by RBC Capital, and in a letter penned by a number of import-heavy business groups.

Just as supporters of the border adjustment tend to overstate the provision’s potential to boost U.S. production, opponents are overstating the possible negative impacts it would have on imports. Both supporters and opponents are missing the fact that taxes and subsidies have a direct impact on the supply and demand of goods, which in turn impact their market prices. Specifically, the border adjustment will have an impact on both the supply and demand of U.S. dollars, resulting in an increase in its value.

The Standard Model

Standard economic theory states that a border adjustment ends up in a wash for both exporters and importers because prices adjust to leave the trade balance unchanged. Specifically, the value of the domestic currency adjusts upward. Standard supply and demand shows why both the import tax and the export exemption work together to push the value of the domestic currency up.

The first piece is the import tax. An import tax would raise the cost of imports and reduce domestic demand for them. When Americans demand fewer imports they also provide foreigners with fewer U.S. dollars. This reduces their supply, makes them more difficult to get, and pushes up the value of the U.S. dollar relative to other currencies.

The second piece is the export subsidy. By itself, an export subsidy would allow U.S. producers to drop their prices in foreign markets. This would increase the demand for our exports. In order to purchase those exports, foreigners will need more U.S. dollars. This drives up demand for U.S. dollars in order to purchase those exports. This increases the value of the U.S. dollar relative to other currencies.

Separately, an import tax and an export subsidy only result in partial adjustments to the value of the U.S. dollar and would impact either exporters or importers. However, the impact of both of these policies together is a full offset of each.

An Example

A quick example shows how this would work for different businesses. Suppose you have three businesses with different business models. The first does all of its business in the United States. The second business imports all of its goods and sells them in the United States. The third business purchases all of its goods in the United States, but exports them all to foreign countries. All three of the businesses have $100 in revenue, $60 of cost of goods sold, and $40 in profit. The tax rate they pay is 20 percent. As such, these businesses pay $8 in tax and have an after-tax income of $32. (See the below table.)

The GOP Blueprint would enact a border adjustment which would eliminate the deduction for the cost of imported goods and completely exempt sales of exported goods.

The first business, since it operates entirely in the United States, faces no change to its tax liability.

The second business, which imports all of its inputs, would no longer be able to deduct its cost of goods sold. As such, it’s taxed on its revenue of $100 and pays $20 under the border adjustment. However, the dollar is expected to appreciate by about 25 percent.[1] This reduces the price this business pays for its inputs by $12 to $48. Overall, the business ends up with the same after-tax income even though it remits more in tax.

The third business, which exports all of its goods, would no longer be taxed on any of its revenues. Its taxable income would decline to negative $60 and its tax bill would be negative $12, meaning that it would get a rebate from the federal government. However, we expect that the dollar would appreciate by 25 percent relative to foreign currencies. This would reduce the value of this company’s revenues from $100 to $80. As a result, the company would receive $32 in after-tax income.

1. 20 percent income tax, no border adjustment
  Business 1: All Domestic Business 2: Foreign Inputs, Sells Domestic Business 3: Domestic Inputs, Foreign Sales
Revenue $100 $100 $100
Cost of Goods Sold $60 $60 $60
Taxable Income/Profits $40 $40 $40
Tax $8 $8 $8
After-tax Income $32 $32 $32
2. 20 percent income tax, a border adjustment, before currency adjustment
  Business 1: All Domestic Business 2: Foreign Inputs, Sells Domestic Business 3: Domestic Inputs, Foreign Sales
Revenue $100 $100 $100
Cost of Goods Sold $60 $60 $60
Taxable Income/Profits $40 $100 -$60
Tax $8 $20 -$12
After-tax Income $32 $20 $52
3. 20 percent income tax, a border adjustment, after currency adjustment
  Business 1: All Domestic Business 2: Foreign Inputs, Sells Domestic Business 3: Domestic Inputs, Foreign Sales
Revenue $100 $100 $80
Cost of Goods Sold $60 $48 $60
Taxable Income/Profits $40 $100 -$60
Tax $8 $20 -$12
After-tax Income $32 $32 $32

How Fast Would an Adjustment Happen?

There is a question as to how fast currencies would adjust to a new border adjustment. It is hard to say, but I tend to think that exchange rates adjust rather quickly. Think back to the presidential campaign: one of the interesting stories of the election was that the value of the Mexican Peso, relative to the U.S. dollar, had an inverse relationship to Trump’s performance. The moves would happen so quickly that they would even respond to how well Trump was doing during a single presidential debate. If currencies can react to what presidential candidates say on stage during a two-hour debate, I think it is also likely that currencies will react quite quickly to a $1 trillion change in tax policy.

Could Other Policies or Economic Factors Offset the Dollar Appreciation?

Another concern is that the border adjustment’s ultimate impact on currencies may be ambiguous due to other concurrent economic factors that have an influence on the value of the U.S. dollar, including actions of the Federal Reserve. It is true that the economy is complicated and the value of currencies shift for a number of reasons. However, if you look at the entire Blueprint and a lot of Trump’s policies, there is good reason to expect the value of the U.S. dollar to rise—not fall—independent of the border adjustment. Trump’s spending proposals and tax cuts would result in a higher budget deficit and the Blueprint would boost the return on capital investment in the United States; both things would attract foreign investment and increase the value of the U.S. dollar relative to other currencies. In addition, one would expect the Fed to raise the interest rate in response to these policies, not reduce them, which would also push up the value of the U.S. dollar.

What About Goods Traded in U.S. Dollars?

Another question that often comes up regarding the border adjustment and exchange rates is whether the offset applies to goods traded in U.S. dollars. There is no reason to think that the impact on goods traded in U.S. dollars would be any different than other goods. Oil, which is traded in U.S. dollars, has a market value like any good that is independent of the value of any given currency. If the dollar increases in value, this has no impact on the real value of oil. What you would expect to happen is that oil would decline in price when measured in U.S. dollars. For example, if oil is priced at $100 a barrel, a dollar appreciation, of, say, 20 percent could move the price of oil down to $83.33 a barrel.

A border adjustment would be new in the United States and novel in the context of a business tax. It could face some challenges at the WTO and is not the only way one can go about reforming the corporate income tax. However, the concerns about its economic impact are overblown.

Click here to see our analysis of the Blueprint.


[1] This is equal to a 20 percent depreciation in foreign currencies, which is equal to the tax rate in the GOP plan.


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