The Open and Closed Case for Cross-Border Capital Flows

November 1, 1998

Download Background Paper No. 27

Background Paper No. 27

Executive Summary How freely capital flows across the nation’s borders is key to how fundamental tax reform would affect the U.S. economy and therefore federal tax receipts. This is one conclusion from the Joint Tax Committee’s examination of economic models o f the U.S. economy capable of accurately assessing the effects of tax reform.

International capital flows could play a critical role as the economy reacts to a change in tax policy. If the economy is closed to these flows, then a change in policy increasing the demand for capital or decreasing the net of government receipts over expenditures must be met with an increase in domestic saving. If domestic saving is unresponsive, then interest rates will rise, thereby dampening the stimulative effect of the policy. However, if the economy is open and international capital is plentiful, then the shortfall in domestic saving is made up by imported saving. Interest rates then remain largely unaffected and the economy would enjoy the full stimulative effect of the policy change.

This paper discusses these issues, describing in detail how the economy responds to a change in policy under the three cases of a closed economy, a perfectly open economy, and a partially open economy. The existence of cross-border capital flows is undisputed, even for countries wit h restrictive capital controls. However, the extent to which capital can flow into or out of a country is contested. Even for the United States, one of the most open economies in the world, there is disagreement regarding the extent to which the economy is open to capital flows and the incentives that drive them. This paper offers a new possibility that reconciles the champions of perfect capital markets with those who find the notion of infinitely responsive international capital flows implausible. This paper demonstrates that one can posit perfect capital markets and still find significant restraints on the ability of the economy to increase net capital inflows. In this case, the restraining mechanism is the balance of payments. It is a fact that no country can increase its net capital imports faster than it can increase its net deficit in trade of goods and services. Trade flows respond relatively slowly to changes in the economic environment, such as a change in the real exchange rate. A change in policy encouraging an increase in net capital inflows would likely increase domestic interest rates and, thereby, increases the exchange value of the dollar. This, in turn, would tend to make foreign goods more expensive to U.S. buyers and U.S. goods more expensive to foreign buyers. The resulting increase in the trade deficit would permit an increase in net capital flows. Thus, the economy can be completely open in the sense that capital markets operate perfectly, and yet its ability to import large amounts of saving from abroad in response to a change in tax policy is limited by the speed with which the net trade deficit can increase.


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