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The proposal for a “border adjustment tax,” sponsored by House Speaker Paul Ryan and other House Republicans, has divided the business community and economic professionals alike, as a recent conference at the Peterson Institute for International Economics (PIIE) made clear. About the only point on which conference participants could agree is that the current corporation tax system is flawed and that a lower corporate tax rate and a value-added tax (VAT) to make up for the lost revenues would be an improvement.
There is no doubt that the high US corporate tax distorts corporate behavior, according to Douglas Holtz-Eakin, former director of the Congressional Budget Office, and Gary Clyde Hufbauer of PIIE. They argued that the political stars have aligned to overhaul corporate taxation for the first time in 30 years. They contended that the US corporate tax rate is out of step with business-friendly systems in the rest of the world and that it should be slashed to promote US investment and growth and enable US multinationals to compete abroad. They argued in favor of a territorial tax system in which corporations would pay taxes only in the territory where they are located.
In contrast, PIIE president Adam Posen raised questions about the magnitudes of the costs and benefits of reforming the tax system. In terms of effective rates, the United States looks like the rest of the world, he said. True, substantial corporate profits—to the tune of $2.6 trillion—are held overseas,1 but the resulting lost tax revenue amounts to less than 2 percent of annual revenues. While the gains from reform are finite, the consequences for productivity of the border adjustment tax (BAT) may be large, as global supply chains have become the norm. Switching to a tax that falls more heavily on consumers will disproportionately affect the poor, while abolishing the corporate income tax will benefit the rich. As a result, Posen said, inequality will increase even further.
Exchange rate adjustment is crucial and not well understood
Conference participants debated how and when exchange rates will adjust to tax policy changes. Holtz-Eakin stated nominal exchange rates will adjust rapidly and completely, while Posen questioned whether adjustment will happen at all, especially given the fact that financial flows dwarf trade flows. Joe Gagnon and I presented evidence from changes in tax policy and border adjustment around the world that the real exchange rate does respond to border-adjusted taxes—but evidence on timing and whether it happens through prices or the nominal exchange rate is murkier. Using a computable general equilibrium (CGE) model, Sherman Robinson concluded that changes in exchange rates or trade balances are large and problematic, given their effects on global markets.
Our analysis of changes in border-adjusted taxes around the world leads me to believe that real exchange rate adjustment will happen. But the adjustment that will follow BAT implementation is also very likely to be messier than a VAT. Existing evidence on what happens after a VAT is introduced suggests that a good deal of adjustment happens, at least initially, through prices. For the BAT, the same could be true because the US exchange rate is largely determined by financial flows, many countries have exchange rates pegged to the dollar, and the dollar is the dominant currency for reserves, commodity prices, and trade invoicing. Because the effective tax rates from border adjustment of a cash flow tax vary across sectors and even firms within an industry, price adjustments will vary across firms and industries. The price and wage response will thus take time to be realized and transmitted through the economy, suggesting there will also be some temporary trade effects.
Whether adjustment comes through prices, exchange rates, or trade, there will be disruptions. The transition could disrupt the global financial system if a big nominal appreciation happens or affect consumers and lenders if prices are the first casualty. Import reductions and export expansions, even if temporary, would offer evidence that US policy is breaking international rules.
Complex transitional dynamics raise the question of whether there are ways of implementing reforms gradually to ease the transition.
Tax reform with border adjustment is going to be a hard sell in Congress
Hufbauer noted that many industry lobbies are opposing border adjustment, which could doom such bold tax reform. My analysis of the effects of the tax at the industry level supports this view. The tax reform proposal initially favors industries with positive net exports (since exports go untaxed and imports are taxed) and industries where the labor cost share of production is high (since wages are excluded). Industries are lining up in favor or against, based on these criteria.
Figure 1 below shows net exports to total trade in a sector, relative to how labor intensive the sector is. The size of the bubbles reflects the size of total trade in the sector. Two things are important: (1) Most industries are net importers, thus they believe they will be forced to raise prices under the proposal. (2) The industries that will gain the most—those with a relatively high labor cost share and positive net exports—are largely absent in the United States. The aerospace industry is the lone exception. This breakdown implies that many more big lobbies will be against the BAT than in favor.

Even exporters may be wary because of international trade rules
Complicating matters, even the big exporters may be less inclined toward the proposal because of the likely response of our trade partners, on whom they depend for business. Both Hufbauer and Chad Bown think our trade partners are likely to file a case over the BAT with the World Trade Organization (WTO). Bown estimates the size of a WTO case involving the BAT to be in the hundreds of billions of dollars, orders of magnitude larger than anything ever litigated in the past. Concern for maintaining global markets could prevent net exporters from supporting border adjustment.
A quick calculation to show why border adjustment is integral to the tax proposal
Several presenters made the point that border adjustment is needed because the revenue it would raise would offset the Trump administration's proposed big tax rate reduction, though Jason Furman questioned the wisdom of counting revenue indefinitely based on an existing trade deficit. If we believe long-run trade is balanced, eventually the revenue will become an expenditure.
(A simple calculation shows why the House of Representatives is banking on border adjustment. The estimated intake from corporate income taxes in 2016 is $473 billion. The statutory federal corporate income tax is 35 percent, so each percentage point reduction in the corporate tax rate reduces the intake by $13.5 billion. To reduce the tax rate from 35 to 20 percent requires filling a gap of a little over $200 billion. The border adjustment tax is expected to bring in $100 billion a year. In other words, half of the corporate rate reduction is financed by the border tax.)
In the absence of BAT, how much could the corporate tax rate be lowered?
Without the $100 billion from border adjustment, the feasible tax reduction is about half of the proposed corporate tax cut of 15 percentage points, which would bring the corporate rate down to 27.5 percent.
While a boon to corporates, this lesser reduction would have few of the positive effects of the House Republicans' tax proposal. Corporations would continue to prefer keeping profits in the Bahamas or Ireland. The primary effect would be that one tax that helps reduce inequality would be cut.
Why can’t we talk about a VAT?
Posen stressed the importance of thinking about the best options for tax reform. One thing that all economists at the conference seemed to agree on is that moving to a VAT, lowering the corporate tax rate, and investing in more redistribution would be a positive change. Unfortunately, despite being a more efficient means of taxation, a VAT always gets dropped as politically toxic in the United States. The dangers of a VAT include higher prices, bigger government, and more inequality. Also, US states consider consumption taxes to be their domain.
Perhaps we should stop calling it a VAT and do it anyway. The destination-based cash flow tax (DBCFT) sort of does this—it combines what is essentially a VAT with a wage deduction, as a kind of pro-labor corporate tax reduction. The problem is that if the incidence is more like a VAT, the United States will be removing one tax that largely hits the wealthy and replacing it with a tax that largely hits the poor, a point Bill Cline has emphasized.
With rising inequality in the United States, ensuring that the new tax is combined with improved redistribution and an offsetting increase in tax on the rich is paramount.
Border adjustment is just one part of the tax reform. The deeper question about this tax reform, which deserves more debate, is the efficiency-equity tradeoff.
Note
1. Joint Committee on Taxation, September 2016.