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As the United States considers moving to a destination-based cash flow tax, there is growing concern about the impact of the proposed border adjustment on trade. Border adjustment on sales taxes, which tax imports and exempt exports, is a common way of taxing only goods consumed in a country, i.e., based on the destination rather than the origin of the goods. Standard economic models imply that border adjustment does not affect trade patterns or the trade balance because the real exchange rate adjusts, keeping domestic and foreign producers on a level playing field. But many market participants fear that border adjustment will be protectionist, favoring domestic products over foreign ones and disrupting supply chains.
To understand whether border adjustments affect exchange rates or trade, our new PIIE working paper examines the experiences of countries that have implemented value added taxes (VATs) and other border-adjusted consumption taxes in three ways. First, the paper uses an event study approach to isolate movements in the real exchange rate, the trade balance, and other variables around the dates that countries first implemented a VAT. Second, it employs cross-country time-series regressions to examine long-run correlations between consumption tax rates, the real exchange rate, and various measures of external balance, while controlling for other variables that would be expected to move the exchange rate and trade. Finally, the paper considered a handful of case studies.
Overall, the results suggest that real exchange rate movements eventually fully offset border-adjusted consumption taxes. In particular, increases in consumption tax rates raise the prices of domestic and imported products equally. There is little evidence that border-adjusted consumption taxes affect the current account balance to any significant degree, although they may have different effects on the components of the current account. Most of the exchange rate adjustment occurs within three years.
The destination-based cash flow tax proposed by the House Republicans (A Better Way, 2016) differs in important ways from the VATs we studied in other countries, raising three important caveats to our results.
First, under the destination-based cash flow tax, the pressure to adjust falls more strongly on nominal exchange rates than on prices. A VAT requires an increase in consumer prices relative to wages, which may explain the adjustment pattern seen in the data. Tax rates under the destination-based cash flow tax vary depending on the firms’ labor cost share and international exposure. Because labor costs can be deducted, a cash flow tax does not require a change in consumer prices relative to wages, so any adjustment may be more likely to come through the nominal exchange rate.
Second, the United States is special. Although appreciation of the nominal exchange rate would facilitate domestic economic adjustment, it might disrupt the global financial system given the dollar’s dominant role in finance. Alternatively, the special role of the dollar could mean that the nominal exchange rate responds only partially to trade pressures, especially if other countries resist the corresponding depreciation of their currencies. Limits on dollar appreciation would force the adjustment to come through US prices and wages instead. It would take time for prices and wages to reach a new equilibrium, because wages are set in advance through contracts, and the Federal Reserve may not accommodate the full shift.
Finally, the House proposal would require a very large adjustment. It would tax gross cash flow at 20 percent, which implies a 25 percent tax rate on cash flow net of the tax, and would require a 25 percent real exchange rate appreciation in equilibrium. Whether adjustment eventually comes through a 25 percent dollar appreciation or a 25 percent increase in US wages and prices or some combination of the two, these adjustments are large, and much larger than the events studied in this paper, and hence more likely to be disruptive.
