Who Pays for Border Adjustment? Sooner or Later, Americans Do

Olivier Blanchard (PIIE) and Jason Furman (PIIE)



Former Senator Russell Long famously quipped that what everyone wanted was, “Don’t tax you, don’t tax me, tax that fellow behind the tree!” Some supporters of the border adjustment to the cash flow tax being considered by Congress maintain that they have finally found a way to tax the fellow behind the tree: Namely with revenue coming from foreign producers. As a result, they say, these additional revenues can be used to pay for reductions in other taxes, in particular corporate tax rates, with American taxpayers getting off free.

This argument is wrong. What foreigners pay, they will eventually get back. And what American taxpayers get, they will eventually have to pay back. In effect, the revenue associated with border adjustment is the equivalent of debt finance: higher tax revenues now in exchange for lower tax revenues later.

“Border adjustment’’ is a proposal made by Alan Auerbach and coauthors and incorporated into the House Republican “A Better Way” tax plan put forward by House Speaker Paul Ryan and House Ways and Means Chairman Kevin Brady. The proposed measure would exclude revenue from exports from taxation and no longer allow a deduction for imports. Assuming the 20 percent rate in the House proposal, their plan would be equivalent to putting a 20 percent tax on imports and a 20 percent subsidy on exports. The United States currently exports about 12 percent of GDP and imports about 15 percent of GDP, so the export subsidy would cost about 2.4 percent of GDP while the import subsidy would raise about 3.0 percent of GDP—for a net annual revenue gain of 0.6 percent of GDP. This calculation is similar to the Tax Policy Center’s estimate that the proposal would raise $1.2 trillion over the next decade.

What the border adjustment does depends very much on the behavior of the exchange rate. Economic theory predicts that the exchange rate will adjust one-for-one with the tax, although there is some debate among economists, especially macroeconomists and more market-oriented economists, about how quickly and fully that would happen. Because our argument is simplest in the case where the exchange rate adjusts fully, we start there and return later to the case where it does not. As we shall show, incomplete adjustment complicates the story, but does not alter our conclusion.

Let's take a simple example of what would happen if the proposal were enacted. Suppose that the exchange rate between the dollar and the euro is initially one-to-one, so 1 dollar is worth 1 euro. Assume that the US government now imposes a 20 percent tax on imports and a 20 percent subsidy on exports. Suppose further that the exchange rate appreciates by the same percentage as the tax and the subsidy, so a dollar is now worth 1.20 euros.

Take a foreign importer. Absent the tax, for a given euro price of, say, 1 euro, the 20 percent dollar appreciation implies a price in dollars of 1/1.20 dollars. With the import tax, this in turn implies a price for the US consumer of 1/1.20 dollars times 1.20—or 1 dollar. The foreign importer gets the same revenue in euros, namely 1 euro, and the US consumer pays the same price in dollars, namely 1 dollar.

The same reasoning applies to US exporters and foreign consumers. Absent the subsidy, for a given dollar price of, say, 1 dollar, the dollar appreciation implies a price in euros of 1.20 euros. With the subsidy, this in turn implies a price of 1.20/1.20 = 1 euro. The US exporter gets the same price in dollars, namely 1 dollar, and the foreign consumer pays the same price in euros, namely 1 euro. And because the trade deficit means more imports than exports, taxes exceed subsidies, and the government gets net positive revenues. No change in the relevant prices, and net revenues for the government, sounds like a great deal. Is there a catch? Unfortunately, yes.

The Catch: Border Adjustment Actually Raises No Revenue in the Long Run. It Only Borrows from the Future

Net revenues from border adjustment taxes and subsidies will be positive so long as the United States runs a trade deficit. But if foreign debt is not to explode, trade deficits must eventually be offset by trade surpluses in the future. Net revenues that are positive today will eventually have to turn negative. Indeed, any positive net revenues today must be offset by an equal discounted value of negative net revenues in the future.

Suppose that higher border adjustment revenues today are used to decrease other taxes—corporate tax cuts for example—leaving the budget unaffected in the short run. As trade deficits eventually turn into trade surpluses, and thus border adjustment net revenues turn from positive to negative, the other tax cuts it initially financed will still be on the books. Sooner or later, taxes will have to increase, or spending will have to be reduced, to compensate for the shortfall. Just as when the government issues debt, taxpayers get a break now, but they will have to pay off the cost of the debt in the future.1

What if the exchange rate does not adjust fully? The story becomes more complicated, but the bottom line is the same. Depending on the demand and supply elasticities of imports and exports, the incidence of taxes will fall partly on US consumers, partly on foreigner producers; the incidence of subsidies will fall partly on US exporters, partly on foreign consumers. In fact, with incomplete exchange rate adjustment, it is plausible that in the short run US consumers will pay more than 100 percent of the net taxes raised—effectively financing a transfer to foreign producers as well. In any case, as trade deficits turn to surpluses, the roles will be inverted. What foreigners paid, they will get back. What US taxpayers received, they will have to give back. In the end, just as for debt finance, whatever tax breaks they got now, they will have to pay for later. On net, again, foreigners will not contribute.

There are good arguments for border taxes. But the argument that the foreigners will pay for it, thus allowing the government to decrease other taxes, is not one of them.


1. As always, there are some complicating arguments, but they go both ways, and are second order. It is still useful to state them.

The net present value of net revenues depends linearly on the net present value of trade deficits. This net present value need not be exactly equal to zero. To the extent that initial net US debt is positive (which it is for the United States), then the present value of trade surpluses must be positive; equivalently, the present value of trade deficits must be negative, and by implication the present value of net revenues must also be negative. This effect implies that there is a net tax cost to US taxpayers.

To the extent that the United States receives a higher interest rate on its assets than it pays on its liabilities (which it does), then the United States needs to run lower trade surpluses. In this case the net present value of trade deficits can be positive, implying a net tax benefit to US taxpayers.

Finally, depending on the domestic and foreign currency composition of US assets and liabilities, the dollar appreciation will lead to wealth effects. If US liabilities are largely in dollars, and US assets partly in foreign currency, the appreciation of the dollar will decrease the dollar value of the wealth of US consumers (taxpayers).

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