Effects of Consumption Taxes on Real Exchange Rates and Trade Balances

This paper examines the effects of border-adjusted consumption taxes (mainly value added taxes or VATs) in a sample of 34 advanced economies from 1970 through 2015. Freund and Gagnon’s findings largely support the theoretical assertion that a country’s real exchange rate rises in proportion to any increase in its border-adjusted consumption taxes, with little effect on the current account balance and modest offsetting effects on the trade and income balances. Case studies suggest that adjustment comes initially through prices. The border-adjusted cash flow tax proposed by House Republicans, however, differs in important ways from the consumption taxes examined in this study, raising the possibility of a slower and more complicated adjustment with temporarily larger trade effects.