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Currency Adjustment Under the DBCFT: the Theory and the Real World

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Currency Adjustment Under the DBCFT: the Theory and the Real World

Opponents of the Better Way corporate income tax proposal have argued that subjecting imports to a corporate income tax of 20%--or whatever level is ultimately agreed upon—is no different from imposing a tariff of that level on imports, increasing the net cost to consumers.

That argument fails to address one of the key assumptions of Alan Auerbach’s proposal for the destination-based cash-flow tax (DBCFT): the dollar should appreciate in such a way that the 20% levy will be fully offset.

Adding imports to the DBCFT tax base and concurrently removing exports is equivalent to imposing a tariff on all imports while granting an equal subsidy to all exports. If the exchange rate were fixed, the DBCFT would benefit U.S. exporters by making them more competitive in foreign markets and would hurt U.S. consumers because the price of imported goods would rise. However, the U.S. dollar is a flexible currency whose value in terms of other currencies adjusts in response to policy changes such as the de facto implementation of an import tariff and an export subsidy.

To see how the dollar would react, suppose that the U.S. trades only with the Eurozone and the exchange rate is one dollar for one euro. Suppose, in addition, that the prices of exports and imports are set in the currencies of the exporters on the basis of their own production costs. We can normalize the initial price levels at one dollar for U.S. exports and one euro—equal in value to the greenback--for U.S. imports.

If the exchange rate parity were maintained, the introduction by the U.S. of a 20% tariff on imports matched by a 20% subsidy on exports would increase the dollar price of U.S. imports from $1.00 to $1.20 while reducing that of U.S. exports from $1.00 to slightly more than 83 cents. (If you take $0.83 and multiply it by 120%, you are very close to $1). The latter follows from the law of one price: U.S. exporters are indifferent between selling in the local market for a dollar or in the foreign market for 83 cents, since the difference is covered by the subsidy. (This example assumes no other changes in economic conditions as a result of tax shifts.)

The increase in export competitiveness due to the export subsidy and the increase in the cost of imports due to the import tariff would raise exports and reduce imports, narrowing the trade deficit. This has a host of macroeconomic implications including an increase in effective demand, hence real GDP; a temporary increase in inflation; and the appreciation of the U.S. dollar due to the fact that the trade deficit narrows. Moreover, as the latter would be anticipated by domestic and foreign investors, the dollar would appreciate almost instantly upon the implementation of the tax reform. The question is by how much.

Professor Auerbach is apparently concerned enough about whether the public debate over DBCFT understands projected currency movements that in late February he released a paper on the subject. In it, he reiterates his earlier view that dollar appreciation would fully and instantly offset the effect of the DBCFT on export and import prices so that nothing would really change. In other words, the appreciation would be enough to bring dollar export and import prices to their initial levels of $1.00 each.

Mr. Auerbach’s view is shared by others including Harvard Economics Professor and former Chairman of the U.S. Council of Economic Advisers Martin Feldstein, who expressed his opinion in an article published recently by The Wall Street Journal. The crux of the argument in both cases is that trade deficits are the difference between national investment and national saving, neither of which are affected by trade policy, at least in theory.

The view expressed by Messrs. Auerbach and Feldstein is based on two critical and (unfortunately) unrealistic assumptions: first, that the market for domestically-produced goods and services clears instantaneously; and second, that the adjusting variable is not the domestic price level, which is sticky, or the level of output, which is presumably constrained by full employment, but the nominal exchange rate, which is fully flexible.

The idea is as follows: at the initial exchange rate, border adjustment increases the price of foreign goods relative to domestic ones, where the latter includes exportables, importables, and nontradables. This creates excess demand for domestic goods, which is quickly eliminated via the nominal and (since the price level is given) real exchange rate (i.e., the nominal rate adjusted for differences in inflation between the U.S. and its trade partners) appreciation.

A more realistic story of the adjustment process would read as follows. On impact, there would be some but not full exchange rate appreciation that would reduce the inflationary impact on the economy without eliminating it. The increase in the domestic price of foreign goods and the reduction in the dollar price of domestic goods (and services) sold abroad would likely have a favorable, but not lasting, impact on the trade account, which could lead to a one-off increase in GDP. This and the temporary acceleration in inflation would likely prompt the Fed to raise interest rates, which in turn would cause the U.S. dollar to appreciate more. The combination of domestic inflation and nominal appreciation would lead the real exchange rate to appreciate to a level strong enough to eliminate any improvement in an external competitive position achieved thanks to border adjustment.

While dollar appreciation helps to moderate the effect of border adjustment on inflation and relative prices, it has a collateral effect on the net international investment position (NIIP) of the U.S. vis-à-vis the rest of the world. The NIIP is the difference between foreign assets and foreign liabilities. Since the former are mostly in foreign currencies while the latter are mostly in dollars, the appreciation of the dollar would reduce the NIIP.

In 2015, the last year for which data is available, the United States’ NIIP was negative $7 trillion, or minus 40% of GDP, the result of subtracting a mildly positive (3% of GDP) net foreign direct investment stock from net external debt equivalent to 43% of GDP. This implies that a 20% dollar appreciation would make the NIIP even more negative, potentially reaching minus 48% of GDP.

Whether this represents an economic problem is subject to interpretation, however. As long as the U.S. dollar remains the world’s preferred reserve currency, U.S. current account deficits, the accumulation of which over the years has determined the current NIIP negative level, will continue to be the mechanism through which the supply of dollar-denominated financial instruments will catch up with the global demand. In this sense, it is hard to see how dollar appreciation can be a problem.

Strong dollar appreciation may be a problem for commodity producers around the world since many commodity prices are set in dollars regardless of market, and the historical correlation—though not set in stone—is that a stronger dollar results in a weakening of commodity prices. The flexible currency aspect of the dollar is moot if the DBCFT is implemented. However, the retail price outside the U.S. is always impacted by the relationship between the local currency and the greenback, potentially impacting demand.

Finally, even if no fundamental changes in U.S. exports, imports, and other financial transactions occur as a result of the border adjustment tax, the trade deficit and NIIP of the U.S. will likely change for accounting and statistical reasons. One of the consequences of a high U.S. corporate income tax is that it creates an incentive for U.S. firms to inflate external liabilities, net imports, and profits earned on foreign investments by manipulating international transfer prices and via loans from a foreign subsidiary to the U.S. parent, benefitting from the lower tax rate in the foreign country and the deductibility of interest payments in the U.S.

U.S. multinational companies can defer taxes on foreign profits until these are repatriated. This gives firms an incentive to locate higher profits abroad, in tax havens or countries where the corporate tax is lower, and report lower profits at home since the tax is higher. To do this, U.S. multinational companies often engage in under-invoicing of exports, over-invoicing of imports, and borrowing from their foreign affiliates to deduct interest payments.

To the extent that border adjustment eliminates these incentives, a likely outcome of it will be an increase in reported exports and a decrease in reported imports, foreign profits and foreign borrowing. While the current account deficit (currently at between 2.5% and 3% of GDP) would not be affected, the data will show a reduced trade deficit coupled with a correspondingly lower net income surplus. Notice, however, that these would be accounting changes devoid of economic meaning. (For a broader discussion on this issue, please see this blog from the Council on Foreign Relations.)

There are other concerns expressed about the currency adjustment associated with border adjustment, but they all assume that the dollar will strengthen. What about foreign assets held by U.S. investors denominated in other currencies that are now weaker than the dollar? What happens to other governments that have debts denominated in greenbacks but whose income is in a now weakened dollar? Will a new international debt crisis be launched as a result? The key point is that both can’t happen: if the rise in the dollar offsets new taxes so that the consumer is not hit, you may have international implications. But if the dollar doesn’t move, then it is the U.S. consumer who will be affected and the value of international assets is spared.