Sunday, January 15, 2017

Border Adjustment Tax

     Congress has proposed several reforms of the corporate income tax.   One reform is a border adjustment tax.   This means that corporate "profit" will be calculated with no deduction for the cost of imported goods and with a deduction of revenues from exports.
      This has been characterized as a tax on imports and a subsidy for exports.   Of course, it isn't actually the payment of a bounty for exported goods, but rather a relief from corporate income tax on profit generated from exports.   Still, the economic impact  should be similar to a more transparent tax and subsidy scheme.
       However, a tariff on all imports and subsidy for all exports has approximately no effect on trade.   A tariff on a single import tends to restrict demand for that imported good, but the resulting appreciation of the dollar expands the demand for other imports while reducing exports.  Trade shrinks.
       A subsidy for a particular export will tend to expand the production of that export, while the appreciation of the dollar will slightly contract other exports and expand imports.   Trade expands.
       But if you tax all imports and subsidize all exports the same, there is no reallocation between various imports or various exports nor is there any expansion or contraction of trade.    The dollar rises, leaving the allocation of resources unchanged.
       The result is not a reduction in the trade deficit or increase in the trade surplus unless the tax impacts saving or investment.   For a trade deficit country, either investment must decrease or saving increase for the trade deficit to decrease.   While possible, this is a second order effect.
        The rationale for the border adjustment tax is to shift from taxing profits from production in the U.S. to instead taxing profits from selling in the U.S.   The result should make the tax system neutral regarding location decisions for firms seeking to sell products in the U.S.
          The tax proposal has other characteristics that also are inconsistent with a tax on profit.   All capital expenditures are to be expensed rather than depreciated.   That means that if a corporation invests its profit in capital equipment, it pays no tax on the profit.  Also, interest expense is not deductible.  That means that corporations will be paying tax on the income they pay out to bondholders, so that all investors, whether stockholders and bondholders will be taxed the same.   This should make the tax neutral regarding the financing of corporations by the issue of stocks or bonds, taking away the existing artificial encouragement of leverage (borrowing.)
         And the corporate tax rate is to be reduced to 20% rather than the unusually high 35% that exists today.
         A true value added tax is a tax on income.   However, the typical value added tax allows expensing of investment, which makes it a tax on consumption.  Border adjustment taxes are typically applied, so that the consumption of imports is taxed just like the consumption of domestically-produced goods.   Exports are exempt, because there is no intention of taxing foreign consumption.
         A national sales tax is more transparent, and would involve the taxation of final sales of consumer goods and services.   (A tax on the sale of all final goods and services would be an income tax.)   Consumption of imported goods would be taxed the same as domestic products, and there would be no taxation of exports.
        The proposed reform of the corporate income tax, then, moves it in the direction of a consumption tax, but the process is not complete because payroll expense will still be deductible.   It would seem, then, that the proposal is a tax on consumption of capital income from sales in the U.S.
         While the tendency for the dollar to rise could occur through a prompt adjustment of the nominal exchange rate with the inflation rate unchanged, this could be prevented by open market purchases of foreign exchange. This resulting money creation would raise the inflation rate.   In the long run, equilibrium would return with prices and wages higher in the U.S.   As U.S. prices rise, imports would expand and exports shrink,  returning imports, exports and the trade deficit to its initial value.
          The use of sterilized foreign exchange transactions would be possible.   Here, the Fed would sell off its holdings of U.S. assets and purchase foreign exchange.   This would tend to reduce the U.S. trade deficit by reducing foreign funding of U.S. investment.   It could last until the Fed runs out of dollar assets.   This policy could be introduced at any time, though it would usually generate a decrease in the U.S. nominal exchange rate.  That would tend to shrink imports and expand exports consistent with the reduction in foreign funded investment in the U.S.   This might be more politically acceptable if it limits and restrains what otherwise would be an increase in the nominal exchange rate.
        Foreign exchange operations are the responsibility of the U.S. Treasury, so I suppose this could be implemented regardless of what the Federal Reserve wants to do.   The Fed could either sterilize to keep to its inflation target or allow inflation to rise until the real exchange rate increases the necessary amount.
        My preference, of course, would be to allow the nominal exchange rate to increase enough.  While I do not favor inflation targeting, nominal GDP targeting would be qualitatively similar in this situation.

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