Border Adjustment Tax Is Bad Economics

President Donald Trump has many ideas for how to get the American economy going again, including some bold changes to our tax system. The fact that they are bold does not necessarily mean they are good. As they say, walking through the lobby of the Waldorf Astoria with your fly open is bold, but not good. 

Trump's plans for cuts to the corporate and personal income taxes are good, though if they are not coupled with substantial reforms to federal spending, they may end up just injecting some more tax revenue into an ailing welfare state. I have some hopes that Trump will get around to that, since during his campaign he talked about structural spending reforms, such as decentralizing Medicaid, welfare and education programs to the states. 

However, there is one idea that Trump has that is unequivocally bad: the Border Adjustment Tax or Border-Adjustable Tax as it is also known. Abbreviated BAT, this is a new gimmick that is designed to raise the cost of imported products while giving a cost advantage to U.S. exporters. 

The theory behind BAT is not new. European countries with fixed exchange rates have, from time to time, manipulated their terms of trade by devaluating their currency vs. their main trading partners. 

For example, suppose Sweden fixes its krona vs. the German Mark (in a pre-euro world) in a four-to-one ratio. It now takes four kronas to buy one mark. This means that a SAAB car  (if only they would start making those again...) that costs 100,000 kronas in Sweden will sell for 25,000 marks in Germany. Similarly, an Audi built in Ingolstadt that sells for 25,000 euros in Germany will sell for 100,000 kronas in Sweden. 

Suppose now that the Swedish government wants to Make Sweden Great Again by steering Swedish consumers over to domestic products. To make SAAB compete better with Audi in Sweden, the central bank devalues the krona by 25 percent. A German mark now costs five kronas instead of four, making imports more expensive. When Audi sells a car in Sweden and want 25,000 marks for it, they now have to charge 125,000 kronas for it. 

More people will buy the SAAB, which still sells for 100,000 kronas.

By the same token, the BAT, as suggested by Trump and proposed by Congressional Republicans, will raise the cost here in the United States of products made in, for example, Mexico. The idea is that companies will repatriate jobs and that consumers will abandon Mexican-made goods in favor of Made In America.

This all works good in theory, but what about reality?

As a matter of fact, consumers and businesses may not at all be able to escape higher costs on imported products by shifting to domestically produced alternatives. Back in the early 1980s, the federal government put in place import quotas on foreign-made cars. This measure is not exactly the same as a BAT or a currency devaluation, but to the consumer it has a similar effect. It rationed supply at given demand; you do not have to have taken a single hour of microeconomics to realize that this would pushed up prices on imported cars. 

That price increase becomes a proxy for a BAT or a currency devaluation. For easily understandable reasons, buyers who wanted a Honda Accord but were discouraged by the higher prices went over to the domestic-brand dealers instead, hoping to find a car they could like at a lower price. 

What did they find? Well, before we get there, let us get back to the hypothetical example from Sweden. Once the price of the Audi has increased to 125,000 kronas, demand for the SAAB will undoubtedly increase. Will SAAB sit on its hands and just sell more cars at the same price? Obviously not: they see a price difference of 25,000 per car, and they see rising demand. Why not rake in some of that price margin as a net profit by raising the product price?

That is exactly what happened in the United States during the import-quota years. In a study from 1985 the Heritage Foundation concluded:

Wharton Econometrics calculates that the average price per new car has risen by $2,600 since the market restrictions were imposed. Brookings Institution economist Robert Crandall estimates that $400 of this price hike per U.S.-made car was possible only because quotas reduced competition. With 1984 sales of nearly 8 million U.S. cars, the quotas took $3.2 billion out of the pockets of consumers and gave it to the auto industry. Crandall further estimates that the low supply of imported cars mandated by the quotas added $1,000 to the price tag of every Japanese car sold in the U.S., a total of $1.85 billion in extra consumer costs. The total 1984 bill for U.S. consumers due to auto trade restraints: $5 billion.

It matters less whether the origin of the price increase on imported cars is a currency devaluation, an import quota or a BAT. To consumers the inflationary effect is basically the same. 

BAT proponents appear to be well aware of the negative effects on U.S. customers from their proposal. For reasons not entirely clear, they suggest that any BAT-caused rise in import prices will be neutralized by an appreciation of the U.S. dollar. The cause of this increase would be stronger exports, which would drive up demand for U.S. dollars by foreigners who need it to buy our products.

Some BAT backers are absolutely certain that this will happen. Kyle Pomerleau and Steve Entin at the Tax Foundation are a good example, stating plainly:

if businesses were able to reduce the prices of their goods they sell overseas due to the border adjustment, this would trigger a higher demand for dollars in order to purchase those goods. This higher demand for dollars would increase the value of the dollar relative to foreign currencies and offset any perceived trade advantage granted by the border adjustment.*

To neutralize trade advantages, the dollar appreciation would have to wipe out any change in prices of foreign products relative domestic products resulting from the BAT. In short: eliminate the inflation effect. 

This is an entirely backward argument that has no support whatsoever, either in economics textbooks, in research or in practical experience. Exports from one country to another increase because:

a) the exporting country's products become better than those of the importing country;

b) the exporting country undergoes a productivity revolution, cutting production costs of existing products; 

c) there is a surge in consumer and business spending in the importing country; or

d) there is a change in the exchange rate between the two countries.

In other words, for exports to increase, something has to happen first. The rise in exports is an effect of some other event, some cause. The only way that the BAT would have a positive effect on exports is if it somehow reduces the cost of exports akin to a productivity increase or an exchange-rate adjustment. 

Let us go back to the SAAB-Audi example. After the devaluation of the krona, SAAB can now sell their cars at a lower price in Germany, while still take in the same revenue. Before the devaluation, a 100,000-krona SAAB sold for 25,000 marks in Germany; after the devaluation SAAB can sell the 100,000-krona car for 20,000 and still make the exact same amount of kronas. This increases demand for their cars.

To attain something like this, Congressional Republicans will have to include a tax-exempt feature in the BAT, allowing exporting companies to exclude their export revenues from their taxable income. This allows them to reduce the price of their exports equal to the tax they would otherwise have paid.

The BAT does exactly this. This is what Pomerleau and Entin from the Tax Foundation use as their argument in favor of the dollar appreciation argument. Remember that they rely on the dollar's appreciation to keep the import-tax part of the BAT from having inflationary effects in the United States.

Unfortunately, there are no reasons whatsoever to believe that demand for dollars will increase even close to offsetting the increase in import prices, and the domestic-price increases they will lead to. More on that in a moment; first, let us listen to some bold thinkers who are willing to put a number on the appreciation. Alan Auerbach, economics professor at Berkeley, and Douglas Holtz-Eakin, president of the American Action Forum, use a 25-percent rise in the value of the dollar in their discussion of the BAT. That same number is mentioned in an article on January 11 by Bloomberg.com, explaining that the 25-percent appreciation is necessary to neutralize the proposed BAT. 

Interestingly, the Bloomberg piece expresses skepticism about the appreciation. They are on the right side of the issue: not a single report or study supporting the BAT has produced an even remotely credible analysis in defense of a 25-percent dollar appreciation. 

On the contrary, a review of basic statistics on imports, exports and currency trade suggests that the appreciation is practically impossible. According to the Bank of International Settlements, international transactions turn over approximately $6 trillion. That is the total global demand for U.S. dollars – in one day.

By contrast, exports from the United States amount to $2.2 trillion – per year.

Adjusted for trading days, total global demand for dollars is approximately 672 times bigger than demand for dollars to buy U.S. products. This gives us a rough picture of what factors determine exchange-rate movements. 

Put simply, for every $1 change in the dollar’s value vs. other currencies, U.S. exports are responsible for 1.4 cents.

That is not to  say exchange rates cannot shift dramatically over time. For example, in early 2015 the euro plunged almost 20 percent against the dollar in a fairly short amount of time. That, however, had nothing to do with a dramatic increase in exports from the United States to the euro zone. It was caused by a plunge in oil prices and a large movement of financial capital from the euro zone’s negative interest-rate environment to somewhat more optimistic U.S. equity and debt markets.

So what exactly must happen if the appreciation advocates are to be proven right? First of all, the appreciation they want would have to happen quickly enough to offset the inflationary effects of the BAT. Import prices rise immediately when a tax is imposed, and domestic producers are likely to respond immediately to increased demand. For these two very simple and easily understood reasons, the appreciation would have to materialize within six months to have the desired, preventative effect on domestic prices.

Secondly, there is the volume problem. In order to cause a 25-percent appreciation of the dollar within the necessary time frame, U.S. exports would have to increase by a value of $550 billion, after adjustments for elasticities of demand and supply for U.S. products. (In other words, the gross value of the increase in exports would have to be significantly higher.) But that is not all: if that increase in demand for dollars is going to have the lasting effect on the dollar exchange rate that BAT proponents assume, then global trade in dollars would have to increase in parity to U.S. exports. If that did not happen, global trade in dollars for financial-market purposes would just drown out this (in itself very unlikely) increase in exports.

That increase in global demand for dollars would have to amount to $369,600 billion per year.

Does that seem likely to anyone...?

BAT is based on bad economics, bad institutional knowledge and bad policy thinking. It is the first bad major Republican idea of the Trump presidency. Let us hope it does not become the law of the land. 

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*) The article by Pomerleau and Entin puzzles me. Its quality is so poor, and its facts so poorly backed up, that it is frankly unbecoming of a reputable, Washington-based think tank. How did it make it up on their website? Have the internal quality checks at the Tax Foundation deteriorated? Or is there a more sinister explanation?