In our previous article in this series (Eye on Tax Reform: A&M Impact Series), we discussed potential legal and practical problems with the border adjustments included in the Republican Blueprint for Tax Reform. This article challenges a widely held belief by experts in macroeconomics about the impact the proposed border adjustments would have on the value of the U.S. dollar and on the U.S. balance of trade.

As the old story goes, an engineer and an economist were walking together through a remote forest when they fell into a very deep hole with steep sides. When the engineer realized what had happened, he cried out: “We’re going to die down here. No one can hear us calling for help, and it is impossible to climb out.” But then the economist said: “On the contrary my friend, there is no problem here. First, we assume a ladder. If we have a ladder, we can climb out.”

That, in essence, seems to be what Republican legislators heard from two renowned economists in a closed-door meeting on December 1 to discuss proposed border adjustments to the U.S. corporate income tax. The two economists are Douglas Holtz-Eakin, a former Congressional Budget Office director, and Alan J. Auerbach of the University of California, Berkeley. They had recently published a report that defends the use of border-adjusted income taxes. We were not invited to the meeting (no hard feelings). But we did review the report, and we are curious about some of its assertions in regard to the laws of economics.

The Blueprint calls for a destination-based cash-flow tax (DBCFT), which would include so-called “border adjustments” that would consist of a complete exemption for export revenues and the complete disallowance of any deductions or cost recovery for imports. The Blueprint acknowledges that the proposed border adjustments included in the DBCFT might be a violation of international trade law. (Perhaps for that reason, the Blueprint also hints at the possibility of moving to a VAT, for which border adjustments are universally believed to be legal.) But according to Holtz-Eakin and Auerbach’s report, the border adjustments to the DBCFT proposed in the Blueprint would not distort the balance of trade; therefore, they should not constitute a violation of international trade law. The Blueprint also attempts to steer clear of WTO challenge by attempting to liken the DBCFT to a consumption tax, rather than an income tax.

Having suffered repeated defeats in a decades-long battle to defend export subsidies delivered through the U.S. corporate income tax system — particularly the Domestic International Sales Corporation (DISC), the Foreign Sales Corporation (FSC) and the Extraterritorial Income exclusion (ETI) regimes — the Republican attendees at the December 1 meeting were no doubt eager to believe what they heard from Holtz-Eakin and Auerbach. But based on our non-economist review of their report, we think that maybe the Republicans should take heed from that old adage: “If it sounds too good to be true, it probably is.”

In fairness to Holtz-Eakin and Auerbach, it is relevant to note that they are not out on a limb all by themselves. The January 6 edition of the Wall Street Journal included an article by economist Martin Feldstein in which Feldstein proffered that virtually all students of economics adhere to the theory espoused in the report.

Also in fairness to Holtz-Eakin and Auerbach, their report does not come out and say that the DBCFT is clearly legal as a matter of international trade law. Rather, it seems to be asserting that the DBCFT should not be treated as a violation of international trade law because (a) the effects of the proposed border adjustments would be trade neutral in economic terms and (b) the impact of the DBCFT on international trade would be the economic equivalent of a VAT (for which border adjustments have been determined to be perfectly legal under WTO rules). As discussed below, we have some reservations about both of those assertions as to the laws of economics, as well as several other assertions made in the report.

Offsetting Border Adjustments Are Trade Neutral? Really?

What the report seems to tell us is that if an export subsidy is coupled with an equal and offsetting import penalty or tariff (as would be the case with the border adjustments proposed in the Blueprint), the net effect would be no change to the balance of trade.

Based on the logic put forth in the report, Congress could have saved any (or all) of its prior failed attempts to include export subsidies in the federal income tax system (i.e., the DISC, the FSC and the ETI regimes) if it had only coupled those attempts to illegally subsidize exports with offsetting penalties on imports. How great is that? We can legally subsidize exports as long as we also penalize imports. That will clearly make America great again.

It appears that the way the report reaches the conclusion that the border adjustments included in the DBCFT would be trade neutral is by assuming a ladder. That ladder consists of the combination of the following two assumptions: (1) the impact that the export incentive and the import tariff, in combination, are assumed to have on the value of the U.S. dollar; and (2) the impact that the resulting change in the value of the U.S. dollar would have on the demand for U.S. exports and imports. Feldstein makes use of that same ladder.

The report acknowledges that the export subsidy and the import penalty that would be imposed by the border adjustments in the DBCFT would, on the one hand, have the effects of stimulating exports and stifling imports. But the report goes on to state that the impact of the increased exports and reduced imports would be to cause the value of the U.S. dollar to increase, which would in turn make U.S. exports more expensive to foreign consumers and imports less expensive to U.S. consumers. Those impacts on the value of the dollar would cause a reduction in exports and an increase in imports, with the result that the proposed border adjustments would be trade neutral.

The report then goes on to state the following conclusion:

For, if the dollar appreciates by enough to eliminate any price changes facing purchasers that result from the border adjustments (i.e., raising the foreign cost of exports to offset the export subsidy and lowering the domestic cost of imports to offset the import tariff), there would be no change in US exports or US imports, no change in the trade balance, and no inconsistency of the trade balance with dollar appreciation.

To the untrained (i.e., non-economist) eye, it would appear reasonable to assume that the proposed border adjustments would have the effects of stimulating exports and deterring imports; it would also appear reasonable to assume that the resulting impact on the balance of trade would place some incremental upward market pressure on the value of the dollar. But where the report appears to require a major leap of faith (or a special appreciation of the laws of economics) is its implication that it is reasonable to conclude that the resulting increase in the value of the dollar would be equal to (and therefore exactly offset) the price changes on exports and imports resulting from the border adjustments.

To be sure, contra Feldstein, there are economists and tax theorists who are skeptical of those claims. Moreover, even if the Republicans and the President are tempted to accept that combination of two assumptions without serious challenge, we suspect that the WTO might be more inclined to accept the following piece of advice delivered by George Will in a speech back in the fall of 1984 on the subject of tax reform at that time: “Never attempt to leap a chasm in two bounds.”

An Import Tariff Would Result in Increased Imports?

Another economic assertion in the report that seems counter-intuitive is that while an export subsidy in isolation would result in increased net exports, an import tariff in isolation would result in increased (not decreased) net imports. The report takes us through a logical explanation of why an export subsidy in isolation would result in increased net exports. It goes on to provide a more abbreviated explanation of the effects of an import tariff and then says that based on the same logic that applies to export subsidies, an import tariff in isolation would have the effect of raising net imports. To the untrained eye, this is where the ladder that is assumed by the report appears to pierce the looking glass. The notion that an import tariff will cause an increase (not a decrease) in net imports appears to go well beyond what then-candidate George H.W. Bush described as “voodoo economics.”

Correlation (or Not) Between Imports, Exports and the Value of the Dollar, and Vice Versa

There doesn’t seem to be any question that the balance of trade (i.e., the difference between imports and exports) is an important factor affecting the value of the dollar. But as we explained in the previous article in this series on tax reform, experts in macroeconomics tell us that the value of the dollar may also be affected by many other competing factors, such as political stability, monetary policy, fiscal policy, the national debt, GDP, industrial production, retail sales, terrorism and the relative popularity of the U.S. president, to name just a few.

Most of these factors have a U.S. and non-U.S. component that can have opposite effects. For example, political stability in the U.S. might be a positive factor on the value of the dollar only if other countries are perceived to be relatively less stable. Increased GDP in the U.S. might be a positive factor only if that increase compares favorably to GDP increases elsewhere. Terrorism in the U.S. might not be a negative factor if there is relatively more terrorism abroad, and so on. And the impact of Trump’s hair on the value of the dollar can be reliably estimated only when juxtaposed with the visual of Putin riding shirtless on horseback.

To say that the increased demand for exports resulting from an export subsidy, coupled with the decreased demand for imports resulting from an import tariff, would produce an increase in the value of the U.S. dollar that would exactly negate (or even come close to negating) those demands on exports and imports produced in the first place by the export subsidy and the import tariff seems to be a very large pill to swallow — or maybe a very shaky ladder to climb.

While an increase in export demand and/or a decrease in import demand may place upward market pressure on the value of the dollar, who is to say that the value of the dollar will increase at all, in light of all of the other forces at work on that value (not to mention that it will increase by an amount that will precisely offset the pricing effects of the export subsidy and the import tariff)? Or who is to say that the movement on the dollar will be synchronized exactly in either timing or extent with those imports and exports?

Correlation Between Income Tax Benefits (or Penalties) and Transfer Prices

Holtz-Eakin and Auerbach’s report makes another implied assumption that may also be questionable: if the U.S. allows a tax exclusion for export revenues and disallows tax deductions (or other cost recovery) for imports, the sale prices for exports and imports would automatically be that much lower (in the case of exports) or higher (in the case of imports). That would be reasonable in the case of a VAT, since a VAT automatically affects the price of the transaction to the consumer. But in the case of border adjustments in an income tax system, there is no automatic impact on the price of goods sold or purchased. As noted above, the Blueprint avoids describing the DBCFT as an income tax. But semantics aside, the DBCFT is very different than a VAT, in terms of its impact (or not) on the price to the consumer of exports and imports.

If the border-adjusted DBCFT is enacted, an exporter may make a business decision to reduce its sale price for exports, in light of its reduced (i.e., eliminated) tax cost on export sales. But in some (perhaps many) cases, exporters may decide to leave their export prices right where they were before the DBCFT. And even for those exporters who decide to reduce prices, who is to say that some of them would not decide to keep at least some portion of their tax savings?

The report assumes that the border adjustment for exports in the DBCFT will result in a surge in the volume of exports. But to the untrained eye, it seems equally likely that such an export subsidy might just result in a surge in the profits of exporters, leaving the volume of exports unchanged. Actually, it seems more likely (than either of those two possibilities) that the real result would be somewhere in the middle.

The same analysis (in reverse) would seem to apply to the effect that the import tariff in the DBCFT would have on the price of imports. Faced with the import penalty imposed by the DBCFT, a foreign company selling into the U.S. might decide to reduce its prices (for all or only a portion of the tax penalty) and/or the U.S. purchaser/reseller might decide to increase its resale price for imports (or for U.S. manufactured products that include imported content) to some extent. But there is no automatic price change.

What About the Impact of Government Spending (or Savings) on the Value of the Dollar?

As discussed above, the report analyzes the impact that an export subsidy (in isolation) and an import tariff (in isolation) would have on the value of the dollar. In that regard, the report states that the surge in exports and the immediate decline in imports would both have a positive effect on the value of the dollar; but it does not address (at least not expressly) whether (or the extent to which) the increased tax expenditures to fund the export subsidy and/or the increased tax revenues from the import tariff would have an effect on the value of the dollar.

Our guess is that Holtz-Eakin and Auerbach would have us assume that the increased tax revenues and the increased tax expenditures will exactly offset, thereby producing no impact on the value of the dollar. Based on that assumption, those factors should not upset the delicate balance of the trade-neutral border adjustments in the DBCFT.

Alvarez & Marsal Taxand Says:

As non-economists, our confidence in the trade-neutrality assertion in Holtz-Eakin and Auerbach’s report is probably about the same as the engineer’s level of confidence with the assumption of a ladder from the bottom of the deep hole in the remote woods. With all due respect, prior to November 8, we would have dismissed the DBCFT and the testimonies of Holtz-Eakin and Auerbach as science fiction. Prior to November 8, we would not have believed that Congress would consciously walk into another trade dispute just like the DISC, FSC and ETI disputes.

But all of us have heard President Trump say many times that he plans to renegotiate our previous “bad” trade deals. So maybe, just maybe, the Trump Administration will push through the Republican Blueprint’s border-adjusted DBCFT, bolstered like the Reagan Administration by the confidence provided by voodoo economics, and calling the WTO bluff of trade sanctions. Or maybe, in the aftermath of what everyone seems to be calling a “change election,” that thing that we all previously thought to be science fiction — i.e., a federal VAT — is now a real possibility.

Regardless of whether border adjustments are included in tax reform legislation, it appears likely that tax reform could have a number of significant effects on the value of the dollar. In any event, as we mentioned in a prior edition in this series, the moral of the story here is that in addition to modeling out the impact of tax reform on a company’s effective tax rate, it may also be prudent to model out the impact of a few selected assumptions about the impact of tax reform on FX rates.

Coming Up Next

In our next edition of the Eye on Tax Reform: A&M Impact Series, we will explain why the border adjustments in most VAT systems are not illegal export subsidies.

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