A fight is brewing in Washington DC, with the proposed “border adjustment tax” dividing both Republicans and the business world. For economists, the potential implications of this tax are the stuff of nightmares.
According to the proposal for “A Better Way” by House of Representatives speaker Paul Ryan, the border adjustment tax aims to make the US tax regime destination-based, offer a tax credit on exports of goods and services and eliminate the tax deduction for imports.
If nothing else changed, US imports would fall, exports would rise and America’s trade deficit would quickly close. But this deficit feeds heavily into the US’s current account, and according to basic national income accounting the current account must equal the capital account. In order to shift the current and capital accounts back into balance, the US dollar must appreciate.
With a 20 per cent corporate tax rate likely to be imposed on imports, the US dollar should appreciate between 15-25 per cent. Taxes levied on imports would make them more expensive for US consumers, but this would then be offset by a stronger dollar.
Similarly, the benefit to US exporters from a corporate tax exemption would be offset by a stronger currency, making exporters less competitive globally. The final impact of the border adjustment tax on the US consumer and the trade deficit would therefore be zero.
That is the theory. The reality will be different.
The US dollar will take years to adjust. There has historically been about a five-year lag between a current account shock and a full adjustment in the real effective exchange rate. Prices tend to be sticky, particularly when 93 per cent of US imports and more than 40 per cent of global trade is invoiced in US dollars. These prices would have to be renegotiated over time. Furthermore, the Federal Reserve and the People’s Bank of China would do their best to lean against such a currency move.
In the short to medium term, importers would pass the cost of the border tax on to US consumers, who have been driving the economic recovery. Hitting them could significantly undermine growth at a time when inflation is accelerating, resulting in stagflation.
Eventually, the dollar will appreciate. But the impact of the tax may then be even more grim because of the US dollar’s role as the global reserve currency. Nearly $10tn of outstanding offshore debt is denominated in dollars.
According to the Bank for International Settlements, about 90 per cent of Turkey’s sovereign debt and more than 80 per cent of China and South Korea’s non-financial corporate debt is dollar-denominated. A 15-25 per cent appreciation of the dollar would make this debt much harder to service and would tighten financial conditions in these countries and across emerging markets.
Furthermore, an appreciating dollar would benefit foreign holders of US assets at the expense of US holders of foreign assets. The result would be a huge, collective sucking sound as capital leaves the rest of the world and races for America. This would further exacerbate financial conditions in emerging markets and could spark defaults and a debt/deflationary spiral.
Some legal experts suggest the border adjustment tax violates World Trade Organization rules, but it stands to raise tax revenues significantly. And it is difficult to imagine how else the White House could fund its spending plans if the proposal were rejected.
The tax risks causing stagflation in the US and a debt/deflationary cycle everywhere else, with a potential emerging market debt crisis thrown in for good measure. And all at a time when central banks have largely run out of tools. For all the optimism that investors may have about the sugar hit to US growth from the government’s policies, this tax could undermine it all.
The writer is chief economist at Manulife Asset Management
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