Why the Proposed Border Tax Adjustment Is Unlikely to Promote U.S. Exports

Mary Amiti, Oleg Itskhoki, and Jozef Konings

There has been much debate about the proposed border tax adjustment, in which U.S. firms would pay a 20 percent tax on all imported inputs and be exempt from paying taxes on export revenue. The view among many economists, including proponents of the plan, is that the U.S. dollar would appreciate by the full amount of the tax and thus completely offset any relative price effects. In this post, we consider the implications of an alternative scenario where the U.S. dollar only appreciates part of the way. This could happen, for example, as a result of the uncertainty surrounding the policy response from other countries. As the proposed tax is effectively equivalent to an import tax combined with an export subsidy, it is possible that there could be retaliation from other countries in the form of taxes on U.S. exports or litigation with the World Trade Organization. If the U.S. dollar does not appreciate by the full amount of the tax, we argue that the effect of the tax will be to lower both U.S. imports and exports in the short to medium run.

The reason for our conclusion is that pricing for the vast majority of contracts governing U.S. international trade, both imports and exports, is preset in U.S. dollars. Consider imports first. The border tax adjustment, which only allows for a tax deduction on domestically produced inputs, will increase the effective price of foreign-produced inputs that U.S. firms will have to pay. So firms that rely on imported inputs and sell predominantly in the U.S. market will be worse off, as intended by the policy. The appreciation of the U.S. dollar will have only a small impact to offset these cost increases, because U.S. imports are predominantly invoiced in U.S. dollars and the pass-through from currency changes into U.S. import prices is quite low, with estimates at around 30 percent or lower.

Higher prices on imported inputs are likely to result in higher domestic prices by both importing and non-importing firms. We provide evidence of “strategic complementarities” for Belgian firms, showing that a 10 percent increase in competitor prices leads to a 5 percent increase in domestic prices of large firms. This channel is also likely to be present in other market economies, such as the United States. For example, if there is a tax on imported steel, local steel producers can also increase their prices and still stay competitive relative to foreign-produced inputs. This will further increase the costs for U.S. firms and consumers.

How will U.S. exporters fare? An unintended consequence of the proposed border tax is that it is likely to depress rather than stimulate exports. As export prices are also invoiced in U.S. dollars, the tax exemption on export revenue will mostly boost exporters’ profit margins rather than increase their export sales. And with the accompanying partial appreciation in the U.S. dollar, the prices of U.S. exports in foreign currencies will rise. This will provide incentives for our trading partners to switch their demand away from U.S.-produced goods, resulting in lower U.S. export sales.

The increased exporter profit margins from the tax exemption could lead U.S. exporters to lower their dollar export prices. However, the effects are complicated by the fact that the largest exporters are simultaneously the largest importers of intermediate inputs. This is a new stylized fact that we uncovered in our paper on Belgian firms and is a pattern that is also prevalent in the United States. We showed that this pattern is important because a currency depreciation that would normally boost exports is less effective because the same depreciation increases those firms’ marginal costs as their inputs become more expensive. This same logic applies in the case of the proposed border tax. U.S. exporters that import their inputs will have to pay more for those inputs, thus offsetting some of the benefits of having their export revenue tax exempt. This effect is most significant for the largest importers, which are also the largest exporters.

In the long run, market forces are expected to undo the tax effects on import and export prices, but both will be affected in the interim. Before the U.S. dollar prices of imports and exports come down—restoring the pretax relative prices—both imports and exports will become more expensive and U.S. foreign trade will be dampened, with the net effect on the U.S. trade balance difficult to gauge. The effects will also be heterogeneous across firms, depending on whether the firms are exporters, importers, or importing exporters. But our research suggests that both firms and households will be faced with higher prices for imports and domestically produced goods alike.

Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

---

Mary Amiti is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Oleg Itskhoki is an associate professor of economics at Princeton University’s Woodrow Wilson School of Public and International Affairs.

Jozef Konings is a professor of economics at the University of Leuven.

How to cite this blog post:

Mary Amiti, Oleg Itskhoki, and Jozef Konings, “Why the Proposed Border Tax Adjustment Is Unlikely to Promote U.S. Exports,” Federal Reserve Bank of New York Liberty Street Economics (blog), February 24, 2017, http://libertystreeteconomics.newyorkfed.org/2017/02/why-the-proposed-border-tax-adjustment-is-unlikely-to-promote US-exports.html.