U.S. Trade: Not Going to BAT

The border adjustment tax (BAT), which the House of Representatives has been floating since June, 2016 seems to be laid to rest for now. Under it, U.S. imports by corporations would have been taxed while U.S. exports would not. This treatment of trade flows is similar to how it’s done with value-added taxes (VATs). What was novel was to blend such VAT-like export incentives into a corporate income tax. This article will show how a BAT is supposed to work and distinguishes between short run and long run adjustments. You may believe that “in the long run we’re all dead”. Nonetheless, good economics must consider all adjustment paths.

Of course, this tax could rise from the dead in the months or years ahead since the Trump Administration and many in Congress are overly fixated on the U.S.’s current account deficit (more specifically, the trade deficit in physical goods). They share the erroneous belief that the trade deficit is a measure of a weak or misaligned economy. It is shortsighted to think of the trade deficit in terms of only final, physical goods. The current account of the balance of payments also comprises trade in services, transfers in business profits, and unrequited transfers of wealth. Also, the current account does not track the inflows and outflows of inputs (which lead to final, physical goods) as part of the international supply chains in which the U.S. is a major link. At any rate, taxing imports (thereby making them more expensive) and exempting exports (to keep their prices down) sounds like a great way to shrink the trade deficit. Not really, as noted below. On the other hand, it may help with the government’s budget deficit. There are other caveats, too, as I’ll make clear below.

The corporate lobbyists who successfully convinced the House to shelve the tax are in error too; that is, if they accept the concept of the long run in economics. True, many of them are retailers and it doesn’t sound nice when they hear that a BAT will raise the price of all the imported consumer items they stock on their shelves. Walmart, Target, etc. count on low import costs when sourcing consumer items from China and elsewhere. In the short run retailers’ import costs will rise if they can’t find domestic vendors to substitute for the imports. But, in the medium to long run, the border adjustment tax should have no effect on the trade deficit. Why? Because the exchange rate of the U.S. dollar will adjust. The U.S. dollar will appreciate so that the seemingly higher priced imports and lower priced exports will return to their previous sizes in relative terms. How can we be sure that the dollar will adjust? Because, in the macro-economy, injections always equal leakages. Net exports (X-M) equals excess domestic savings (S-I). In this context, a trade deficit means that domestic savings (S) cannot finance domestic investment (I). In other words, (M-X)=(I-S). Since a BAT cannot change the domestic savings rate or the rate of investment, the trade deficit (M-X>0) will be unchanged. But what of the higher prices for imports and tax-exempt exports? That’s where the exchange rate adjustment fits in.

For example, consider a corporation which imports an item costing $100. Let the corporate income tax rate be 20%--- which would be the highest rate under the latest Republican tax reform plan. It wants to sell the item in the U.S. for $110 (i.e., it has a 10% mark-up to account for value-add). With no BAT the cost of the import (since it’s now an input) is tax deductible from the sales revenue earned. So, tax payable is (110-100)(0.2)= $2. Only the value-add is taxed. The corporation will retain $108 out of the $110 in revenue--- or an $8 profit.

Under a BAT, no import deduction is allowed and tax is paid on the final sale price of $110. Tax payable is 110(0.2)= $22. Here, the corporation would retain $88 out of the $110 in sales revenue; that is, a $12 loss from the $100 outlay. To avoid this situation, the corporation would want to price the item to try to retain $110 after tax. In other words, solve for x-x(0.2)=110. In this case, x=$137.50. So, the BAT has the effect of raising domestic prices (which include imports as inputs) from $110 to $137.50 or a 25% increase. No wonder U.S. retailers are bothered by such a tax. However, the long run exchange rate argument below is meant to allay their concerns to some degree.

What are the effects on exports? Suppose the corporation above decides to build the $100 item entirely in the U.S. and export it (thus, alleviating the need for the 10% mark-up). Further suppose that the destination country maintains a 15% VAT. In this case, the destination price would be $115. Without a BAT in place there is no corporate tax on exports. The corporation retains the $100 in sales revenue.

Under a BAT the price of the export is tax deductible. This means the corporation can deduct $100(0.2)= $20 from its tax bill. In this way, the corporation could pass these savings onto the foreign customer if it wants to enhance its competitive edge. It could price the item at $80. In that case, the destination price drops to $92 (i.e., a 15% VAT added to $80). So, the BAT has the effect of lowering the destination price from $115 to $92 or a 20% decrease. This looks good for exports. Note that a question arises concerning whether or not the BAT is a de facto export subsidy (which is frowned upon in the trade community). This is a matter for the World Trade Organization (WTO) as noted below.

So it looks like the price of exports fell by 20% and the price of imports rose by 25%. This, on its surface, implies a reduction in the trade deficit. The higher demand for now cheaper U.S. exports and the lower demand for now more expensive imports puts upward pressure on the value of the U.S. dollar. If and when the value of the dollar rises by 25% the $110 (import-inclusive) item is just as affordable at $137.50. Now, a 25% appreciation of the dollar is the same thing as a 20% depreciation of a foreign currency. And a foreign currency worth 20% less in U.S. dollar terms shows a $115 item just as affordable at $92. This means that the trade deficit will remain unchanged. Note, I have assumed a special case in the Marshall-Lerner conditions where U.S. export and import price elasticities add up to one. Only in that special case do changes in exchange rates have no effect on trade balances.

The good news under a BAT is that the U.S. Treasury definitely earns tax revenue while the relative costs of imports and exports remain unchanged. But are there caveats? Yes. The adjustments I note above are dependent upon how flexible export/import markets and currency markets are. If any market is less flexible than the others there will be dislocations in capital and labor flows while the dollar appreciates as expected. Marshall-Lerner conditions on an appreciating U.S. dollar suggest that the trade deficit would grow larger if the sum of the price elasticities exceeds one. Their sum would have to be less than one to close the trade deficit.

So, are U.S. exports and imports sufficiently price-inelastic in the face of a BAT? Imports with no domestic substitutes are price inelastic (e.g., coffee beans, bananas, etc.). Crude oil may be too--- to the extent that domestic production is not ramped up fast enough to meet domestic demand. The same argument holds for U.S. exports. Then there is the concept of tax incidence. Can the U.S. importer in the example above pass most/all of the BAT onto its U.S. customers? It may not if its domestic competition sources at home and avoids the BAT’s bias on imports. Would the U.S. exporter in the example above use the effective export subsidy the BAT provides to actually lower its prices charged to foreign customers? Only if their market is sufficiently competitive. 

Is the BAT a trade subsidy? Well, another tricky bit is the World Trade Organization (WTO). Is the proposed BAT more of a VAT or more of a twist to the corporate income tax? VATs around the world exempt exports and tax imports. But no VAT disallows the deduction of import costs by corporations after value is added. So if a U.S. importer adds value at home it should be able, under a standard income tax, to deduct those import costs. That’s the question the WTO would need to sort out if the BAT were ever imposed.