Border-Adjusted Taxes: A Primer

Border-Adjusted Taxes: A Primer

January 6, 2017
Border-Adjusted Taxes: A Primer
The “Better Way” tax reform blueprint issued by House
This relation reflects the requirement that dollars bought
Speaker Paul Ryan on June 24, 2016, proposed replacing
must equal dollars sold. Foreign purchasers must buy
the current corporate and business income tax with a
dollars to buy exports from the United States. Analogously,
destination-basis cash-flow tax (with some minor
U.S. purchasers must buy foreign currency (sell dollars) to
modifications). A destination-basis tax is a border-
buy imports or investments abroad. The demands for
adjustable tax that exempts exports from the tax and
exports and imports are dependent on the relative prices of
imposes the tax on imports. It taxes production consumed in
U.S. goods and domestic goods and on the exchange rate,
the United States, whereas the current corporate tax is
P/(ePf). When the U.S. price rises, exports become more
(largely) imposed on income produced in the United States.
expensive in foreign markets and thus the quantity of X
(exports) falls. If foreign prices rise, U.S. exports are more
The most broadly known destination-based consumption
attractive. Imports become more attractive when the U.S.
tax in the world is the value-added tax (VAT). A VAT that
prices rise because imports become relatively cheaper than
taxes imports and exempts exports is sometimes mistakenly
domestic goods. This relative price is the only price that
viewed as permitting an export subsidy and an unfair
matters, which can be seen by dividing each term in
advantage to countries that have them. These border
equation (1) by P to obtain equation (2); the relative price
adjustments are irrelevant to any real trade effects in the
will appear inverted in the equation in the middle term.
case of a uniform VAT, which imposes the same rates on
all products—that is, it does not affect real imports, real
(2) 𝑋 − (𝑒 × 𝑃𝑓/𝑃) × 𝑀 − 𝐹 = 0
exports, or the trade balance. (Taxes could have other
effects unrelated to border adjustments, such as influencing
The relative price appears in three locations: it determines
savings or the composition of demand through
the demand for exports, it determines the demand for
distributional effects, but these would occur regardless of
imports, and it determines the price of imports (the inverted
the border adjustment.) The imposition of a tariff or an
price relationship in the second term of equation (2)). The
export subsidy in isolation, however, does have real effects.
crucial point is that if the relative price P/(ePf) remains
fixed, the balance of payments remains equal to zero with
See CRS Report R40735, International Competitiveness:
the same quantities and nothing changes.
An Economic Analysis of VAT Border Tax Adjustments, by
Donald J. Marples, for a more detailed discussion of the
Suppose the United States were to enact a VAT of x% on
material presented below. See CRS Report R44342,
all goods consumed in the United States, including imports,
Consumption Taxes: An Overview, by Jeffrey M. Stupak
such that the U.S. price, P, rose by x%. By rebating the tax
and Donald J. Marples, for a discussion of consumption
on goods exported, the price, for the purpose of export
taxes generally.
demand, is its original pretax level. Thus, the relative price
that drives export demand is unchanged. In the case of
The Impact of Border Adjustments on
imports, the U.S. price rises by x%, but at the same time a
Trade for a Uniform Tax
tax is imposed on the foreign price also at x%, so the
Border adjustments can best be explained with a simple
numerator of the relative price term rises but the
equation for the balance of payments. Generally, the
denominator rises by the same percentage. These effects
balance-of-payments framework holds that if a country
cancel out, leaving the same fixed relationship. The tax on
maintains a trade deficit, the country must borrow foreign
imports has increased the foreign price, for purchasers, by
capital to finance the purchase of imports. The balance-of-
the same percentage as the increase in the domestic price,
payments relationship (which says that dollars sold equal
and imports are no more or less attractive relative to home-
dollars bought) is shown in equation (1):
produced goods.
(1) 𝑃 × 𝑋 − 𝑒 × 𝑃𝑓 × 𝑀 − 𝑃 × 𝐹 = 0
Suppose the border adjustments were not made. Now the
U.S. price level rises by x%, export demand falls, and
where P is the U.S. price level, X is the quantity of exports,
import demand rises. But these price and demand effects
Pf is the foreign price level, e is the exchange rate relating
create an imbalance in payments. In response, the exchange
dollars to foreign currency, M is the quantity of imports,
rate e will increase (the price of the dollar will fall). For
and F is the quantity of net capital outflows and other
example, if x is 10%, e will rise by 10% (this movement is
financial flows for the United States. The value of e is the
referred to as dollar depreciation, because it now takes more
ratio of the dollar to foreign currency. For example, $1 for
dollars to purchase a given amount of foreign currency). All
¥115 (Japanese Yen) would be 1/115. Although there are
that is required to restore the original balance with
many trading partners and currencies, and many products
unchanged quantities is a percentage change in the
and thus multiple exports and imports, treating these as
exchange rate of the same magnitude.
composites does not change the analysis.
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Border-Adjusted Taxes: A Primer
Or suppose the money supply did not accommodate the tax
income tax that other members of the WTO regarded as
and was passed backward in lower nominal wages and asset
prohibited export subsidies. Ultimately, as a WTO panel
values (a consumption tax is effectively a tax on wages and
found the third version of this provision to be in violation
existing assets). This outcome would be expected for an
and members of the European Union prepared to impose
alternative version of a VAT, the flat tax. A VAT is a sales
retaliatory tariffs, the United States repealed that provision
tax imposed at each stage of production, and it consists of
in 2004.
receipts minus costs of goods and investments. A flat tax
splits the VAT into two parts: it imposes a cash-flow tax on
The Better Way border adjustments would affect both
business (receipts minus expenditures and wages) along
imports and exports and, from an economic view, are
with a wage tax on workers, which is the equivalent of a
considered, in general, consistent with the WTO agreement.
VAT. Not making a border adjustment would preserve all
Nevertheless, since the cash-flow tax system in the Better
of the original nominal prices and lead to no effects.
Way tax plan has a number of features that differ from a
However, if a border adjustment is nevertheless made, so
VAT (such as the deduction of wages and no allowance for
the price of exports falls, while the price of imports rises,
immediately refundable rebates on exports for firms
the exchange rate will fall as a result (dollar appreciation),
without sufficient tax liability, as losses will instead be
again leaving relative prices—and therefore quantities of
carried forward with interest), whether the border
imports and exports—unchanged in the long run.
adjustments will be found to be WTO compliant is in
question. (See CRS Report RS20088, Dispute Settlement in
This latter point is important because the cash-flow tax in
the World Trade Organization (WTO): An Overview, by
the Better Way blueprint is the type of tax that would not
Daniel T. Shedd, Brandon J. Murrill, and Jane M. Smith,
require a price accommodation. Unlike a VAT, it would not
for a discussion.) The border adjustments also may be
collect a large tax from producers (because wages are not in
incompatible with U.S. tax treaties.
the base) who would need to increase prices to pay the tax
and maintain their profit margins. Making a border
Further Caveats
adjustment would, in the case of no domestic price increase,
Although economic analysis indicates that exchange rates
result in a currency adjustment.
should adjust to keep imports and exports constant with a
border-adjustment tax as outlined in the Better Way tax
Why Border Adjustments Are Important plan, the size of the adjustment is large. For the 20% tax
Border adjustments are important because many VATs are
rate in the Better Way, the exchange rate should fall by
not imposed at a uniform rate across goods. The United
20%. If that is expressed as dollar appreciation (the amount
States itself has border-adjusted excise taxes on specific
of currency a dollar can now purchase), it is t/(1-t) or 25%.
products, such as alcohol and tobacco. A border tax
(In the illustration of the exchange rate of $1 to ¥115, 80
adjustment is appropriate when different tax rates are
cents now buys ¥115 and $1 buys ¥143.75, or 25% more).
imposed on commodities to allow each country to choose
This effect is very large, and there may be some lag in the
its own consumption tax regime. Exchange-rate
adjustment.
adjustments allow only for addressing the general price
level.
Some analysts point to the difficulty of predicting
exchange-rate movements with macroeconomic models in
Another reason that border adjustments matter is that the
the near term. This difficulty may be tied in part to the large
consumption base and the production base may differ.
speculative component of exchange-rate trading.
Because of financial flows, imports can be larger than
Nevertheless, although the forces affecting the exchange-
exports or vice versa. In the United States, imports
rate adjustments may be obscured, they should still be
historically have been larger than exports, and that trend is
operating.
expected to continue in the future. A consumption tax base
that includes imports and excludes exports is larger than
Another issue is that some countries manage their currency
one that does not do so and therefore collects more revenue
(by changing investments, the F in equation (1), which can
for a given tax rate.
affect the exchange rates). Presuming these countries’
objective is competitiveness, however, they should
Also, in the case of the Better Way tax, taxing domestic
recognize that the exchange-rate adjustment is needed to
consumption eliminates the many complications of taxing
keep exports and imports at the same level (i.e., achieve
income on a source basis. One of those complications is
their original export and import goals) and not intervene in
income-tax avoidance stemming from profit shifting.
this case.
Tariffs, Export Subsidies, and the WTO
Note that this discussion does not address exchange rate
The neutrality of border-tax adjustments does not apply
effects that might occur due to other aspects of the Better
with taxes and rebates that apply only on exports or only on
Way tax proposal, such as repatriation of foreign profits,
imports. For example, imposing a tariff (imposing the tax
exempting dividends from foreign subsidiaries of U.S.
only on imports and not rebating the tax on exports) will
firms, or increasing investment incentives in the United
affect the quantities of imports and exports. The World
States.
Trade Organization (WTO) agreements are in conflict with
practices such as allowing border adjustments for corporate
Jane G. Gravelle, Senior Specialist in Economic Policy
income taxes. The United States was embroiled in a three-
decade controversy involving a series of provisions of the
IF10583
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Border-Adjusted Taxes: A Primer

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