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Keynes at the Border?

Wednesday, April 15, 2009

A common fallacy holds that imposing taxes on imports and rebating taxes on exports would stimulate the economy.

A common fallacy holds that border tax adjustments—imposing taxes on imports and rebating taxes on exports—would enhance American exports and reduce imports. The reasoning behind this mistake is simple enough. A border adjustment seems to provide a subsidy to exporters and to levy a tariff on importers. Border adjustment proponents, noting that international trade rules allow nations to border adjust consumption taxes such as European-style value added taxes, urge the adoption of a consumption tax in the United States so that we can border adjust and enhance our trade competitiveness.

Yet, such an argument ignores an essential truth about imports and exports: over the long term, exports and imports must be equal. We can think of a country like a household. Purchases are paid for from the proceeds of sales, and sales are made for the purpose of additional purchases. In the long run, purchases and sales must be equal. A nation’s trade policy works the same way. Over a nation’s history, the value of exports in current dollars must equal the value of imports in present value. Any attempt to permanently increase exports and decrease imports is futile.

What would actually happen if we border adjusted imports and exports is that exchange rate movements would offset the trade effects and the dollar would appreciate. The key variable is the real exchange rate, which determines the terms at which a country buys and sells. (For the United States, the real exchange rate is the value of the dollar in terms of foreign currency—the nominal exchange rate—multiplied by the U.S. price level and divided by the foreign price level.) The real exchange rate adjusts to keep the present discounted value of exports and imports equal. The adoption of a border adjustment by the United States would trigger an increase in the real exchange rate that would offset the perceived boost to exports and the perceived restraint on imports.

The argument for border tax adjustments ignores an essential truth about imports and exports.

Imagine, for the moment, that one euro and one dollar have the same value under the current trade regime. If a firm in the United States wanted to import one euro’s worth of German chocolate, the cost of the chocolate to the importer would be one dollar. 

Now, let’s imagine that we institute a 25 percent border adjustment. The cost of the chocolate to the importer would increase to €1.33 (25 percent of 1.33 is 0.33). At the same time, the dollar would appreciate to €1.33; conversely, one euro would be worth 75 cents. At the new exchange rate, the €1.33 chocolate would still cost the importer one dollar, so there would be no net increase in cost.

The same dynamics would be at play in the case where the United States is an exporter. Imagine that a German importer wants to buy one dollar worth of Florida oranges, which would cost one euro under the current trade regime. Under the border adjustment, the United States would rebate the American exporter 25 percent, so the cost to the German importer would decrease to 75 cents. Because the dollar would appreciate to €1.33, however, the cost to the German importer would still be one euro. There would be no competitive advantage for U.S. exports.

These examples reveal that the impact on overall trade flows would be neutral.

Even if a border adjustment could permanently increase exports and reduce imports, the impact of the change would be disastrous for an economy. In that case, the United States would send more goods and services, produced by our own labor and resources, abroad while receiving fewer goods and services in return. Because imports are the gain from trade while exports are the cost of trade, a permanent increase in net exports would reduce our standard of living. Although attractive at face value, the desire to permanently increase exports and reduce imports reflects the misguided view known as mercantilism, the doctrine that Adam Smith condemned so forcefully in 1776.

Even if a border adjustment could permanently increase exports and reduce imports, the impact would be disastrous for an economy.

Ironically, a border adjustment would result in a one-time wealth transfer from American to foreign asset holders. A border adjustment would tax the consumption of Americans financed by their holdings of foreign assets and would exempt from the tax base the consumption of foreigners financed by their holdings of American assets. Consequently, the value of foreign assets held by Americans would decline while the value of American assets held by foreigners would appreciate.

The popularity of Keynesian stimulus during the current recession has led to a renewed interest in border adjustments as a way to stimulate aggregate demand. But a border adjustment would not produce permanent changes in trade patterns. In addition, the desire to provide a permanent boost to the economy through a border adjustment constitutes a misunderstanding of Keynesianism. Sound Keynesian policies seek to make output more stable throughout the business cycle by increasing aggregate demand in a downturn and restraining demand during an upturn; they do not permanently boost aggregate demand in a futile effort to permanently raise output.  

Supporters of consumption taxation in the United States often rely on misperceptions about border adjustments in order to make their case. There are compelling reasons to adopt a consumption tax in the United States, including simplification and enhanced capital accumulation. The ability to border adjust is immaterial. The border adjustment fallacy should not obscure the real case for consumption taxation.

Alan Viard is resident scholar at the American Enterprise Institute. He was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He has also worked for the Treasury Department’s Office of Tax Analysis, the White House’s Council of Economic Advisers, and the Joint Committee on Taxation of the U.S. Congress. This article was adapted by Amy Roden, a research assistant at AEI, and Scott Ganz, AEI’s program manager for economic policy studies, from a longer paper

FURTHER READING:  Viard recently released Tax Policy Lessons from the 2000s (AEI Press, 2009), a collection of essays which explore the role taxes play in setting policy and their effect on businesses' financial and investment decisions. Findings were discussed at this AEI event. 

 

Image by Darren Wamboldt/the Bergman Group.

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