A BORDER ADJUSTMENT TAX
In the first part we concluded that a whole change of tax regime from one based on income tax to one based on VAT, would have deep consequences, heralded by a currency appreciation. Some studies put the VAT- equivalent rate for the current US regime at around 20-25%, with important sectoral differences. If that is the level of currency appreciation, it should have huge implications: for non-tradable sectors within US, for US capital markets and for trade and capital markets in the rest of the world. The real implications go well outside the limited theoretic model of one product imported and one exported in a small-sized country without currency.
In these circumstances, the idea that an exchange-rate appreciation will take care of the taxation changes is far from being guaranteed. Worst, the theoretic requirement is a real exchange rate appreciation; it could be reached through inflation!
An initial theoretic weakness appears because the importer and the exporter are normally different enterprises, so the cancellation of gains and loses cannot be done within one enterprise’s accounts. Some mechanism must be instituted for this purpose, and, as we already saw, it has limitations under WTO regulations: it can’t be instituted as a direct rebate to the income tax.
Another problem in that simple theoretical model is the sequencing: the first impact is on import and export prices. Then, the exchange rate should change to bear the burden of the change, but this change might be slow and the intermediate state could derive in a permanent one, before things would come back to normal. In particular, note that if the exchange rate adjustment is slow, and part of the adjustment is borne by prices, the answer from the FED could derail fundamental and permanently the expected result.
Last, but not least, an appreciation or an expectation of appreciation of the world’s main reserve currency would originate huge adjustments in current and capital balances around the world. This is, however, outside the purpose of this short text.
In view of the deep impacts of a whole change of regime, it is understandable that the projected bill in the Congress is not aiming at a whole change, but to to make small steps in that direction, like the proposed border adjustment tax. As any mixed regime, it could be complex to institute and manage, because it aims to compensate the differences between the VAT regime and the current US income and sales tax regime. Trying to do this on a country-by-country basis means discriminating between WTO parties, again forbidden by WTO. A flat border tax might be WTO-compliant, and is this the kind of tax in the Congressional proposal: a flat tax of 20%.
The other side, the rebate to exporters, might be instituted as an exact devolution of indirect taxes, border tax comprised. As explained in the first part, any rebate on direct taxes for exporters is the definition of subsidy in WTO, and therefore, forbidden.
Following this path, the US will end in a system very similar to a VAT: a flat tax in the border, equivalent to the direct taxes paid by domestic products in the domestic market. For being compliant with WTO regulations, it must be an exact equivalent to federal or state taxes imposed over products. This will be complemented by a deduction on indirect taxes paid by exporters.
Although it would be very similar to a VAT system, the proposed mechanism might be susceptible to WTO disputes. Two main problems: how to guarantee the same tax being applied to each products competing with imports and how to give rebates to exporters without falling in the subsidies definition.
It has two additional practical disadvantages: it wouldn’t have the informational benefits of a VAT and the agreement between federal government and the states seems full of difficulties.
In fact, this has been already tried and scrapped in previous legislation in US congress, because the already mentioned problems.
The progressive extension of VAT system around the world in the last half century has left the US as one of the few countries outside it. This fact poses apparent disadvantages for exporters and incentives to imports. Any adjustment would have an exchange rate component, meaning a dollar appreciation that theoretically, will counter-balance those incentives and disadvantages. However it is at least naif to think that the exchange rate will take the whole and exact burden of the adjustment. In a more realistic approach, enough consideration should be given to the central role of the US dollar in capital markets, to the international trade regulations, and to the shocking possibility of having the inflation as a part of the adjustment process.
Considering the international trade regulation, the realistic way for implementing a border tax in the US is making use of the VAT system. This will give big incentives to exports and big disadvantages to imports. In case it is the selected solution, some dollar appreciation may be expected, and some inflationary pressures within the US shall happen. In case the mechanism is slightly different, WTO’s dispute settlement mechanism will have a lot of work in the next years.