Would the GOP’s border tax adjustment lead to a trade war?

Among the bolder tax reform ideas being contemplated by the Republican congressional leadership is a border tax adjustment aimed at improving the U.S. trade balance. There are, however, good reasons to doubt whether such a tax would achieve that goal considering how foreign exchange markets might react and how our trade partners might respond to such a tax adjustment.

More importantly, there are all too many reasons to fear that the introduction of a border tax adjustment might inflict serious damage on both the U.S. and the global economies by taking us down the path toward a full-blown trade war.

The essence of the border tax adjustment proposal, which currently seems to enjoy serious congressional support, involves two basic elements.

The first involves exempting U.S. companies from the payment of taxes on any profits that they made from exporting.

The second involves the imposition of the corporate tax, at its proposed new rate of 20 percent, on the value of imports.

Taken together, these two elements would in themselves be equivalent to a U.S. dollar depreciation of around 15 percent. The imposition of a border tax adjustment on imports would also have a direct impact on U.S. inflation, since it would raise the cost of imports to U.S. consumers and thereby bump up the consumer price index.

{mosads}Many economists are now arguing that any potential positive impact from the border tax adjustment on the U.S. trade balance would be fully offset by a strong and rapid appreciation of the dollar.

The argument being made is that foreign exchange market participants would anticipate the positive impact that the border tax adjustment would have on the U.S. trade balance and the affect that such an improvement would have on the dollar. Anticipating these effects, foreign exchange traders would immediately send the dollar to a higher level that would largely offset the benefit of the tax adjustment to the trade balance. A rise in the dollar would also offset any impact that the border tax adjustment might otherwise have had on consumer price inflation.

There would seem to be at least two reasons to doubt that the border tax adjustment will result in a rapid and large dollar appreciation even though one might still subscribe to the idea the tax adjustment will in the end have little impact on the U.S. trade balance.

The first is that one would suppose that foreign exchange participants would anticipate that U.S. trade partners are likely to respond to the border tax adjustment by retaliating. They would do so by taking similar trade measures as did the U.S. with the aim of boosting their own exports and of penalizing U.S. imports.

If the U.S. trade partners did indeed act in that way, those measures would have the effect of boosting those countries’ currencies in much the same way as the border tax adjustment would boost the dollar. At the same time, those retaliatory measure would prevent any improvement in the U.S. trade balance.

A second reason for doubting that the border tax would lead to a rapid and strong dollar appreciation is because of the adverse impact that such an appreciation would have on the major emerging market economies. Those economies would be hit hard by a dollar appreciation since their corporate sectors are excessively indebted in U.S. dollar terms.

Indeed, according to the Bank for International Settlements, emerging market corporations constitute a major risk to the global economic recovery since those corporations have increased their dollar-denominated borrowing by around $3.5 trillion over the last eight years.

If a dollar appreciation were now to cause the emerging market economies, including China, to falter, those economies would import less from the U.S., which would limit the degree to which the U.S. trade balance might improve. That, in turn, would have the effect of attenuating the dollar’s tendency to appreciate because of the border tax adjustment.

One has to hope that the Trump administration soon backs away from the border tax adjustment idea. This is not so much because such a tax adjustment is likely to do little to improve the U.S. trade balance; rather, it is because such a tax adjustment is likely to cause tensions with U.S. trade partners that could degenerate into a full-blown trade war.

If we should have learnt anything from the experience of the 1930s, it is that trade wars have the real potential to be very damaging to both U.S. and international economic prosperity.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

The views expressed by contributors are their own and not the views of The Hill.