GED Explains: Border Adjustment Tax

One of the keystones of economic policy for the new US government is what is referred to as a border adjustment tax, which acts as a combination of higher import taxes and export subsidies. The aim of this tax reform is to increase US exports, while at the same time reducing imports. In and of themselves, both instruments are capable of achieving this aim. However, if the exchange rate reactions that can be expected are taken into account, this tax policy package has less of a chance of succeeding.

Terminology

The underlying principle of the border adjustment tax is a corporate tax reform which will mean that pre-products imported by US companies are no longer tax-deductible. By contrast, American companies’ exports will be exempt from tax. Under the corporate tax rate of 20 per cent currently planned, this approach would mean an import tax of 20 per cent and an export subsidy of the same percentage.

Impact of an import tax

A country’s import volumes depend upon foreign companies’ supply-side behavior (import supply) and demand-side behavior from domestic consumers (import demand). In this respect, the volume of imports in supply or demand depends on the price for the imported goods. This gives rise to an equilibrium in the goods market (Q₀ in Fig. 1) with an equilibrium import volume and (IM₀) and an equilibrium price (p₀).

By imposing a tax on imported goods and services, a state drives a wedge between the net price received by the seller and the gross price paid by the consumer. Supply from the company depends on the net price, while demand depends on the gross price. As shown below, the fact that there are two prices in play means that alongside the supply curve (IM^supply₀ in Fig. 1), which is dependent on the net price (p^net), there is a second supply curve (IM^supply₁), which depends on the gross price (p^gr). The latter consists of the net price plus the import tax. As a result, there is a new import supply curve, running above the original supply curve.

The new equilibrium on the market for imported goods is characterized by the fact that there are fewer imports than there would have been without the import tax (IM₁ < IM₀). The gross price the consumers have to pay is higher than the original equilibrium price (p^gr₁ > p₀), due to the import tax. The net price received by the foreign company is lower than the former equilibrium price (p^net₁ < p₀), due to the tax payable.

Impact of an export subsidy

An export subsidy also leads to a second price in addition to the price paid by the consumers (p): the price received by the company. This consists of the price paid by the consumers and the subsidy (s) that the company receives from the state. This means that the price obtained by the company (producer price: p + s) is higher than the price paid by the consumers (consumer price: p). Export subsidies present the seller with an additional source of income.

As a result, company exports depend on the producer price (p + s), while export demand depends on the consumer price (p). In order to represent export market equilibrium graphically, either demand has to be shown dependent on the producer price, or the supply curve has to be shown dependent on the consumer price. If the subsidy is deducted from the exporters’ income, this shifts the export supply curve downwards (see Fig. 2).

The export demand curve, which remains unchanged, intersects with this new supply curve (point b) to give rise to a new equilibrium in the exported goods market. The price which the consumers have to pay has dropped (p₁ < p₀), with the result of this lower price being higher export demand. Companies are willing to supply these higher volumes, because in addition to the consumer price, they receive state subsidies, meaning that the producer price obtained is now higher than it was originally (p₁ + s > p₀). The objective of increasing exports has been achieved (EX₁ > EX₀).

Effects under a full exchange rate adjustment

At first glance, this combination of an import tax and an export subsidy achieves the objective of decreasing imports, increasing exports and thus bringing down the present trade deficit. However, the analyses undertaken so far have neglected to take into account the exchange rate adjustments which arise from an increase in exports and decrease in imports.

After all, exports always have to be paid for in the currency of the exporting country, since the exporting companies have to pay wages, rent, taxes and other costs in their domestic currency. An increase in exports will therefore lead to greater demand for the currency of the exporting country. As a result, the price for the exporting country’s currency will rise on foreign exchange markets. This means that if a country introduces a combination of higher import taxes and an export subsidy, that country’s currency will appreciate.

• Export subsidies increase the country’s exports, causing the appreciation described above.
• An import tax reduces the country’s imports and therefore, exports for other countries. Falling exports mean lower demand for the currency of foreign countries, so causing foreign currencies to depreciate. If foreign currencies depreciate, this automatically means that the domestic currency will appreciate.

Under ideal model assumptions, a flexible exchange rate will theoretically ensure that the price changes caused by subsidies and import taxes will be fully compensated for.

Import market under a full exchange rate adjustment

For the import market, an exchange rate adjustment will mean that the price increases caused by the import tax will be fully compensated forby the appreciation of the importing country’s currency. This can be demonstrated by the following example, which is based on the simplification that $1 = €1. If the assumption is made that a European company can supply a product at €10, then a 20 per cent import tax will have the following consequences:

• Before the tax on imported products is introduced, the European product costs $10 in the USA.
• After the import tax is introduced, if the European company wishes to continue to obtain a price of €10 for this product, it will have to raise the price to €12.50 (20% of €12.50 = €2.50).
• With the exchange rate assumed here ($1 = €1), the price in the USA will rise to $12.50. Because of the higher gross price of the European product, demand among US consumers for the product will fall. As a consequence, the euro will depreciate.

As a consequence of the depreciation of the euro, European companies will then be able to offer whatever volume of the imported goods that is required in the USA, for a lower dollar price.

• Coming back to our example, this will result in the dollar appreciating by 25 per cent, i.e. $1 = €1.25. Correspondingly, the euro will depreciate by 20 per cent (€1 = $0.80).
• The gross price which the American consumers pay would therefore return to €12.50, which at $0.80 to €1 = $10. As a consequence, the import volumes in demand from US consumers will remain constant.
• Calculated in dollars, European companies will obtain a lower net price at a gross price of $10 ($10 minus $2 =$8), due to the import tax payable. However, due to the dollar’s 25-per cent appreciation, this will still mean a net price of €10 ($8 at €1.25 per euro = €10). This means that European companies’ supply volumes in the USA will remain unchanged.

Export market under a full exchange rate adjustment

On the export market, too, the appreciation of the dollar will compensate for the export subsidy. If an exchange rate of $1 = €1 is assumed once again, the following would apply:

• Before the export subsidy is introduced, an American product worth $10 costs €10 in Europe.
• A 20 per cent export subsidy reduces the production costs by $2, so that the American company can sell its products in Europe for a price of $8, which equals €8. This lower price leads to an increase in demand in Europe for products from the USA, which means that the USA can increase its exports.
• This higher demand for exports among Europeans increases the demand for dollars, causing that currency to appreciate. This appreciation results in an increase of the price of American products, calculated in euro. The dollar appreciates by 25 per cent, meaning that American products in Europe will once again cost $8. €1.25 per dollar = €10. Since the price for the US product in Europe calculated in euro will remain unchanged at €10, exports from the USA will still correspond with their original level.
• Due to the appreciation of the dollar and the depreciation of the euro accompanying it, American companies will now only receive $8 for each unit of product sold in Europe. However, the American state will pay a subsidy of $2, meaning that total revenue will be $10. This will keep the export volumes supplied by US companies constant.

As has been demonstrated above for the import market, little will change for the export market either. Export volumes and the price to be paid by European consumers will remain unchanged. The same applies to American companies’ revenue, calculated in dollars. The only difference is that the American state is now paying an export subsidy.

Conclusion and outlook

Under the ideal assumptions applied here, a 20-per cent export subsidy in combination with a 20-per cent import tax in the USA leads to a 25-per cent appreciation of the US currency. This appreciation makes US products more expensive in the rest of the world, while at the same time making products imported from abroad cheaper. At the end of the day, exports and imports remain constant, because both the higher import prices and the lower export prices are compensated for by the appreciation of the dollar. This means that the US trade deficit remains unchanged.

All the same, the USA’s public finances would improve: in 2015, US exports of goods and services amounted to around $2.2 trillion. By contrast, imports were almost $2.8 trillion. This resulted in revenue from import taxes of around $560 billion, while export subsidies cost just under $440 billion. This resulted in net additional annual revenue for the public purse of around $120 billion dollar.

Under economic conditions in the real world, however, it cannot be assumed that the dollar would appreciate by exactly 25 per cent. One reason for this is that the exchange rates depend on other factors than exports and imports alone. Most importantly, there is a demand for foreign currency due to foreign direct investment and portfolio investment, or even currency speculation. This means that there is no guarantee that exchange rate adjustments will fully compensate for the import tax and export subsidies. Changes in import and export volumes and prices will therefore arise. If the dollar appreciates by less than 25 per cent – and depreciation of the euro is also lower as a result – there will be an increase in US exports, a drop in imports and an increase in the price for imported goods, leading to higher inflation in the USA.

However, it can basically be concluded that a combination of import taxes and export subsidies leads to exchange rate adjustments, which will limit the extent of the desired increase in exports and decrease in imports.