Border-Adjusted Consumption Taxes and Exchange Rate Movements: Theory and Evidence

Summary

In June 2016, House Speaker Paul Ryan proposed a destination-based cash flow tax (DBCFT) as part of the “A Better Way” tax reform blueprint. One component of the DBCFT proposal is the implementation of a border adjustment, which is a common feature of national consumption-based taxes. Were the United States to adopt a DBCFT and the accompanying border adjustment, it would only tax production that is consumed in the United States—domestically produced goods and services sold abroad would not be taxed.

Although there are many important issues surrounding a DBCFT that would require careful consideration before implementation, the response of exchange rates is one that has received substantial attention. (For clarity, this report will refer to the border adjustment under a DBCFT as a border-adjustment tax or BAT.) Economists generally agree that standard economic theory predicts exchange rates will adjust to offset the implementation of a BAT in the United States. As a result, in theory a BAT should have no direct effect on the trade balance. The standard theory rests on two important assumptions—flexible U.S. exchange rates and a full border adjustment. The full border adjustment assumption simply means that all imports are taxed at the same rate, and that all exports are completely excluded from taxation.

While most economists believe that exchange rates will adjust to offset the tax, there is debate over how fast the adjustment will occur. Some have argued that the adjustment should occur almost instantaneously or even before the tax is enacted if market participants include the tax in the price in anticipation of enactment. Others have argued that there may be frictions that would slow the adjustment process and which could result in a situation where the trade balance does favor exports for a number of years until the exchange rate fully adjusts.

Although no other countries have implemented a destination-based cash flow approach to taxation, studies of closely related tax systems may provide some empirical insight into how exchange rates react to border adjustments. The existing literature includes some studies that are broadly supportive of a full exchange rate response and limited timing concerns. Other research has found evidence suggestive of a full exchange rate response in the long run but less clarity in short-term adjustments and industry-specific effects.