The Border Adjustment Tax The Way Forward, or Regrettable Sidetrack?

The persistent trade deficit being run by the US, which is the major manifestation of the lopsided global trading system, has to be dealt with to ward off economic disaster. The reason for this is outlined specifically in this previous post, and generally in these posts. It is a sad but revealing commentary that it has taken this long to get someone in charge who at least acknowledges the problem and promises to rectify it. The question now is, how to go about it?

In another previous post, I argued that the best way to do so would be not to impose tariffs and a protectionist regime (for more on tariffs, see these posts as well). Of course, if President Trump follows through on his threats against certain supposed recalcitrants and does so, he would only be acting in quintessentially American fashion, for during the course of the first hundred-plus years of the Republic, such tariffs were the chief source of revenue for the US government.

Such tariffs are also a blunt instrument that have significant economic disadvantages. Beyond that, they do not contribute to any kind of smooth transition toward a better framework for global trade, which is what is ultimately needed. As I argued in “Trumponomics and the Great Rebalancing” (singling out China), “such a tariff would dislocate whole industries and so undermine economic growth in the short to medium term. In the longer term, a tariff might lead to a functioning economy in the US, as domestic industry restored itself to some level of its former glory, but it would damage China severely, without providing any mitigating mechanism to enable it to begin producing for the domestic economy on a sustainable basis.”

The goal, then, is not to create more economic distress, but less. This is a tall order in a global economy erected upon, and addicted to, the divorce of production from consumption. We need to restore the balance between production and consumption, and so enable the financing of consumption out of production, and not out of indebtedness. But how?

The “Great Rebalancing” will have to be achieved, first, by identifying the factors that lead to imbalances, and secondly, implementing policies that constructively deal with those factors.

Michael Pettis, an author to whom I have often referred, provides us with a competent summary of the structural factors which have deranged trade relations.[1] These factors go far beyond measures like currency manipulation and tariffs, which obviously have a direct impact on trade. Policy measures with an indirect impact are as great a problem, for they function precisely as a tariff or a devalued currency would.

The basic goal of these policies is underconsumption. In order to promote exports, a country imposes policies upon its population causing production to exceed consumption. It thus imposes a form of forced saving. Macroeconomic accounting tells us that production (Gross Domestic Product) = consumption + saving – investment; as such, an increase in saving is accompanied by a reduction in consumption, assuming investment stays the same. The non-consumed production is thus left over, to be exported. As Pettis explains, “Anything that reduces consumption … without changing total production or total investment, must cause an increase in exports relative to imports” (The Great Rebalancing, section entitled “Trade Intervention Affects the Savings Rate”).

One of the policies that makes this happen is “financial repression.” This is basically the Japanese model, and has been followed by other Asian Tiger economies, particularly China. In this policy variant, the banking and financial system is essentially controlled by the government, which dictates interest rates and allocates loans according to its own criteria. The upshot is that lenders (consumers) are paid below-market interest while borrowers (business) are charged below-market interest. For all intents and purposes, this is a subsidy to business, a wealth transfer from consumers. It is also a restriction on consumption in favor of production, and so a generator of structural net exports.

How to deal with this? It helps to realize that these countries by now have come to realize the shortcomings of this model. After all, it is one of the reasons the Japanese economy has tanked since 1990. But weaning a country away from it is another matter, as so many vested interests are involved in maintaining it.

Another – and for this article, very important – method is the Value-Added Tax (VAT). VAT is a consumption tax and as such provides for a structural surplus of production over consumption. And given the high levels at which such a tax is often levied (e.g., 21% in the Netherlands) it constitutes a severe form of consumer repression. Consumers thus bear the brunt of a policy that favors exports over domestic consumption.

VAT includes yet another element making it even more favorable to exporting countries. This is called border adjustment. In this arrangement, VAT is “adjusted” depending upon whether goods are exported or imported: goods that are exported are exempted from domestic VAT, while goods that are imported are assessed VAT.

VAT thus acts as both an export subsidy and an import barrier. Therefore, it has a double effect on trade relations: the fact that it suppresses consumption acts, as we have seen, as an export stimulant; and the effective boost it gives to exports through border adjustment likewise acts as an export stimulant.

For these reasons, countries that make use of VAT enjoy a great advantage as far as terms of trade are concerned. And countries that don’t are left holding the bag, as it were, for that advantage held by exporting countries is the mirror image of the disadvantage at which non-VAT countries are placed.

It comes as no surprise that this setup, putting non-VAT countries[2] generally and the US in particular at such a disadvantage, receives such severe criticism. Progressive political commentator Thom Hartmann puts it like this: “Germany is not alone in this [border-adjusted VAT]. Japan, South Korea, China, Taiwan, and most European nations do the same thing. The only developed country without a VAT tax to use as an effective tariff is the USA – we’ve become the international village idiots. Nothing protects our workers or manufacturers, which is just fine with the big transnational corporations making billions exporting our jobs.”

The obvious thing to do would be to implement a similar border-adjusted consumption tax in the US. The problem with this is that it would introduce the same sort of onerous tax arrangement that countries in, e.g., Europe labor under. A 21% tax on most goods and services, such is holds in the Netherlands, forms a real drag on household spending, and disproportionately affects lower income classes (which means that, in the parlance, consumption taxes are regressive).

An interesting side note: what sparked the Dutch Revolt against Spain in the 16th century was not religious intolerance or political domination – it was the imposition of a 10% sales tax, Alva’s Tenth Penny tax. An unkind interpretation would be that the Dutch might suffer their consciences to be oppressed, but not their pocketbooks! Nowadays, however, the tables have been turned: freedom of conscience is protected while pocketbooks are rifled.

The long-term goal would be gradually to reduce or eliminate VAT in favor of other tax regimes that are not so oppressive both to economies abroad and to lower income classes domestically. But what to do in the meantime? How can the US in particular achieve some sort of harmonization within this ubiquitous tax framework?

Thankfully, a VAT does not look to be in the offing. But another proposed tax reform might achieve a similar goal. I refer to the so-called Border Adjustment Tax (BAT) put forward by the House GOP as part of a wide-ranging tax reform plan. Reportedly it is under consideration by the Trump administration in conjunction with Congressional Republicans, although Pres. Trump has referred to it as “too complicated,” going on to say, “Anytime I hear border adjustment, I don’t love it. Because usually it means we’re going to get adjusted into a bad deal. That’s what happens.”

The proposed BAT is a bit complicated, but is also widely misunderstood. The border-adjustment part makes it comparable to VAT, but rather than being a tax on goods and services, it is a tax on business income – corporate earnings. That in itself puts this tax into another category. The tricky part is the border adjustment facility being added to it.

The BAT would eliminate the deduction companies currently enjoy when they import goods, including intermediate goods – goods that are used in the manufacture of other goods – but especially consumer goods purchased for resale. That would take away part of the advantage companies have had by importing cheap foreign manufactures. It would also take away some of the advantage retailers like Wal-Mart have had in terms of price competitiveness, which is why Wal-Mart opposes the measure.

In this way the BAT would act as an import barrier, in the same way that VAT does. By the same token, the BAT would exempt from taxation earnings from goods sold abroad. And that would act as a stimulus to exports, for if business earnings from exports are exempt from taxation, that would lower the price of exported goods, making them more competitive on the world market.

There is concern that this new regime would run afoul of current World Trade Organization (WTO) regulations. The WTO makes a distinction between indirect (consumption) tax and direct (income) tax. According to its rules, indirect taxes may be border adjusted, but direct taxes may not be. Thus, by virtue of this agreement, the US with its tax code has been disadvantaged against most of the rest of the world, another example of the “bad deals” Donald Trump says the US has been making.

But in effect the BAT works as a consumption tax. The House GOP’s proposal (as explained in the Better Way Tax Policy Proposal) argues as much: this “cash-flow tax approach for businesses… reflects a consumption-based tax.” And because it does, “for the first time ever, the United States will be able to counter the border adjustments that our trading partners apply in their VATs.” Harvard economist Martin Feldstein likewise argues that this objection is a red herring. “So what are they going to say, you can’t have a VAT?”

A bigger concern is that the BAT will lead to a stronger dollar, which in turn would have a negative impact on the trade balance, negating the advantage provided to exports. The argument is that stronger demand for US exports will increase demand for dollars to purchase those exports, while weaker US demand for imports will shrink the number of dollars being brought onto foreign exchange markets, likewise increasing the price of dollars there.

I don’t believe this argument has much merit, because it only looks at one element of what would be a complex interaction of causes and effects. As we explored above, a key mechanism behind trade balances is domestic policy that reduces consumption while holding production and investment steady. In this case, the leftover production has to be sold abroad, automatically producing a trade surplus (or reduction in a trade deficit). This is the effect VAT has had on global trade for all these years. Therefore, if such an effect were predominating, then all the countries gaining a trade advantage by implementing border-adjusted VAT would subsequently have lost that advantage as their currencies appreciated. But this has not been the case. Quite the contrary: their trade surpluses have been unremitting.

The truth is, if the US likewise introduces a tax which acts like a consumption tax and thus reduces consumption vis-à-vis production, it would similarly affect the trade balance by offsetting the advantage other countries have had in promoting underconsumption. The net effect will be to reduce trade imbalances; exchange rates will have to find a new equilibrium, hopefully without the manipulations in which central banks love to engage. The following step would be to repair the divorce of production from consumption by gradually removing such underconsumption-oriented policies. Equal underconsumption is offsetting, but no underconsumption is the ultimate goal. If, along with this, central banks show restraint, and countries likewise scale back their various systems of financial repression, the global trading order just might plod along toward the rebalancing it so desperately needs.


[1] In The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton and Oxford: Princeton University Press, 2013).

[2] Go here for a list of countries that implement VAT (160 countries), or that do not (41 countries).