Discussion Paper

No. 2017-10 | March 09, 2017
Exchange rate implications of Border Tax Adjustment Neutrality

Abstract

This paper investigates the implications for the nominal exchange rate of a Border Tax Adjustment (BTA) when there is BTA neutrality. A border tax adjustment is a change from an origin-based system of taxation, that taxes exports but exempts imports to a destination-based system that taxes imports but exempts exports. Both indirect taxes (e.g. a VAT) and direct taxes (e.g. a cash-flow corporate profit tax) can be subject to a BTA. In the US, a BTA for the corporate profit tax is under discussion. There is BTA neutrality when the real equilibrium, including measures of profitability and competitiveness, of an open economy is unchanged when it moves from an origin-based to a destination-based tax. The conventional wisdom on the exchange rate implications of a neutral BTA is that the currency of the country implementing the BTA will strengthen (appreciate) by a percentage equal to the VAT or CPT tax rate. The main insight of this note is that this ‘appreciation presumption’ is not robust, even when all conditions for full BTA neutrality are satisfied. Indeed, plausible alternative assumptions about constancy (or stickiness) of nominal prices support a weakening (depreciation) of the currency by the same percentage as the tax rate. On the basis on the very patchy available empirical information, it is not possible to take a view with any degree of confidence on the implications of a BTA for the nominal exchange rate, even if full BTA neutrality prevailed. Whether BTA neutrality itself is a feature of the real world is also a disputed empirical issue. Therefore, buyer (or seller) beware.

JEL Classification:

E31, E62, F11, F13, F41, H25, H87

Assessment

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Links

Cite As

Willem H. Buiter (2017). Exchange rate implications of Border Tax Adjustment Neutrality. Economics Discussion Papers, No 2017-10, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2017-10


Comments and Questions


Anonymous - Invited reader comment 1
March 30, 2017 - 08:29

see attached file


Willem Buiter - Reply to reader comment
April 03, 2017 - 08:29

see attached File


Anonymous - Referee report 1
April 26, 2017 - 16:43

The Trump administration is discussing a Border Tax Adjustment, a switch from an origin- based tax system (taxing exports and exempting imports) to a destination-based tax system (taxing imports and exempting exports). Many observers (“conventional wisdom”) claim that there will be no improvement in the current account, the appreciation of ...[more]

... the dollar will neutralize all real effects of the tax reform. This paper argues that the appreciation of the dollar is no robust result. Depending on the price setting behaviour of exporters and importers, BTA neutrality may require a depreciation of the dollar.

Comments

(1) Different assumptions on the stickiness of nominal variables (export prices and import prices) lead to different results concerning the nominal exchange rate. This result does not come as a surprise, but it deserves attention, since it points to the implicit pricing assumptions of the “conventional wisdom”.
(2) Both economists and politicians are interested in the real equilibrium. How are exports, imports, employment, output etc. affected by the BTA? This paper is silent on this question, it assumes BTA neutrality. If exports, imports etc. do not react, much of the air has gone, the change of a nominal variable is, at least from my point of view, of second order importance.
(3) The paper focuses on nominal variables, but the author does say anything on the money market and monetary policy. A short discussion of this issue would be helpful.
(4) PTM for net-of-tax prices generates the depreciation outcome. But PTM implies a violation of the Law of One Price, which is somewhat strange as equilibrium outcome. The model circumvents this problem by assuming that Home produces two different goods, one for the domestic market and one for the Foreign market. Does the main result crucially depend on this modelling strategy?
(5) Starting with Feenstra (JIE 1989) there is a discussion on the tariff pass through. The author should use this literature to motivate the pricing policy of exporters and importers.


Willem Buiter - Response to referee report
May 02, 2017 - 13:04

see attached file


Willem Buiter - Revised version
May 02, 2017 - 13:07

see attached file