DP11885 Exchange rate implications of Border Tax Adjustment Neutrality
A border tax adjustment (BTA) is under consideration for the corporate profit tax in the US. Mainstream economic theory holds that BTAs – a switch from taxing exports and exempting imports to taxing imports and exempting exports – is neutral: it will not affect competitiveness and sectoral profitability in the country implementing the BTA or abroad, through adjustments in the exchange rate and in domestic and foreign prices and costs.
Conventional wisdom has it that (real) BTA neutrality is achieved through an appreciation of the currency equal in percentage terms to the tax rate. So, with a 20% US corporate tax rate, a neutral BTA would cause the US dollar to strengthen (appreciate) by 20%.
This paper shows that the conventional wisdom is not robust. Alternative assumptions about the behaviour of domestic and foreign nominal prices that are (at least) as plausible as the assumptions that imply a 20% appreciation of the US dollar, would instead result in a 20% strengthening of the foreign currency and a matching depreciation of the US dollar.
Two key aspects of rigidities in nominal prices are involved: (1) are prices sticky (constant) in terms of the currency of the country of origin or in terms of the currency of the country of destination (pricing-to-market)?; (2) are prices sticky (constant) net-of-tax or tax-inclusive? The empirical evidence slightly favors pricing-to-market (US import prices constant in dollars and US export prices constant in foreign currency). There is no empirical evidence on whether nominal rigidities apply to tax-inclusive or net-of-tax prices.
Pricing-to-market for net-of-tax prices produces the depreciation outcome. So does currency-of-origin pricing for tax-inclusive prices. Pricing-to-market for tax-inclusive prices and currency-of-origin pricing for net-of-tax prices produces the appreciation outcome.
Given the lack of robust empirical evidence, I believe it is not possible to have any confidence about even the direction of the response of the dollar to a BTA in the US – let alone about the magnitude.
The paper has real BTA neutrality as its maintained hypothesis. This is, however, a disputed empirical issue. This further boosts the uncertainty about the exchange rate implications of a BTA.