Editor's note: We are reposting this VoxEU column, which was originally published in August 2017, in celebration of William Nordhaus's Nobel Prize.
You might hear someone say, “That’s a fact. People can look it up.” It was not always so. The modern concept of a ‘fact’ emerged with the scientific revolution of the 16th century. Before that, descriptions of the natural world were determined by religious or secular authorities. The discovery of a new star by Tycho Brahe in 1572 was a “killer fact” that ultimately destroyed the earlier conception of the heavens. In a well-functioning society, the status of a fact is decided by evidence and experiment.1
Or so we thought. In a scene reminiscent of medieval times, the administration of President Donald Trump has turned the clock back to an era in which authority determines which facts are fake and which are real. This plays out daily in tweets and press conferences. The English language has been enriched with phrases such as “fake news” and “alternative facts.”
The notion of alternative facts was well described by George Orwell in Nineteen Eighty Four (Orwell 1949) as “to be conscious of complete truthfulness while telling carefully constructed lies.” Even alternative facts can change, as when former White House press secretary Sean Spicer defended the employment data after attacking them, quoting Trump as saying, “They may have been phony in the past, but it's very real now.” The White House is said to be considering creating alternative facts about trade by excluding re-exports from the trade balance (Maudlin and Barrett 2017), in effect creating a trade deficit for the entire world.
While the President and the press battle daily over facts, the more consequential struggle over ideas has been overshadowed. What are Mr. Trump’s economic ideas and philosophy? The Trump administration has largely embraced the standard Republican agenda items of lowering taxes, cutting spending, reducing the burden of regulation, and freeing the market.
There is one area where Mr. Trump as candidate and president has espoused an economic policy that is dramatically opposed to traditional Republican policies, however, and that is his embrace of trade protectionism. Since his rejection of free trade is so unusual, and so quintessentially Trump, it is worth a careful review.
The Trump campaign rhetoric is familiar to those who followed the 2016 presidential campaign. Here is a sample from 25 February 2016:
“It's not free trade; it's stupid trade…. I don't mind trade wars when we're losing $58 billion a year….We are killing ourselves with trade pacts…. Free trade can be wonderful if you have smart people, but we have people that are stupid…. I think NAFTA has been a disaster.”
What lies behind the bluster? The Trump Theory of Trade has four strands at variance with modern economic analysis: overlooking the gains from trade, focusing on the trade deficit, ignoring the changing nature of trade, and disdaining the need for cooperation in international affairs. In this column, I review current thinking on these as well as losses from trade and the business tax proposal with border tax adjustment.
The gains from trade
The most fundamental point is that trade – whether domestic or international – is mutually beneficial. The basic analysis was developed exactly 200 years ago by David Ricardo in his theory of comparative advantage (Ricardo 1817). Ricardo used the examples of Portuguese wine and English cloth. Today, the examples have changed but the principles are the same. By specialising in the production and export of goods that countries make relatively cheaply, and importing and consuming goods that the country makes relatively expensively, each country can improve its living standards.
While wine and clothing continue to be staples of international trade, we can use the iPhone as an example of the benefits of trade in the modern era. Some people may remember the first mobile telephone produced by Motorola in 1973. It was nicknamed ‘the brick’ – heavy, huge, and costing $10,000 in today’s prices. Over the next four decades, vigorous competition between many companies around the globe led to the smart phone that is probably one of the most cherished products today, with 3 billion users.2
One of the most fascinating stories about trade is a ‘teardown’ analysis of how the Apple iPod is made (Varian 2007). Our trade statistics record the iPod as made in China, but the analysis finds that China added only $4 of the $299 retail price, with the 451 parts being made by companies around the world. Apple earned about $80 for its design, research, and marketing. However, all this would not have been possible without the free trade in electronic products that allows easy exchange of the parts built into iPods and iPhones. The cameras in today’s smart phones cost about $20 and produce a trillion pictures a year. These show, in vivid colour, how people around the world benefit from the vigorous competition inherent in international trade.
Suppose you were a reader of Mad Magazine when it was first published in 1952. You would need to wait for the US Postal Service to get your copy. Today, you can read the latest issue on your smart phone – after having used your phone to locate a coffee shop, buy the coffee, email your family, take a picture and send it to your family, check on your flight delay, read the news, and play a game. These would not have been possible without the gains from trade.
Focus on the trade deficit
One of Mr. Trump’s major themes is that the US is losing in its trade policies, and the trade deficit shows the score. The administration’s economic theory of trade was described at length by Peter Navarro, director of the White House National Trade Council in the Trump administration. His argument is as follows:
“The economic argument that trade deficits matter begins with the observation that growth in real GDP depends on only four factors: consumption, government spending, business investment and net exports (the difference between exports and imports). Reducing a trade deficit through tough, smart negotiations is a way to increase net exports—and boost the rate of economic growth”. (Wall Street Journal, 5 March 2017)
Navarro’s statement is simply an accounting identity and does not recognize the effect of policies, trade or other, on output and employment. As economics, it fails on three grounds.
- A first mistake is to read any significance into bilateral trade balances. Here is a typical claim from Mr. Trump, made on Twitter on 26 January 2017: “The US has a 60 billion dollar trade deficit with Mexico. It has been a one-sided deal from the beginning of NAFTA...” One of the first lessons in economics is that bilateral trade balances have no significance in a multi-country world. A simple example with triangular trade will illustrate. Suppose the US exports $100 billion of computers to Australia, which exports $100 billion of wheat to China, which exports $100 of billion clothing to the US. The US has $100 billion deficit with China, but each of the three countries has a zero overall trade deficit. So what is the true “score” for Mexico, its current account? Mexico was actually running a $36 billion deficit in 2016. While Mexico had a bilateral surplus with the US, it had large bilateral deficits with China, the EU, and Japan. So while the bilateral deficit is a fact, it is an irrelevant fact.
- A second mistake is the belief that trade deficits are an economic malady. Modern macroeconomics looks at the issue completely differently: trade deficits are the counterpart of low domestic saving and high foreign saving. My second column in this two-part series explains this as the paradox of the tail wagging the dog.
- The third flaw, closely related to the second, is the idea that trade deficits and job losses are the result of ‘bad trade deals’. Actually, to a first approximation, trade deals have no impact on the unemployment rate or the trade deficit. Trade deals are important. They increase imports and exports of all sides of the deal. They increase the volume and variety of goods consumed and exported. Along the way, they produce economic benefits to both the US and its trading partners. However, trade deals have minimal effect on joblessness. For the US, trends in unemployment are largely determined by monetary and fiscal policy as well as shocks such as wars and financial crises. And, to reiterate the second point, trade deals do not affect the trade deficit – this is determined by saving and investment trends at home and abroad.
The Auerbach-Ryan Tax Plan and border tax adjustment
Suppose that policymakers are alarmed about the trade deficit and wish to ‘do something’. While economists might argue this is wrong-headed, or that the way to deal with trade deficits is through fiscal policy, one interesting new approach involves business tax reform and ‘border tax adjustment’.
This new approach is the brainchild of Alan Auerbach, a distinguished fiscal policy economist at Berkeley (e.g. Auerbach et al. 2017). The idea moved from the academy to Washington when it was proposed by the House leadership (Tax Reform Task Force 2016) – although at the time of this writing it is not on the Republican agenda for tax reform. It would have a major impact on trade and finance, so we need to weigh it carefully.
The technical name of this proposal is a ‘destination-based cash flow tax’, or DBCFT. It has two parts, one relating to cash flow and the other because it is destination-based. The first part is a move from the current corporation income tax to a cash flow tax. This would involve principally removing the tax preference that allows deductibility of interest and allowing investment to be completely deducted in the current year (‘expensing’). The US Treasury estimated that the tax base would be about the same as today’s tax system, so a straight change with unchanged tax rates would be roughly revenue-neutral (Patel and McClelland 2017). Many economists would favour this kind of reform (if it were revenue-neutral and distribution-neutral) because of the distortions caused by interest deductibility.
The second feature of the DBCFT is to change the cash flow definition to be destination-based. This is designed to correct for the international ‘race to the bottom’ in which companies minimise their taxes by moving their assets (such as intellectual property) to low-tax countries such as Ireland.
Companies race to the bottom because some elements of the current US corporate tax involve mobile factors. While it is hard to move my house or Wyoming’s coal mines out of the US, and out of the US tax system, it is easy to move the ownership of Apple’s intellectual property (IP). Suppose that Apple moved its IP from the US to Ireland. In the US, this would be taxed at the federal rate of 35%, but it was apparently taxed at only 0.005% in Ireland in 2014 (Taylor 2016).
DBCFT would move the tax base to where a good is consumed (i.e. the destination) rather than on where it is produced (i.e. the origin) because consumption is relatively immobile. We can move the production of running shoes to Vietnam, but I consume (i.e. wear) my running shoes in Connecticut. In its focus on taxing consumption, the DBCFT is like a sales tax or a value-added tax. From an international perspective, if Apple is taxed only on its domestic cash flow (US sales less US costs), then the location of ownership of its IP no longer enters into the calculation of US taxes. So the race is over because there is no reward for winning it.
Here is where the border tax adjustment comes in. The previous paragraph pointed to cash flow equalling “US sales less US costs”. This means that imports are not part of costs, and exports are not part of revenues. So if the DBCFT rate is 20%, then there is a tax of 20% on imports and a 20% subsidy on exports. Therefore, companies such as Walmart who are net importers are screaming foul, while major exporters are quiet.
This plan is devilishly complicated, and a few overview comments must suffice at this point. First, there is no country in the world that has the DBCFT… not a single one. As a result, there are huge obstacles to its implementation, such as because there is no experience with it, it does not comply with WTO rules, and it may violate tax treaties (for an explanation of some of the problems, see Graetz 2017).
A second point just mentioned is that many of the advantages would arise only if the DBCFT were universally adopted. However, it would make tax life more complicated and create new tax havens if the US adopted it and other countries did not. For example, the advantage of removing the tax arbitrage from locating intellectual property (IP) in a low-tax country would look quite different with partial adoption. Since imports are taxed and exports are subsidised under a DBCFT, there would be tax arbitrage possibilities from moving all IP (and other footloose costs) to the US. To put this in perspective, the WTO estimates that trade in IP was more than $300 billion in 2013. Moving to a DBCFT system from an income tax system would involve tens of billions of dollars in tax reductions and reallocations. This is perhaps the most dramatic example of the distortions that would arise from unilateral adoption of this proposal.
Third, an important facet of the plan is that it would (in its pure form as applying only to goods) raise substantial revenues for the US. At a 20% tax rate, the import taxes would at last year’s trade levels be $440 billion, while the export subsidies would be $290 billion. So this would lead to $150 billion in additional US federal revenues at current trade levels. The total would be lower if services were included (because the US has a surplus there). Revenues would also be lower if the border tax adjustment reduces the trade deficit (as seems likely). Revenues would be further lower if other countries retaliate with their own border taxes. It is hard to imagine all the corporate finagling that would occur with those hundreds of billions of dollars at stake.
Some defenders of the plan argue that it will have little trade impact because the dollar exchange rate will adjust to offset the tax. To illustrate, if the dollar appreciates by 20%, then this will exactly offset the 20% import tax and export subsidy. While this is true as a matter of logic, there are at least two problems with this defence. First, several countries are actually or effectively pegged to the dollar (Hong Kong being an example). Unless these countries specifically devalue by 20%, the offset will not occur. A second concern is the imbalance in the US financial account. At the end of 2016, the US owed $32 trillion to foreigners. If the dollar were to appreciate by 20%, this would comprise a $6.4 trillion capital gain to foreigners. The US owns $24 trillion of foreign assets, and US owners would suffer a huge capital loss with dollar appreciation. So if the defenders are right that dollar depreciation would offset the tax-and-subsidy aspect of the DBCFT, they need to defend the major wealth redistribution from Americans to foreigners.
Given all these problems, you might ask why Congressional Republicans are so enamoured with this plan. Conservative economists have for many years advocated a cash flow corporate tax. However, the ‘destination-based’ element, implying border tax adjustment, is a new feature of the tax landscape. The obvious reason is that Republicans need revenues to finance their 2017 version of a supply-side tax cut, and border tax adjustment could provide $1 trillion or more of revenues over the next decade. This feature is pure “America first” in which taxes are collected to benefit the rich at the expense of trading partners.
The verdict on this new corporate tax proposal is that it has many attractive features, but it also has many disadvantages. It is mightily complicated, both domestically as a matter of tax law, and internationally in meshing with other countries’ tax systems. While it has been shelved by the administration and Congressional leadership as of the summer of 2017, it seems a safe bet that the DBCFT will return.
Auerbach, A J, M P Devereux, M Keen and J Vella (2017), “Destination-Based Cash Flow Taxation”, Oxford University Centre for Business Taxation working paper 17/01.
Graetz, M (2017), “The Known Unknowns of the Business Tax Reforms Proposed in the House Republican Blueprint”, Columbia Journal of Tax Law, 8(117).
Mauldin, W and D Barrett (2017), “Trump Administration Considers Change in Calculating U.S. Trade Deficit”, Wall Street Journal, 19 February.
Orwell, G (1949), Nineteen Eighty-Four, London: Secker & Warburg.
Patel, E and J McClelland (2017), “What Would a Cash Flow Tax Look Like for U.S. Companies? Lessons from a Historical Panel”, US Treasury Office of Tax Analysis working Paper 116.
Ricardo, D (1817), On the Principles of Political Economy and Taxation, London: J Murray.
Tax Reform Task Force (2016), "A Better Way, Our Vision for a Confident America", speaker.gov, 24 June.
Taylor, H (2016), “How Apple managed to pay a 0.005 percent tax rate in 2014”, CNBC.com, 30 August.
Varian, H (2007), 'An iPod has Global Value. Ask the (Many) Countries That Make It,' The New York Times, 7 June.
Wootton, D (2105), The Invention of Science: A New History of the Scientific Revolution, London: Penguin.
 For a discussion of the history of ‘facts’ and the role of the scientific revolution, see Wooton (2015). The quotation on “look it up” was Marco Rubio criticising Donald Trump for hiring Polish workers.
 A useful history is found at https://en.wikipedia.org/wiki/History_of_mobile_phones. The number of smart phone users is an estimate that comes from https://www.statista.com/statistics/330695/number-of-smartphone-users-worldwide/.
 For an illuminating critique, see Graetz (2017).
 For data on intellectual property trade, see https://www.wto.org/english/res_e/statis_e/its2014_e/its14_toc_e.htm.