An obscure but consequential debate is playing out on Capitol Hill that pits lobbyists for America’s large retail chains against the conventional wisdom of the economics profession — and a new analysis from Goldman Sachs’s research division suggests the lobbyists may have this right and the wonks wrong.
House Republicans are trying to gain support for a major overhaul of business taxation in the United States, one of whose features is “border adjustment.” Corporate income under this system would be taxed based on the location of sales, so the cost of importing things (whether components of a larger product or finished goods intended for resale in stores) would not be deductible, while exports would not be taxable.
On its face, this sounds like a huge deal for trade policy. On the one hand, that kind of destination-based taxation could be a boon to American manufacturing employment — boosting American producers against foreign competition. On the other hand, it sounds like a disaster for low-margin retailers, because it could mean higher prices across the board for imported consumer goods.
Economists — and wonky journalists — have largely been arguing that this isn’t true. The real effect, say the experts, would be a higher price of the dollar that offsets the impact of pricing and leaves dollar-denominated prices exactly where they were before. Practitioners seem less certain. Major retailers are lobbying against the change, as is Koch Industries, while a number of manufacturing companies are lobbying for it.
Joining the ranks of practitioner skepticism this week is Goldman Sachs’s research team, which, though neither for or against the tax change per se, is interested in correctly forecasting exchange rates. A recent one-pager from Michael Cahill, one of their foreign exchange strategists, argues that wonks are drastically oversimplifying how this actually works.
What the model really says
Economists and the journalists who cover them often get into trouble by being insufficiently precise in their descriptions of what basic economic models actually say. In the case of border taxes, it’s true that if you look back at a textbook, it would say these taxes impact exchange rates rather than trade flows — whether taking the exotic form of the House GOP’s corporate tax reform, a European-style value added tax, or even an old-fashioned broad tariff. But like many other conclusions in economics, that’s assuming “all else is equal,” and the world’s governments actually allow exchange rates to float freely.
Cahill’s point is that it’s very unlikely this would happen. Many emerging markets, he writes, “intervene in some way to limit volatility against the dollar.” Over half of American trade is “against EM currencies, and China alone has a weight of more than 20 percent.”
Some observers think you can wish this currency intervention away by assuming that foreign countries manipulate their currencies only to hold the price down and maintain competitiveness. But that’s simply not true. China has been acting to prop up the value of its currency recently, and it’s not the only country to do this.
“Since EMs intervene under both appreciation and depreciation pressure,” Cahill writes, “it would seem more than competitiveness considerations are at work.”
A political question, not an economic one
The theoretical model’s prediction that the tax impact will be fully neutralized by exchange rates has some empirical evidence to back it up. But that evidence, more or less necessarily, is drawn from countries that are a lot smaller than the United States and/or that were making more modest tax changes. For the world’s largest economy to undertake a tax reform on the scale House Republicans are contemplating entails a 25 percent increase in the value of the US dollar.
That’s simply much too big a change for world governments to watch from the sidelines.
As the American Enterprise Institute’s Stan Veuger writes, for example, there is about $3 trillion dollars’ worth of dollar-denominated debt outstanding in various emerging market countries. A 25 percent increase in the value of the dollar would make many of those debts untenable, leading to cascading waves of bankruptcies.
One read is that this shows the GOP tax plan would lead to cascading waves of bankruptcies. Goldman says a better read is that foreign governments would probably try to avoid letting the value of the dollar actually rise that much. How successful would they be at stopping this? And how would they strike the balance between competitiveness concerns and debt burden concerns? I’m not sure, and Cahill doesn’t have a precise forecast either.
His point, however, is that this ends up being fundamentally a question about international politics and not one about trade economics. The United States is way too big and the dollar is much too globally important for foreign players to just “let the market sort it out.” Market forces would clearly tend to push the value of the dollar up, but exactly how far that goes would end up being a complicated balancing act between the Fed, the People’s Bank of China, and various other central banks and finance ministries around the world. If it doesn’t rise enough to fully compensate for the cost of paying the tax, that could mean broadly higher prices for American consumers across the board.
