Economist Martin Felstein has an article in the Wall Street Journal arguing that those who are opposed to the Border Adjustment Tax (BAT) are simply misunderstanding it. He claims that we are wrong to warn lawmakers and the American people that under the very complex tax that would only apply to imports, some of the tax burden will raise the cost of doing business for American retailers, which will in turn shift part of the burden to consumers. Not to worry, Feldstein argues, “what would happen instead is a 25% increase in the dollar relative to other currencies, enough to offset the tax on imports and the subsidy on exports.”
I am sorry to say that while Mr. Felstein’s overconfidence may be a good tool for advocacy, it needs to be treated with extreme caution. For one thing, this is simple speculation as there are no real-world examples for any countries adopting a BAT. That’s right — as I have written before — despite the implied claims made by pro-BAT people, no countries actually adjust their corporate income tax. They border-adjust their Value Added Tax (VAT), a tax that sits on top of their own corporate income tax.
Under the circumstances, the closest thing we can look at to understand how currencies will adjust in the real world — as opposed to how they will adjust in the friction-free pages of economic textbooks — is to look at the adoption of VATs around the world. My colleagues, Adam Michel and Jason Fichtner, and I just did that. In a paper released last week, we reviewed the empirical literature of currency adjustments after the introduction of a VAT. The results are pretty clear: In a majority of cases, currencies certainly do not adjust entirely or quickly.
Better yet, I am surprised to see such assertions coming from Felstein, whose own academic research finds that “in reality, VATs will not be neutral in the effects on trade,” because imperfect implementation undermines the idealized academic models that show no trade effects.
Another selling point of the border-adjusted tax, Feldstein argues, is that it will raise a lot of revenue. He is not the only one making that claim. However, even that may be a disappointment if his perfect academic assumptions aren’t true in the real world. If the real world remains as messy as we know it is — meaning there is a less than perfect currency adjustment, there is foreign retaliation in the form of higher tariffs on American exports, or even a WTO challenge, which would affect currency adjustment — then revenue projections may not come through as currently expected levels.
The bottom line is that Mr. Felstein’s overconfidence seems unjustified. As we conclude in our paper:
The academic and policy debate on DBCFTs is generally fragmented, overly confident, and lacking in evidence, as there are no real-world examples of a destination-based cash flow tax. In this paper, we explore just a few of the most pressing questions that threaten to undermine the theoretical benefits of such a reform. Given the uncertainty and large downside risk to a DBCFT, we conclude that the proposal is not yet ready to be implemented and policymakers should focus on more traditional and straightforward reforms.
Those straightforward reforms are well-known to those who have worked on this for decades: Lower the corporate tax rate, which is currently the highest of all the OECD countries, and move to a territorial tax system. The current 35 percent corporate tax rate doubled with our worldwide tax system explains why U.S. companies keep their money abroad rather than bringing it to the U.S. To eliminate our companies’ competitive disadvantage, we should move to a territorial tax system and lower our corporate tax rate. The United Kingdom and Japan did just that in 2009 to their benefit — without resorting to a complicated tax increase like the border-adjustment tax.