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How a border adjustment phase-in would widen the trade deficit for years
View related content: Economics
The border adjustment, a combination of a tax on imports and a subsidy for exports, is a key source of revenue in the House Republicans’ tax reform plan. House Ways and Means chairman Kevin Brady recommended yesterday that it be phased in gradually, over a five year period. Such a phase-in would change most economists’ expectations of the implications of the policy.
As I have discussed before, most economists believe that nominal exchange rates would adjust to undo the terms-of-trade effects of a permanent, unexpected, comprehensive border adjustment. Based on similar assumptions, economists expect different effects if the introduction of the adjustment is predictable: greater trade deficits during the phase-in period and smaller trade deficits (or greater trade surpluses) after the phase-in period.
The mechanism that would lead to these effects is the following. Without forward-looking behavior by market participants, the border adjustment would induce an offsetting appreciation of the dollar upon implementation. With forward-looking behavior by market participants such a predictable appreciation produces an arbitrage opportunity that, if exploited, induces preemptive appreciation of the dollar.
The appreciation of the dollar that takes place before the border adjustment is fully implemented raises the price of domestically produced goods relative to imported goods throughout the phase-in period, which raises the demand for imports and lowers the demand for exports. As a consequence, the trade deficit will widen and domestic consumption will increase during the phase-in period. The flip-side of this widening trade deficit is greater capital inflows from abroad and an increase in external debt. Domestic consumption will increase.
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The increased trade deficit during the phase-in period requires larger post-implementation trade surpluses. Stated differently, the increased external debt requires reduced consumption after the implementation. This, in turn, reduces the relative domestic price level, dampening the currency adjustment post-implementation. The dollar will not appreciate by quite enough to fully offset the border adjustment, although it will converge toward the full-offset level over time.
This means that the prices of imports will be significantly higher during the phase-in period than they would have been in the absence of the policy change, but not as high as they would be if the dollar appreciated by enough to fully offset the ultimate border adjustment. After implementation, the prices of imports will be slightly higher than they would be under a fully offsetting dollar appreciation, while the prices of exports will be slightly lower. Together, these relative price shifts generate larger trade deficits early on, and smaller ones starting in 2022 or 2023.