Resident Scholar Alan D. Viard

In 2004, I wrote two letters rebutting the border-adjustment fallacy.[1] The fallacy holds that exports are permanently increased and imports permanently reduced by the import tax and export tax exemption (the "border adjustment") typically included in retail sales taxes and VATs. As I pointed out in 2004, countless economists have demonstrated that a border adjustment triggers a real currency appreciation that offsets any apparent competitive advantage for domestic producers.[2]

The border-adjustment fallacy has frequently appeared in arguments supporting the FairTax. (The FairTax plan, which has been introduced in Congress as H.R. 25 and S. 1025, would replace individual income, corporate income, payroll, self-employment, estate, and gift taxes with a tax-inclusive 23 percent retail sales tax.) Interestingly, a recent article by Hank Adler opposing the FairTax also relies on the fallacy.[3]

Of course, a fallacy remains a fallacy, no matter by whom it is invoked. Accordingly, I write on this topic yet again. I discuss Adler's distinctive perspective on the fallacy and also briefly examine his discussion of other issues.

Most believers in the fallacy praise border-adjusted taxes for their alleged stimulus to exports. Adler describes this alleged effect in far less favorable terms: "If a foreign buyer who is not subject to U.S. taxes on U.S. exports has a 30 percent price advantage over a U.S. buyer, that buyer could afford to substantially outbid the U.S. buyer yet still pay a lower price than the U.S. buyer. That's clearly a problem for U.S. buyers." In Adler's view, the alleged export boost is a loss to U.S. buyers, not a gain to U.S. sellers.

Most believers in the fallacy also praise border-adjusted taxes for their alleged penalty on imports, viewing this effect as a gain to the U.S. sellers who compete against imports. Although Adler does not discuss the point, he would probably view the alleged import restraint as a further loss to U.S. buyers.

Adler's perspective is much more sensible than that of his fellow believers. If a border adjustment (or any other policy) actually yielded a permanent export increase and import reduction, the result would be a catastrophe rather than a triumph. We would forever send additional real goods and services, produced by our toil and our natural resources, to foreign buyers for their enjoyment while receiving fewer real goods and services from them in return. Our living standards would needlessly decline.

Imports, not exports, are the gain from trade. Exports are the cost of trade--the goods and services that we give up to obtain the imports that we need and desire. The effort to increase exports and reduce imports is a product of mercantilism, a pernicious doctrine against which Adam Smith warned two centuries ago. He observed that running a trade surplus ("the importation of gold and silver") was not the "principal, much less the sole benefit which a nation derives from its foreign trade" and explained that the real purpose of trade is to exchange "that surplus part of the produce . . . for which there is no demand" for "something else for which there is a demand."[4]

In the end, though, it is pointless, except as a matter of pedagogy, to debate the desirability of border adjustments' alleged trade effects since those effects would not actually occur. Any such discussion resembles the famous Catch-22 passage in which two atheists debate what God would be like if he existed.[5]

Since long-term budget constraints require that imports and exports equal each other in present discounted value over the country's entire history, any effort to permanently boost exports and reduce imports is as futile as it is undesirable. After a switch to border-adjusted taxes, an offsetting adjustment to real exchange rates would occur. Although U.S. sellers would not be taxed on sales to foreign buyers, their earnings from such sales would be reduced by the strengthening of the dollar, eliminating any special incentive to sell abroad rather than at home.

Adler discusses a number of issues in the remainder of his article. He reviews the well-known flaws of the FairTax plan: a high- rate retail sales tax is likely to face significant compliance problems, the bizarre provision for state administration of the tax guarantees weak enforcement, and the 23 percent tax-inclusive rate does not achieve revenue neutrality. These flaws have been documented by many authors, recently including Bruce Bartlett.[6] Adler also correctly notes that the plan would shift some of the tax burden from the rich to the middle class, eliminate preferential treatment for state and local governments' borrowing, reduce the value of existing assets in general and existing municipal bonds in particular, complicate the administration of the Social Security system, and encourage tax planning during the transition. Observers can debate how serious these problems are or whether some of them are problems at all.

I feel compelled, however, to correct five important errors in Adler's article:

For good or ill, Social Security recipients would gain buying power under the FairTax plan. The income tax currently imposed on some benefits would be removed and the cost-of-living adjustment would fully offset any increase in the consumer price level.[7]

The FairTax would be neutral between investor-owned housing and owner-occupied housing. Sales tax would apply to the rental proceeds, but not the purchase price, of investor-owned housing; it would apply to the purchase price, but not the (imputed) rental proceeds, of owner-occupied housing. Since the purchase price and the rental proceeds have the same expected present discounted value, the two approaches are economically equivalent.

The FairTax plan would measure self-employment earnings for purposes of determining Social Security benefits as value added (sales to consumers and other firms minus purchases from other firms) minus wage costs. The measure is conceptually sound, matching the base on which firms would be taxed by a Hall-Rabushka "flat tax" or Bradford X tax. Adler's claim that sales to other firms would be excluded from the computation rests on a misreading of H.R. 25.[8]

The costs of state and local government services relative to the costs of private purchases would be roughly unchanged under the FairTax. The plan simply taxes state and local government purchases in the same manner as private purchases. Current law follows a similar approach; the income and payroll taxes that apply to the private sector also apply, with some exceptions, to employees of state and local governments and to firms from whom those governments purchase inputs.[9]

Finally, the plan's denial of prebates to unlawful residents would pose no constitutional problems. For good or ill, the U.S. Supreme Court has ruled that Congress has virtually unlimited power to deny benefits even to noncitizens lawfully present in the United States, let alone to unlawful residents.[10] Congress currently denies the earned income tax credit and various federal payments to unlawful residents and to some other noncitizens.[11]

The FairTax debate has long been plagued by the unfounded claims made by many of its supporters: the border-adjustment fallacy, the misconception that the plan would tax the underground economy, the fantasy that switching to a consumption tax without transition relief would raise the value of existing assets, and the absurdity that the FairTax would leave both consumer prices and nominal wages unchanged. The debate is not improved, however, when opponents make equally unfounded claims. The FairTax should be considered (and, in my view, rejected) based on its actual provisions and effects.

Unfortunately, the discussion of border adjustments and other fallacies threatens to obscure the important issues at stake in the debate over fundamental tax reform. Income taxation is a seriously flawed policy that penalizes saving and thereby impedes capital accumulation and long-run economic growth. Large economic gains can be achieved by a revenue-neutral switch to a well-designed consumption tax. Such a tax may, but need not, be border-adjusted. I end on the same note I ended on in 2004, "The border-adjustment fallacy should not obscure the real case for consumption taxation."

Alan D. Viard is a resident scholar at AEI.

Notes

1. "Border Adjustments Won't Promote Competitiveness," Tax Notes, Oct. 4, 2004, p. 122, Doc 2004-19117 [PDF], 2004 TNT 193-52 ; "Why Attacks on Analysis of Border Adjustment Were Unsuccessful," Tax Notes, Nov. 22, 2004, p. 1153, Doc 2004-21938 [PDF], 2004 TNT 226-34. 

2. I cited numerous references in "Border Adjustments Won't Promote Competitiveness," supra note 1, at 122 n.2.

3. "FairTax--Not Ready for Prime Time," Tax Notes, Jan. 14, 2008, p. 301, Doc 2007-28078 [PDF], 2008 TNT 10- 26 .

4. An Inquiry Into the Nature and Causes of the Wealth of Nations (1776), Book IV, Chapter 1.

5. Joseph Heller, Catch-22 (1961), Chapter 18.

6. "Why the FairTax Won't Work," Tax Notes, Dec. 24, 2007, p. 1241, Doc 2007-26563 [PDF], 2007 TNT 248- 33 .

7. Section 303 of H.R. 25 specifies that Social Security benefits would be indexed to the sales-tax-inclusive consumer price level.

8. Section 903(c) of the proposed new Internal Revenue Code, as set forth in section 201(a) of H.R. 25, defines self- employment earnings as gross payments received for "taxable property or services" minus wages and gross payments made for taxable property or service. Proposed code section 2(a)(14) defines "taxable property and services" to include property and services sold by firms to other firms. Although proposed code section 102 exempts those sales from the retail sales tax, no provision removes those sales from that definition or from the computation of self-employment earnings.

9. State and local governments are exempt from federal income tax on the (imputed) income generated by their holdings of capital and some of their employees are exempt from payroll taxes under code section 3121(b)(7) and (u)(2).

10. In Matthews v. Diaz, 426 U.S. 67 (1976), the Supreme Court, citing Congress's broad power over immigration and naturalization, unanimously upheld Congress's denial of certain Medicare benefits to noncitizens other than green card holders with five years of continuous residence in the United States. (In contrast, the Court has generally prohibited states from discriminating against noncitizens who are legally present, Graham v. Richardson, 403 U.S. 365 (1971), and has limited their power to discriminate against unlawful residents, Plyler v. Doe, 457 U.S. 202 (1982).) The recent judicial decision cited by Adler struck down an employment-verification regulation under the Administrative Procedures Act and addressed no constitutional issues.

11. See code section 32(c)(1)(D), (E), (3)(D), and (m) (restricting eligibility of noncitizens for earned income tax credit) and 8 U.S.C. section 1612 (denying various federal payments to noncitizens other than those in specified categories).