How border adjustment reduces the value of your Scottish golf course

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Republicans, newly ascendant in DC, are planning on fundamentally transforming the corporate tax system. Besides a lower marginal rate, another central feature of House Republicans’ reform plan is the introduction of a border adjustment – a combination of a tax on imports and a subsidy for exports. The debate over this potential change is just starting to warm up, and it is not yet clear who will gain and who will lose.

REUTERS/Lucy Nicholson.

The import tax and export subsidy looks like a mix of protectionism and mercantilism. Some people, including Ted Cruz, believe that it is – and they like this, because they believe running a trade deficit (that is, foreigners giving you more stuff than you give them) is bad. Other people, including Larry Summers, also believe that it is – but they don’t like that. Retailers have come out in opposition to border adjustment for a similar reason, complaining that they would face massive tax increases because they rely heavily on imports.

The conventional deep logic of international economics suggests otherwise. As my colleague Alan Viard has long argued, and as Emmanuel Farhi, Gita Gopinath and Oleg Itshkoki explain here, nominal exchange rates would adjust to the increased demand for subsidized US exports and the decreased demand for foreign products in the US. A 25% strengthening of the dollar would perfectly offset the border adjustment tax, leaving the effective terms of trade unchanged. Retailers would enjoy lower- cost imports, offsetting their tax increases, and the trade deficit would not change. In addition, and this has earned the plan the support of people like Martin Feldstein, the US would gain a significant amount of tax revenue as long as it runs a trade deficit.

Let us assume for now that nominal exchange rates will indeed adjust instantly the moment the new tax system is applied – not earlier or later – and no one will change his behavior in anticipation. Trade will then not be affected. But there will be drastic shifts in the dollar value of assets and liabilities denominated in foreign currency, as Farhi, Gopinath, and Itshkoki point out:

An appreciating dollar would erode America’s net foreign-asset position, because an overwhelming 85% of its foreign liabilities are denominated in dollars, while around 70% of its foreign assets are denominated in a foreign currency. With US foreign assets amounting to 140% of its GDP, and its foreign liabilities amounting to 180% of GDP, a dollar appreciation of 20% would result in a capital loss equal to about 13% of GDP.

In dollar terms, that is a loss of almost $2.5 trillion to American citizens and firms, or almost $8,000 per American.

And that is only the net number. In reality, assets and liabilities are not distributed evenly, and some individuals and firms will suffer large losses. Many pension funds, for example, own sizable amounts of foreign assets, but their future liabilities are practically all dollar-denominated pension obligations. Or imagine that you are a reality TV show host who also owns golf courses. If you, for example, own a $38 million golf course in Scotland, you will lose over 7 million the moment the exchange rate adjusts.

With the value of US-held foreign-currency denominated assets totaling some $18 trillion, there will be many such cases. And there are risks to dollar-dominated foreign assets as well, as I will discuss in my next blog post. But even without those, the massive redistribution of wealth induced by a 25% dollar appreciation will produce strong interests both in favor of and in opposition to the border adjustment.