Abstract
Abstract This paper investigates the implications for the nominal exchange rate of a Border Tax Adjustment (BTA) when there is BTA neutrality. A border tax adjustment is a change from an origin-based system of taxation, that taxes exports but exempts imports to a destination-based system that taxes imports but exempts exports. Both indirect taxes (e.g. a VAT) and direct taxes (e.g. a cash-flow corporate profit tax) can be subject to a BTA. In the US, a BTA for the corporate profit tax is under discussion. There is BTA neutrality when the real equilibrium, including measures of profitability and competitiveness, of an open economy is unchanged when it moves from an origin-based to a destinationbased tax. The conventional wisdom on the exchange rate implications of a neutral BTA is that the currency of the country implementing the BTA will strengthen (appreciate) by a percentage equal to the VAT or CPT tax rate. The main insight of this note is that this ‘appreciation presumption’ is not robust, even when all conditions for full BTA neutrality are satisfied. Indeed, plausible alternative assumptions about constancy (or stickiness) of nominal prices support a weakening (depreciation) of the currency by the same percentage as the tax rate. On the basis on the very patchy available empirical information, it is not possible to take a view with any degree of confidence on the implications of a BTA for the nominal exchange rate, even if full BTA neutrality prevailed. Whether BTA neutrality itself is a feature of the real world is also a disputed empirical issue. Therefore, buyer (or seller) beware.
Highlights
This paper investigates the implications for the nominal exchange rate of a Border Tax Adjustment (BTA) when there is BTA neutrality
BTA neutrality implies that no real equilibrium values are affected by a change from an origin-based to a destination-based direct or indirect tax system, if financial market participants positioned themselves in a way that would make sense if one confidently anticipated the 20 percent appreciation held out by conventional wisdom, there could be serious disruption should a 20 percent depreciation – shown in this paper to be not implausible – were to occur instead
Exchange rate depreciation occurs under a neutral BTA when tax-inclusive prices are constant and US export prices are constant in dollars and US import prices are constant in euro – the case of origin currency pricing for both imports and exports
Summary
This paper investigates the implications for the nominal exchange rate of a Border Tax Adjustment (BTA) when there is BTA neutrality. It does not address in any detail the empirical evidence in support of or against BTA neutrality It is focused instead on the question of what BTA neutrality, should it hold, implies for the behavior of the nominal exchange rate. BTA neutrality implies that no real equilibrium values are affected by a change from an origin-based to a destination-based direct or indirect tax system, if financial market participants positioned themselves in a way that would make sense if one confidently anticipated the 20 percent appreciation held out by conventional wisdom, there could be serious disruption should a 20 percent depreciation – shown in this paper to be not implausible – were to occur instead. On the basis on the incomplete empirical information that is available, it is no more likely that the conditions that support an appreciation are satisfied than that the conditions supporting a depreciation are satisfied.
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