Krugman’s blog, 1/27/17

There was one post on Friday, which was delayed here by computer gremlins.  Here’s “Border Tax Two-Step (Wonkish):”

Trump tantrums aside, you may be finding the whole border tax adjustment discussion confusing. If so, you’re not alone; I’ve worked in this area my whole life, I co-wrote a widely cited paper (with Martin Feldstein) on why a VAT isn’t an export subsidy, and I have still had a hard time wrapping my mind around the Destination-Based Cash Flow Tax border adjustment that sort-of-kind-of constituted the basis for the Mexico incident.

But I have what I think may be a (relatively) easy way to think about it, which starts with the competitive effects of a VAT, then analyzes the DBCFT as a change from a VAT.

So, first things first: a VAT does not give a nation any kind of competitive advantage, period.

Think about two firms, one domestic and one foreign, selling into two markets, domestic and foreign. Ask how the VAT affects competition in each market.

In the domestic market, imports pay the border adjustment; but domestic firms pay the VAT, so the playing field is still level.

In the foreign market, domestic firms don’t pay the VAT, but neither do foreign firms. Again, the playing field is still level.

So a VAT is just a sales tax, with no competitive impact.

But a DBCFT isn’t quite the same as a VAT.

With a VAT, a firm pays tax on the value of its sales, minus the cost of intermediate inputs – the goods it buys from other companies. With a DBCFT, firms similarly get to deduct the cost of intermediate inputs. But they also get to deduct the cost of factors of production, mostly labor but also land.

So one way to think of a DBCFT is as a VAT combined with a subsidy for employment of domestic factors of production. The VAT part has no competitive effect, but the subsidy part would lead to expanded domestic production if wages and exchange rates didn’t change.

But of course wages and/or the exchange rate would, in fact, change. If the US went to a DBCFT, we should expect the dollar to rise by enough to wipe out any competitive advantage. After the currency adjustment, the trade effect should once again be nil. But there might be a lot of short-to-medium term financial consequences from a stronger dollar.

I think this is right, and I hope it clarifies matters. Oh, and no, none of this helps pay for the wall.



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