The recent discussion over a possible 20% border tax/subsidy scheme has me more puzzled than anything else I've seen since I began blogging. Advocates like Martin Feldstein say it would not be a protectionist policy, as the dollar would appreciate by 25% to offset any trade distorting effects.
That claim seems roughly correct to me, but why don't the foreign exchange markets seem particularly interested in the proposal? Or maybe they are interested, and I've simply been looking in the wrong place.
One argument is that the tax seems unlikely to be implemented, because while Congress favors the idea, Trump is opposed. But yesterday, Trump seemed to change his mind and come out in favor:
After the speech, in a brief, impromptu news conference as Mr. Trump flew back to Washington, Mr. Spicer told reporters that the president now favored the plan to impose a 20 percent border tax as part of a sweeping overhaul of corporate taxation. Only last week, Mr. Trump had dismissed the tax as too complicated, favoring his own plan to impose a 35 percent tariff on manufactured goods made by American corporations in overseas factories.
Mr. Spicer said that the plan for the tax was "taking shape" and that it was "really going to provide the funding" for the wall.
Doesn't this make the tax/subsidy scheme much more likely? Or are markets still assuming that special interests will be able to kill the idea:
Many economists also doubt that the change would end up penalizing imports or encouraging exports. They predict that the value of the dollar would rise, offsetting those effects.
Nonetheless, many businesses in industries such as retail and energy, which rely heavily on imports, were in a panic.
In theory the dollar should rise, and the fears of retail and energy should be groundless. But where is the evidence that the dollar will rise by 25%? If that were true, shouldn't the sudden switch by Trump have dramatically impacted forex markets?
And yet the theory of exchange rate offset seems rock solid. Perhaps the problem is that in the real world the tax will not be as uniform as theory assumes (not applying to services, for instance). Or perhaps some of the post election rally in the dollar was due to expectations of a border tax, not the response to fiscal stimulus and growth enhancing supply-side measures than many assumed at the time. But I'm dubious, and in any case the rally has been small.
For now, the lack of wild swings in the foreign markets seems like the dog that didn't bark. I feel it's telling us something important, but am not quite sure what.
There's much more to be said here. It seems that Trump might be convinced that this action is protectionist, and that the revenue could be used to pay for the wall. For free traders like me that's actually good news, because economists don't believe this tax/subsidy scheme is protectionist at all. It might end up satisfying Trump's desire for "protection" without doing much damage.
However, I still fear the impact of this on emerging markets with large dollar-denominated debts. And it also raises important question about monetary policy. Suppose the dollar did not appreciate---would the Fed have to tighten to prevent inflation from exceeding 2%? But that could cause prices of domestically produced goods to fall. That's certainly not what the GOP wants to see happen. So the 25% appreciation of the dollar really is a key part of this policy.
[After I wrote this post I learned that there is some confusion as to whether Trump actually endorsed the border tax idea. Any help here would be appreciated.]
PS. If you are confused by the 20% and 25% figures thrown around, it has to do with the fact that a 20% decrease in equal in proportion to a 25% increase. Thus when I say the dollar will need to rise by 25%, I'm saying foreign currencies will need to depreciate by 20%, to offset the tax. Percentages work differently in the down direction as compared to the up direction. (There must be a more elegant way of making this point.)
PPS. John Cochrane indicates that the border tax would only apply to corporate businesses, not imports by non-corporate businesses. That has me even more confused. If true, it's a massive problem with the proposal. The House GOP really needs to clarify what's going on here. BTW, I highly recommend Cochrane's entire post on taxes, I almost entirely agree with his views.