When a country does a currency reform, say exchanging 100 old pesos for 1 new one, it doesn't have major macroeconomic effects. Debt contracts and wage contracts get automatically adjusted in the same way, leaving both types of contracts the same in real terms.
The proposed border tax/subsidy plan is often assumed to be neutral, for similar reasons. In theory the dollar should appreciate by 25%, preventing the import tax from distorting trade. And there's lots of evidence from other countries that this would occur---similar provisions are part of most (all?) VAT systems. We know that this can work.
And yet I've always had a nagging feeling that this particular plan might cause problems. Matt Yglesias has a post that helps to explain my concern:
In the case of border taxes, it's true that if you look back at a textbook, it would say these taxes impact exchange rates rather than trade flows -- whether taking the exotic form of the House GOP's corporate tax reform, a European-style value added tax, or even an old-fashioned broad tariff. But like many other conclusions in economics, that's assuming "all else is equal," and the world's governments actually allow exchange rates to float freely.
Cahill's point is that it's very unlikely this would happen. Many emerging markets, he writes, "intervene in some way to limit volatility against the dollar." Over half of American trade is "against EM currencies, and China alone has a weight of more than 20 percent."
Some observers think you can wish this currency intervention away by assuming that foreign countries manipulate their currencies only to hold the price down and maintain competitiveness. But that's simply not true. China has been acting to prop up the value of its currency recently, and it's not the only country to do this.
"Since EMs intervene under both appreciation and depreciation pressure," Cahill writes, "it would seem more than competitiveness considerations are at work." . . .
The theoretical model's prediction that the tax impact will be fully neutralized by exchange rates has some empirical evidence to back it up. But that evidence, more or less necessarily, is drawn from countries that are a lot smaller than the United States and/or that were making more modest tax changes. For the world's largest economy to undertake a tax reform on the scale House Republicans are contemplating entails a 25 percent increase in the value of the US dollar.
That's simply much too big a change for world governments to watch from the sidelines.
A US border adjustment tax would be a massive contractionary shock for the global economy. The only question is what type of shock. Here are three possibilities:
A. The dollar appreciates by 25%.
B. The dollar is unaffected.
C. The dollar appreciates by 12.5%.
In case A, trade is unaffected, but foreigners with dollar denominated debts would immediately see their debts rise by 25% in local currency terms. This could create a global financial crisis.
In case B, dollar debtors would be unaffected, but you would have a massive trade shock. The real (after tax) exchange rate for foreign countries would immediately appreciate by 25% relative to the US dollar. Over time, equilibrium would be restored through a painful process of reducing wages and prices in foreign countries, until the real exchange rate moved back to equilibrium.
In case C, you have a fairly sizable debt shock and a fairly sizable trade shock at the same time. Emerging market exporters would lose exports at exactly the same time that their dollar denominated debts rose by 12.5% in local currency terms. Not good.
I've been trying to wrap my mind around the question of why this border tax would be such a big shock. I think it might have something to do with the fact that money inflows to the US caused by the export of Boeing jets would receive a 20% subsidy, but money inflows to the US in repayment of dollar debts would not receive any subsidy. Perhaps someone who knows more about border taxes/subsidies can clarify this issue.
It looks to me like a border tax would be a really big negative for emerging markets. It's one of those "pick your poison" situations. Do you want a debt crisis, or a jobs crisis?
PS. I believe that Matt is wrong about "old-fashioned broad tariffs", which do in fact distort trade (unless accompanied by export subsidies.)
PPS. Full disclosure. I own overseas stock funds that could be hurt by the border tax. Also, in fairness, the border tax does have some positive aspects, making the corporate tax system simpler and less distortionary.