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Trade and Fiscal Deficits, Tax Reform, and the Dollar: General Equilibrium Impact Estimates

IIE 2017.08.24
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Advocates of using a border tax adjustment (BTA) to shift the corporate profits tax to a "destination" basis argue that such an arrangement would not be protectionist, because the import tax and export subsidy would be fully offset by an induced appreciation of the dollar. To examine this claim, this study applies an updated and extended general equilibrium model from the author's 2005 book, The United States as a Debtor Nation. Cline finds that across various scenarios, the dollar appreciation typically would be less than half the amount needed to offset fully the BTA. Advocates of the BTA implicitly assume a strong, prompt expectational boost to the dollar upon announcement of the shift. Instead, market practitioners and mainstream macroeconomic models see the interest rate as the main driver of the exchange rate. Although an incipient rise in the trade balance would indeed put upward pressure on the interest rate and thus the exchange rate, it would also result in reduced investment. With the trade deficit equal to investment minus saving (I?S = M?X), reduced investment would tend to set the new equilibrium at a lower trade deficit before the interest rate would rise sufficiently to boost the dollar to a level that would completely offset the BTA.

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