A key piece of the 2016 House Republican Tax Reform Blueprint proposed remaking the corporate income tax into a destination-based cash-flow tax (DBCFT). The new tax would have included a border adjustment that raised about $1 trillion in revenue to offset the cost of other tax cuts. Cash-flow taxes are relatively uncontroversial. They allow businesses to fully deduct their costs upfront so that they only pay taxes on their profits when investments are deployed productively. Destination-based income taxes, which require a tax and rebate system to “border adjust” the levy, face numerous theoretical and practical implementation issues.
As Congress readies for the 2025 expiration of the 2017 tax cuts, policymakers will desperately search for ways to offset some or all of the more than $4 trillion price tag to make the reforms permanent.
The desire for additional revenue and former President Trump’s penchant for imposing across-the-board tariffs on all imports has resurfaced the idea of a border-adjusted corporate income tax. Writing for the Heritage Foundation’s Project 2025, Peter Navarro, Trump’s director of the White House National Trade Council, calls the new tax “an innovative alternative to the application of tariffs.”
Whenever a bad idea raises its head after being abandoned, it’s worth reviewing the reasons the idea was abandoned the last time.
Border Adjustments in Theory
Adding a border adjustment to the corporate income tax would allow exporting firms a deduction for the cost of exports and would tax the value of imports at the corporate tax rate (currently 21 percent). This tax effectively raises revenue by taxing the value of the US trade deficit.
Combining an effective export subsidy and a tax on business imports creates a system that only taxes profits earned from consumption in the United States (i.e., the destination of the goods and services). Under certain (unlikely) conditions, the economic burden of the tax may fall on Americans whose investments earn profits, wherever in the world those occur.
In theory, the tax on business imports—like an across-the-board tariff—reduces domestic demand for taxed imports, which reduces the supply of US dollars in foreign markets. This will cause a partial appreciation of the dollar relative to international currencies to offset the reduced supply. The export subsidy reduces the price of US products abroad, increasing demand for both US products and US dollars in which those products are denominated. Proponents of this tax system argue that the combination of decreased supply and increased demand for US dollars leads to a currency appreciation that fully offsets the effect of the border adjustment tax on trade flows.
At a 21 percent tax rate, the US dollar would need to appreciate by just under 27 percent to offset the tax wedge of a border adjustment.[1] For the economic theory to match reality, the border adjustment must be implemented completely and permanently across all imports and exports, and international currency markets need to fully adjust to offset the new tax wedge on domestic consumption. However, with imperfect implementation, real-world frictions, and uncertainty in currency markets, a border adjustment is likely to pose significant economic costs—akin to an across-the-board tariff—to the American economy, creating winners, losers, and broad economic losses.
Currencies Don’t Adjust Quickly or Fully
Imperfect implementation and real-world frictions are likely. Most studies indicate that exchange rate adjustments are often partial and gradual rather than immediate and full. This is due to several factors, including price stickiness, market expectations, and the slow response of trade balances to changes in exchange rates.
Macroeconomists’ understanding of what drives short-run exchange rates is poorly understood and, thus, difficult to predict. In some cases, exchange rates seem responsive to policy changes. For example, the anticipated removal of a US export subsidy in the late 1990s resulted in the standard model’s prediction of offsetting dollar depreciation. However, more broadly, the academic literature shows that exchange rates tend to adjust less than predicted in response to tariffs and other changes in import prices. For example, research by the IMF spanning 50 years and 151 countries shows that a 1 percentage point increase in the tariff rate increases the exchange rate by just 0.19 percent, far less than would be required for a border adjustment to be fully offset.
The reality of imperfect currency adjustments is also reflected in US industry group support and opposition to the border adjustment proposal in 2017. Partial currency appreciation gives the border adjustment a tariff-like effect, creating penalties for importers and subsidies for exporters. This anticipated effect led export-heavy firms to support the border adjustment tax and importers to oppose the new tax, claiming the new tax bill “could be as high as five times their profits.” Private sector analyses informed these lobbying efforts, one of which concluded that “slow real exchange rate adjustments are the historical norm.”
Border Levies Will be Incomplete
In addition to partial and gradual exchange rate adjustments, imperfect implementation of the border taxes will also likely keep theory from matching reality. One summary of the macroeconomic effects of border adjustments concludes it “is unlikely to be neutral at the macroeconomic level, as the conditions required for neutrality are unrealistic.” A survey of economists in 2017 confirmed this conclusion, with the plurality of respondents being “unsure” about the economic effects.
Some of the unrealistic conditions that lead to economic uncertainty include consistent application of the adjustments on all cross-border trade, full removal of the tax from exports, and passive monetary authorities.
Because a border-adjusted corporate income tax would be the first of its kind, the most common analogous policy for studying implementation and currency responses is the similar border adjustment applied to value-added taxes (VATs). In reality, VATs tend to exempt or provide preferential rates for politically sensitive types of consumption, such as food, energy, and health care services. Across the Organisation for Economic Cooperation and Development (OECD), VATs only apply to 56 percent of consumption.
If similar exemptions applied to the border adjustment, so that the tax only applied to about half of the total trade volume, policymakers should expect to only get half of the theoretical currency appreciation. This would leave importers paying what amounts to a 10.5 percent tariff (on a 21 percent total rate), with all the downsides that protectionist tariffs bring.
A border adjustment in the United States would very likely face similar imperfections. Before any political exemptions are made, it is unlikely that a border tax and exemption system could capture trade where the foreign counterparty is physically in the United States, such as with pleasure tourism, health tourism, and university education, or when trade is difficult to track, such as small-value packages, financial service, and some B‑to‑C internet services. In 2023, travel accounted for 6 percent of US exports and 4 percent of imports.
Despite the theoretical prediction that border-adjusted taxes are trade neutral, Mihir Desai and James Hines find that “10 percent greater VAT revenue is associated with two percent fewer exports.” Similar research confirms these results, showing that border-adjusted VATs distort trade flows. More broadly, the literature reports mixed results, such as a recent study by Youssef Benzarti and Alisa Tazhitdinova, which finds much smaller relative effects of VAT changes on trade, especially compared to tariffs. However, a policy that is less damaging than tariffs is not a ringing endorsement.
Another practical concern relates to the treatment of net exporters, such as General Electric and Boeing, who would likely have net-negative tax liabilities. Without a direct cash rebate for taxes paid on domestic production, US exporters would face significantly higher effective tax rates, especially if their supply chain includes imports subject to the import levy. A US Treasury Department working paper concludes that about 10 percent of US firms would need direct subsidies to implement the border adjustment fully.
Instead of writing big tax rebate checks to some of America’s largest corporations when they face net-negative tax liabilities, the 2016 Republican Blueprint instead proposed a system of net operating losses (NOLs) that can be inflation-adjusted and carried forward.[2] However, a subset of domestic exporters may never have a positive tax liability to offset their accumulated NOLs, which could add up to hundreds of billions of dollars. Such a system would create incentives for net exporters with negative tax liabilities to merge with net importers to fully realize their tax benefits.
Lastly, the neutrality of the border adjustment and resulting currency appreciation requires that the monetary authorities in both the implementing country and foreign trade partners do not respond to the currency changes. It is unlikely that such a large depreciation in foreign currencies relative to the dollar would not precipitate some response by central banks around the world to mitigate the sudden currency move. A large currency appreciation could also set off fiscal crises in emerging economies with significant debts denominated in US dollars.
Currency Appreciation Transfers US Wealth to the Rest of the World
Whether a border adjustment results in a fully offsetting currency appreciation or a partial appreciation, the resulting effects on dollar-denominated cross-border assets would be nonneutral. Emmanuel Farhi, Gita Gopinath, and Oleg Itskhoki estimate that about 85 percent of US foreign liabilities are denominated in dollars, which, upon an appreciation of the dollar, results in an equal increase in the value of future payments to foreign holders of the debt. Only about 30 percent of US foreign assets are denominated in dollars, so the offsetting increase in asset values does not compensate for the losses.
Stan Veuger estimated in 2017 that a full currency appreciation of 25 percent would amount to a $2.5 trillion net loss to Americans or about $8,000 per American (today, those numbers would be larger). Another estimate using slightly different assumptions concludes, “a 15% border adjustment tax results in a transfer from the US to the rest of the world of the order of magnitude of 20% of the US GDP.”
Veuger goes on to note that foreign “assets and liabilities are not distributed evenly, and some individuals and firms will suffer large losses. Many pension funds, for example, own sizable amounts of foreign assets, but their future liabilities are practically all dollar-denominated pension obligations.”
These significant wealth effects will change domestic saving and investment decisions, which means the border adjustment tax will affect trade flows and exchange rates.
A Risk Not Worth Taking
The new coalition of Trump-aligned backers of a border adjustment has assessed the new levy as a protectionist tool that would reduce imports and subsidize exports. While these effects are far from certain, the analysis above suggests their assessment is directionally correct. However, even if the textbook macroeconomic conditions are met, the effects will be far from neutral, creating large and uneven wealth transfers from Americans to the rest of the world.
If other non-protectionist proponents of the reform are correct, and the new tax is a highly efficient source of revenue with few, if any, economic distortions, it could become, as a Mercatus Center analysis describes, “an irresistible source of additional tax revenue for future policymakers.” Others have also worried that the tax could be easily transformed into a VAT by denying businesses the wage deduction. New sources of revenue, like VATs, often fuel an expansion in the size and scope of government. This fact drives an analysis by the left-leaning Center for American Progress, which promotes the border adjustment as a way to preserve the corporate tax as an important source of federal tax revenue by protecting the US from the pressures of tax competition.
Policymakers ultimately can’t have it both ways. The border adjustment is either tariff-like—and currencies do not fully adjust—or it is trade neutral and thus will not meet the policy priorities of mercantilist advocates, leaving them to desire additional tariffs in the future. The new border tax is bad either way. Ultimately, it’s an unnecessary new source of revenue that comes with high economic risks to global trade and American wealth.
When the Tax Cuts and Jobs Act expires at the end of 2025, Congress will face pressures to find novel sources of revenue to offset some or all of the package’s more than $4 trillion revenue reduction. Border taxes are neither necessary economically nor as a source of revenue. If Congress wants to keep taxes low, it can always cut spending to rein in the government’s costs. Congress could also limit more than $14 trillion in tax loopholes and subsidies, which would have positive economic incentives and raise additional revenue, as I’ve detailed in a recent Cato Policy Analysis, “Slashing Tax Rates and Cutting Loopholes.”
Additional Reading:
Jason J. Fichtner, Veronique de Rugy, and Adam N. Michel, “Border Adjustment Tax: What We Know (Not Much) and What We Don’t (All the Rest),” Mercatus Center.
Adam N. Michel, “Time to Move Past the Proposed Border Adjustment Tax,” Heritage Foundation.
Gary Clyde Hufbauer and Zhiyao (Lucy) Lu, “Border Tax Adjustments: Assessing Risks and Rewards,” Peterson Institute.
Scott Lincicome, “Deductions Could Spell WTO Trouble for the GOP ‘Border Adjustable Tax’ Plan,” Cato Institute.
Stan Veuger, “Adjusting to the Border Adjustment Tax,” Mercatus Center.
Veronique de Rugy and Daniel J. Mitchell, “The Border-Adjustment Sleight of Hand,” Wall Street Journal.
