It didn't take long to find out just how extensively President Trump would shake up the status quo. The shockwaves triggered by his executive order aimed at preventing terrorists from entering the country are a perfect illustration. In the coming weeks, the discussion on the business tax reform in Congress has every chance of generating even bigger waves, liable to affect both the dollar exchange rate and international trade relations. The Republican’s reform plan shares many of the proposals mentioned by Donald Trump. Both call for a sharp cut in the tax rate and total deductibility of taxable income from investments rather than interest paid (as is currently the case). One measure in particular – the “border adjustment ”– has the potential to stir up serious controversy, possibly between the President and Congress, but even more certainly between the United States and the rest of the world.
Under the Republican plan, cross-border transactions would no longer be included in the calculation of taxable business income, meaning export proceeds would be excluded from the calculation, as would expenses associated with payments on imported products. At first glance, this would appear to be a straightforward protectionist measure: by reducing the taxable profit earned by exporting companies and increasing it for companies that get their supplies abroad, this adjustment can only encourage firms to relocate production to the United States. The proposal has everything it takes to win over the new President, even though he has thus far described it as... “too complicated.” Implementing customs duties seems much easier! The problem is that the Republican Party traditionally stands behind free trade, and for those suggesting it, the border adjustment is not a matter of trade policy: it's a purely fiscal matter. Not only does it not aim to alter the balance of US trade, but it has no reason to do so, they gladly explain.
Of course, the rationale leading to this reassuring conclusion is worth a closer look. Let's just imagine the “border adjustment” in action. What would happen? Its supporters have a simple answer to that question: US companies, confronted with the higher tax-cost of their imports compared with tax-free exports, would be driven to import less and export more. The US current account would improve and the dollar would appreciate to the point that the incentive to export more and import less associated with the border adjustment would vanish. The dollar would climb until the after-tax profit of US companies returns to its previous level. And the proponents of the measure blithely affirm that, with a business tax rate at 20%, a 25% increase in the dollar would make the border adjustment “neutral”!
This projected appreciation of the dollar rests on the interaction of mechanisms belonging to a bygone era, however. Financial globalisation has drastically changed the nature of the forces that influence exchange rates. When it comes to the dollar, in particular, the influence of the US trade balance has grown considerably weaker, while that of financial forces – interest rate gaps and investor expectations – has grown stronger. It is difficult to understand how the latter forces could rapidly lead to such a sharp increase in the dollar. And if it did, a series of presidential tweets would be sure to get in the way.
The conclusion is clear and troubling: the business tax reform that will soon be discussed by the US Congress is very likely to have major consequences for international trade and it will be up to the rest of the world to see how it will react. One thing is certain: discussing it with the new US President will be no easy task!