President Trump has the US’s trade deficit in his sights. He has signed two Executive Orders authorizing work to understand and eliminate the US’s bilateral trade deficits with about sixteen countries, of which the largest by far is China: others include Germany, Canada, Mexico and Japan. The architect of this scheme is Commerce Secretary Wilbur Ross, who believes that eliminating bilateral trade deficits would close the US’s overall trade deficit, raising GDP and helping to increase jobs and prosperity in the US.
WASHINGTON, DC – MARCH 31: Secretary of commerce Wilbur Ross speaks before U.S. President Donald Trump signs Executive Orders regarding trade in the Oval Office of the White House March 31, 2017 in Washington, DC. President Trump signed two executive orders that aim to boost U.S. manufacturing by addressing foreign trade. (Photo by Olivier Douliery-Pool/Getty Images)
Ross assumes that the US’s overall trade deficit is due to unbalanced trade flows arising from unfair trading practices by the countries he identifies. I have previously explained why this is wrong in relation to Germany. It is also wrong in relation to the other countries on Ross’s list.
Ross’s view of the world is a US-centric “hub and spoke” model, where the only important trading relationships are those between the US and other countries. He ignores the fact that other countries also trade with each other. Consequently, he fails to see that in today’s complex world, measures to close bilateral trade deficits, by affecting the balance of global trade beyond the US, can have untoward effects. For example, Michael Pettis explains how eliminating Mexico’s trade surplus with the US could perversely widen the US’s overall trade deficit:
In 2015, Mexico ran a current account deficit of 2.8 percent of its GDP, and in 2016, it is expected to report a fairly large deficit again. This means Mexico is importing excess global savings and, rather than contributing to global and U.S. trade imbalances, is in fact helping to absorb them. If Washington takes steps to reduce or eliminate Mexico’s bilateral surplus with the United States, and this causes net capital inflows into Mexico to decline, Mexico’s current account deficit must decline, regardless of what happens to its bilateral surplus with the United States. The paradoxical consequence could very easily be a wider American trade deficit even as the American trade deficit with Mexico contracts.
Tinkering with bilateral imbalances is not going to eliminate the US trade deficit. It is the enormous global flows that drive the overall trade deficit that need to be addressed – and these days, those are capital flows, not trade flows. The US’s trade deficit is principally caused by international demand for dollars.
Taxation can be a good way of influencing international capital flows. So, reforming corporate taxation might be a more effective way of closing the trade deficit than attacking bilateral trade deficits. But is the Republican plan for corporate tax reform fit for this purpose?
At first glance, it appears that it could be. The border adjustment tax would discourage imports and encourage reshoring of production to the US, potentially increasing domestic production and exports. The proposed large reduction in the headline corporate tax rate, coupled with a tax amnesty, might encourage companies to bring profits back to the US where they can either be invested in productive enterprise or taxed – though previous experience of tax amnesty suggests that share buybacks are more likely than productive investment. However, to encourage investment, the Republican plan also allows capital asset purchase to be fully expensed in the year of acquisition, rather than depreciated on some basis over the assumed lifetime of the asset. And to encourage companies to reinvest earnings rather than borrowing to invest, the Republican plan would end tax relief on interest expense.
Thus, the Republicans’ plan is focused on encouraging businesses to invest in the US, improve production facilities, employ more people, use local suppliers and increase exports. These are laudable ambitions. But will the plan close the US’s trade deficit – and if it does, what will be the effect on the US’s fiscal position?
The Republicans’ plan is supposed to be “budget neutral”, which means it should not increase the US’s fiscal deficit. It is unlikely to get through Congress on any other basis. But the plan relies heavily on the border adjustment tax raising large amounts of revenue for years to come. The problem with this is that the border adjustment tax is what is known as a Pigouvian tax. It is intended to change behaviour. The idea is that companies will avoid the tax by sourcing materials and components from suppliers in the US instead of importing them, thus effectively repatriating supply chains, and the effective subsidy for the domestic production of exports will encourage companies to sell more overseas. If the border adjustment tax succeeded in doing this, it would bring down the level of imports and increase exports over time, thus reducing the trade deficit. But this would progressively reduce the revenues raised by the tax. This is not a bug, it is a feature.
