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How would a Trump border tax work?

President Trump is contemplating the introduction of a border tax, essentially a tariff, aimed at countries that have large trade surpluses with the US. Exporters from Mexico and China appear to be most at risk. This could spark a tit-for-tat response from the world’s second largest economy and in an extreme downside scenario may result in a trade war—a clear negative for some Australian exporters.

The other proposal under consideration from the GOP is a destination based cash-flow tax system with a border-adjustment tax—which includes tax breaks on export revenues and lower corporate taxes. The current system taxes US businesses on their profits, meaning costs of production, whether for domestic inputs or imported ones, are deductible from revenue. Under a border-adjustment tax, businesses are not able to claim back tax on imports used in production, but will be allowed tax concessions on foreign sales revenue. The following example may help clarify the difference between the current tax regime and the proposed border-adjustment tax. 

Take three companies: A, B and C

 

Figure

The border tax adjustment is intended to favour businesses that source their inputs from the US and export. Conversely, the tax adjustment appears to penalise companies who import a lot and sell their final product domestically. The effect of such a tilting of the tax system would be to drive greater import substitution. But this wouldn’t fix the US trade over the long term as fewer imports and greater exports would drive up the USD, making US exports less competitive, whilst making imports cheaper. The impact on Australian exporters would initially be negative, but a stronger USD, would help restore competiveness.