Who Will Pay for the Wall?

The Issue:

The wall on the Mexican border that has been a centerpiece of President Trump’s policies to control immigration has been controversial. One source of controversy is the funding of this project. The estimated cost of constructing the wall ranges widely. Senate Majority Leader Mitch McConnell stated the cost could be as low as $12 billion. But, Marc Rosenblum, deputy director of the Migration Policy Institute (a non-partisan think tank), predicts the cost could range between $15 billion to $25 billion, with the higher estimates including costs for land acquisition, maintenance and staffing. And a recent internal report by the Department of Homeland Security, viewed by Reuters, put the price tag at the upper estimate of the range: $21.6 billion. The Trump Administration has stated that a Destination Based Cash Flow Tax (commonly referred to as a “Border Adjustment Tax”) applied to US-Mexico trade is one possible way to fund the wall.

There are questions about the amount of revenue that a Border Adjustment Tax applied to Mexico could raise. And, even more importantly, the wider consequences of this tax, not only for trade with Mexico but for trade with all countries.

The Facts:

• The Destination Based Cash Flow Tax (DBCFT) imposes taxes on cash flow, revenues minus non-interest expenditures, based on where the spending takes place. The idea for this tax comes from the House Republican proposal to reform corporate taxes led by House Ways and Means Chairman Kevin Brady (R-TX). The new tax would apply a 20 percent rate to corporate cash flow (revenues minus purchased American inputs and wage payments) originating from sales in the United States. Imports would not be included in this calculation of cash flow, and so would be implicitly taxed at a 20 percent rate. Exports from the U.S. would not be subject to the 20 percent tax, and hence would be cheaper than in the current system.
• Many economists believe that implicitly taxing imports and exempting exports would lead to changes in the value of the dollar's exchange rate. The higher demand for exports, and the lower demand for imports could result in greater net demand for dollars, causing the dollar to strengthen. If this were the case, the stronger dollar could fully or only partially offset the effect of the tax on imports on the price faced by American consumers. In this latter case, a greater burden of the tax would be borne by foreign producers who receive a lower price for their goods but do not have a commensurate increase in sales. This tax is similar to a Value Added Tax (VAT), which many of the U.S.'s main trading partners currently levy, except that a VAT applies to revenues minus both non-wage and non-interest expenditures. Border adjustment accomplishes the same effect with a VAT as with a DBCFT. If the dollar adjusts fully, then both types of tax systems will be neutral for trade prices relative to a regime of no corporate taxes.
• The Prices of imported goods could very well rise with the DBCFT. The stability of the price of imports depends upon the exchange rate strengthening to fully offset the increase in the price due to the tax. But exchange rates are determined by a range of factors, especially macroeconomic factors like interest rates, not just by the volume of exports and imports. Furthermore, foreign governments may try to stabilize the value of their currencies against the dollar. This, too, would cause the price of imported goods to rise since it would prevent a stronger dollar from lowering the price of imported goods. To the extent that the dollar will not rise to offset the higher price of imports, U.S. consumers will pay a higher price for all imports and, in so doing, effectively finance at least part of the building of the wall.
• The range of varieties of goods and services will be reduced. The tax on imports will lower the amount that producers receive, making them less willing to sell to the United States. One consequence of this will be a decrease in the range of imported goods available in this country, which will lower people’s standard of living.
• It is not clear that the tax revenue derived specifically from U.S.-Mexico trade will be sufficient to completely fund the construction of the Wall. The US-Mexico goods trade deficit in 2015 was $58 billion. A 20 percent tax would yield $11.6 billion/per year, assuming imports and exports do not respond to the change in prices caused by the tax demand. However, this is not likely. If imports decline and exports rise, the resulting tax revenue will be diminished. Since the DBCFT applies to flows with all our trading partners, all our trading partners will be funding the wall.
• The DBCFT is likely to spur retaliation on the part of all our trading partners, not just Mexico. The proposed tax system treats domestic firms and foreign firms differently, in direct violation of World Trade Organization principles (see the EconoFact memo by Joel Trachtman). Hence, U.S. trading partners would have a legal basis for retaliation using trade measures. Resulting barriers to U.S. exports would reduce American exports, GDP and employment.