By Maurice Obstfeld
BERKELEY – This election season in the United States has brought forth many bad policy proposals. One of the worst is the idea that America should pursue balanced trade through taxes on US borrowing from foreigners. Under such a “capital inflow tax,” any US resident selling an asset (such as a stock or bond) to a foreign resident would owe the US government a percentage of the payment he or she receives. Since this would make foreign financing more expensive, interest rates and the cost of capital would rise throughout the economy.
Advocates of a capital inflow tax present it as an attractive alternative to tariffs as a means of reducing the US trade deficit, which they blame for a range of economic ills. Of course, most mainstream economists have a nuanced view of trade deficits, and many view them as a minor issue for the US economy, if they are an issue at all. But Donald Trump, the presumptive Republican presidential nominee, has long believed that countries with deficits are somehow “losing” through trade, and that only balanced trade – where a country’s exports fully pay for its imports – can be fair.
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Thus, a future Trump administration would surely attempt to boost US exports and curtail imports through various mechanisms, including tariffs, renegotiated trade deals, bullying bilateral trade partners, weakening the dollar, and, perhaps, measures that raise the cost to US firms and financial institutions of borrowing abroad.
Capital inflow taxes have been used frequently over the years in developing and emerging economies, but proposals to apply them in US financial markets are more recent. In 2019, Senators Tammy Baldwin (a Democrat) and Josh Hawley (a Republican) introduced legislation that would require the US Federal Reserve to levy a “market access charge” on foreign purchases of US assets in order to target a US trade balance near zero. The bill went nowhere at the time, but the scheme would most likely be revived under a new US administration that is fixated on trade grievances.
Trump’s first-term US Trade Representative, Robert Lighthizer, who would surely assume a leading policy role again, alludes to this possibility in his recent book, No Trade Is Free – though he would prefer to achieve balanced trade through tariffs that rise until imports are reduced to a level equal to exports. Moreover, some influential commentators such as Michael Pettis, who is rightly skeptical of tariffs, have argued that capital inflows are the cause of US trade deficits, and that trade would be “broadly balanced” were it truly governed by comparative advantage. His conclusion is that capital flows impede the operation of comparative advantage, and thus should be limited by taxes.
But a capital inflow tax is a bad idea. While free capital flows can cause plenty of problems for the world economy, the best way to address the disruptions with minimal damage elsewhere is through narrowly targeted policy interventions, not blunt instruments like a blanket inflow tax.
A capital inflow tax big enough to balance US trade would inflict economic damage at home and abroad in several ways, but the most notable effect would be a steep rise in US real interest rates. When a country’s imports exceed what it can pay for through its exports, it must borrow from foreign residents to cover the difference (a capital inflow). The capital inflow tax would, of course, raise the cost of foreign borrowing by the amount of the tax. But perhaps less obviously, it would also raise the interest rate paid by every US borrower on every loan, whether the funding source was domestic or foreign. After all, some foreign funding is necessary in the face of a trade deficit, however small; but nobody would be willing to borrow from abroad unless domestically sourced and foreign funding were equally costly.
This rise in interest rates points to the key mechanism through which a capital inflow tax reduces the trade deficit. A country’s borrowing from foreigners must also equal the amount of its investment (in equipment, research and development, and so on) in excess of what it can cover out of national savings. Thus, the trade deficit (or, more precisely, the current-account deficit) equals investment minus saving. The rise in interest rates may compress the trade deficit through some increase in saving, but its main effect would most likely be a fall in investment, leading to reduced demand, lower growth, and less innovation.
Worse, all these repercussions would be magnified if, as seems likely, the inflow tax undermined global confidence in the safety of the US dollar and the liquidity of US financial markets.
The implications for monetary and fiscal policy are also worrying. On monetary policy, the capital inflow tax would raise the neutral real interest rate – what economists call r* – and introduce the risk of runaway inflation if the Fed did not raise its policy rate commensurately. And on fiscal policy, it would raise borrowing costs for the Treasury (as for everyone else in the US) at a time when Republican taxation and spending policies would be adding further to the US government’s deficit. The sustainability of US public-sector debt is already a problem, and while the tax would generate revenue, its net effect could be to make the fiscal situation even worse.
These scenarios are all too plausible if a new Trump administration were serious about pursuing trade-deficit reduction. All the other options that the Trump trade team is apparently considering – tariffs (which could well widen the deficit, unless they were prohibitively high), a weaker dollar, pressuring foreign trade partners – simply will not get the job done. The only two strategies that would be immediately effective would be to reduce the federal budget deficit – which is not likely – or to tax capital inflows.
Given previous bipartisan support for the tax, it could become a reality regardless of the composition of the next Congress. That would be a shame, because the size of America’s trade deficit is among the least of its problems.
Maurice Obstfeld, a former chief economist of the International Monetary Fund, is Senior Fellow at the Peterson Institute for International Economics and Professor of Economics Emeritus at the University of California, Berkeley.
Copyright: Project Syndicate, 2023.
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