LC. H4. IS?/3: S’-7*‘-13.? E. 87-428 E % Government Puwcations cas REPORT FOR coucaass I ‘t H Unt , 9 U ; Aug 17 1994 l . 1 . A ~ ' Libraries l h n ton Umverstty J was ‘stg. Louis, Mo 63130 The effects of the Tax Reform Act of 1986 on internation- al trade are estimated to be of relatively small magnitude. The composition of trade would be little affected because the effect of the tax bill on final product prices would be is small. Moreover, if the change reduces foreign capital inflows into the United States, the changes would tend to narrow the trade deficit. These effects are also expected to be small in magnitude, however. by Jane C. Gravelle Specialist in Industry Analysis Economics Division May 15, 1987 - n|mTu - bia °° umm ll lnlj» I n ljlillllllifl o1o- 0393 8 The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providing information at the request of committees, Mem- bers, and their staffs. The Service makes such research available, without parti- san bias, in many formsincluding studies, reports, compila- ° o T as E-1; ound briefings. Upon request, CRS . V . F - *1’ analyzing legislative proposals and '9 ing the possible effects of these proposals . - g. ives. The Service’s senior specialists and u“* , flgflsié‘/av?’ so available for personal consultations ' T .4 ds of expertise. .-|'g_.I.v a.....Iu..MH...u. 2‘ . "T32:-nnjcol ‘ I 7‘ .-- l|_lI. . o _@| I , ‘_ ' .______ . O and Finance G ESSIONAL . 5°” THE LIB RY OF CON ESS The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providing information at the request of committees, Mem- bers, and their staffs. The Service makes such research available, without parti- san bias, in many forms including studies, reports, compila- tions, digests, and background briefings. Upon request, CRS assists committees in analyzing legislative proposals and issues, and in assessing the possible effects of these proposals and their alternatives. The Service’s senior specialists and subject analysts are also available for personal consultations in their respective fields of expertise. CRS-iii CONTENTS EFFECTS ON THE TRADE DEFICIT: A BRIEF THEORETICAL EXPOSITION . EFFECTS ON SPECIFIC INDUSTRIES . . . . . . . . . . . . . . . . O O C C O O I C I O I I I O I O O O O O O O O O O O O O O O I O O O O O O O O O O O O I INTERNATIONAL COMPETITIVENESS AND THE TAX REFORM ACT OF 1986 The size of the current U.S. trade deficit and the effect of Government policies on that deficit has attracted considerable attention in the Con- gress. One of the major pieces of legislation in the 99th Congress was the Tax Reform Act of 1986, and this concern with effects on international trade extended to that legislation as well. There were arguments made that the tax revisions would be detrimental to the competitiveness of U.S. exports, or to certain industries particularly hard hit by the tax changes. Some of the arguments made regarding the international competitiveness effects of tax legislation are inconsistent with economic nalysis. Others are sound in direction but uncertain in magnitude, and are thus a matter for empirical analysis. The results presented in this analysis suggest that any effects of the recent tax legislation for particular industries are quite minor and that, on balance, the changes would be more likely to shrink rather than expand the aggregate trade deficit. l_/ The Tax Reform Act of 1986 made a number of changes of major import in the tax treatment of business investment. The investment tax credit was re- pealed, and depreciation was modified in a way that made it less valuable for most assets. The trade-off for this change was a substantial reduction in tax rates. In the case of the corporate income tax, the rate was reduced from 46 percent to 34 percent. Overall tax burdens on the corporate sector are expected to rise by about $25 billion a year over the next five years. EFFECTS ON THE TRADE DEFICIT: A BRIEF THEORETICAL EXPOSITION with no downward adjustment of interest rates (which economic theory would predict to occur eventually), the cost of investing in capital assets would rise as a result of the Tax Reform Act of 1986. It is this increase _1_/ For a more detailed discussion of this subject and for estimates relating to earlier tax reform proposals, see Gravelle, Jane C. Interna- tional Tax Competition -- Does it Make a Difference for Tax Policy? Na- tional Tax Journal, v. 39, September 1986. p. 375-384. See also U.S. Li- brary of Congress. Congressional Research Service. Corporate Tax Reform and International Competitiveness. Report No. 86-42 E, by Jane C. Gravelle. Washington, 1986. Similar results were reported by the International Trade Commission. Effects of Proposed Tax Reforms on the International Competi- tiveness of U.S. industries. USITC publication 1832, April 1986. For gen- eral back ground articles on trade, the reader may also wish to consult U.S. Library of Congress. Congressional Research Service Review, v. 8, no. 2, February 1987. Economic Policy and Competitiveness by G. Thomas Woodward in that issue contains a general theoretical discussion of the relationship be- tween Government economic policies and competitiveness. CRS-2 in the cost of production which has led to arguments that the tax changes would be deleterious to international competitiveness because exports of U.S. firms would rise:in cost and domestic production would rise in cost relative to imports. While this reasoning it would be correct for a cost increase in a single firm, it would not be sound for an across the board change in the cost of production for all industries. Two offsetting adjustments in the economy would eliminate any aggregate effects on competitiveness and the trade deficit. First, it is likely that interest rates would fall and that the tax would not be fully shifted forward in price. Secondly, to the extent that initial price effects occur, adjustments in the exchange rate would offset any overall price increases. This analysis does not consider the former effect explicitly. The effect on the exchange rate may be briefly explained as follows, ignoring at this point the possible changes in capital flows induced by the tax changes. The exchange rate is determined by the currency market, which itself is driven by exports and imports. In the currency market, dollars bought must be exactly equal to dollars sold. If a general price increase in exports occurs, foreigners will want to purchase fewer exports and, in general, they will be likely to purchase a sufficiently smaller amount of exports so that even taking into account the fact that the price is higher, fewer dollars will be paid for these exports. Thus, the amount of dollars purchased (or demanded) byzforeignersvfill fall. At the same time, because the prices of domestic production have risen, individuals in the United States will want to purchase more imports. In order to do so, they must sell dollars to buy foreign currency. Thus, the amount of dollars bought by foreigners will fall and the amount sold by U.S. individuals will rise. This imbalance in the supply and demand for dollars will result in a fall in the price of the dollar. In the absence of capital flows, the dollar will fall by just enough to return all prices and quantities in trade to their original levels. 2/ Moreover, there is never likely to beany observable change in the trade deficit because both the initial change in price and the offsetting exchange rate adjustment will take place slowly. Firms will only raise their prices as they are able to adjust their output, an effect which occurs slowly, and this price effect will be then offset by the exchange rate ef- fect. What would be expected is a gradual decline in the price of the dollar which has no meaning for real quantities of exports and imports. EFFECTS ON SPECIFIC INDUSTRIES A second argument which has been made is that some industries will be especially harmed by the tax changes because they are very capital intensive, or because the type of capital they use is particularly heavily ;/ It is possible for governments to intervene in exchange rate mar- kets and prevent the full response described here. Such intervention can only have a temporary effect, however, as the change in the money supply will lead to changes in price levels and eventually induce an offsetting exchange rate adjustment. Thus, such a possibility is not relevant to the effects of a permanent change in tax policy. CRS-3 taxed. Such an argument may have merit, because the tax change pro- duces an uneven set of price changes for different industries owing to their production characteristics. That is, the price effects are like a set of differential excise taxes which favor some industries and hurt others. In order to assess the magnitude ofthese effects, the tax changes were modeled to produce the change in the cost of production for each industry taking into account the type of capital used, the importance of capital in the production process and the effects on the prices of intermediate goods in production. These price effects were then introduced into an exchange rate adjustment equation to determine the aggregate change in the price of the dollar. The net effects of the initial price change and the reduction in the price of the dollar provide a set of estimated relative price ef- fects, some positive and some negative, by industry. The results of this calculation are displayed in table 1. Note that none of the price effects is of significant magnitude. Moreover, those in- dustries where the largest relative price changes are likely to occur are in industries which are not heavily traded, such as utilities. The major tradable goods -- in agriculture, manufacturing, and crude oil production -- experience relatively small price changes generally under one percent. Certainly these changes are small compared to observed fluctuations in the exchange rate. Note incidentally that a uniform product tax, such as a value added tax or a business transfer tax would produce no effects on either the trade def- icit or the composition of exports or imports. Any consequences of such a tax change would arise from the uses to which the revenues are put. EFFECTS OF INVESTMENT FLOWS In the case of a tax change on business income, it is possible to affect the trade balance if the change affects international capital flows. In the earlier example, ignoring capital flows, dollars bought to purchase exports exactly equal dollars sold to purchase imports. Dollars can also be used to purchase capital investments. If foreigners wish to invest in the United States they must purchase dollars to do so with, so that any change which alters the demand for U.S. investments would cause a change in the exchange rate. Similarly, if U.S. citizens wish to purchase investments abroad they must purchase foreign currency, by selling dollars, to do so with. A change in capital flows can alter the balance of trade. The changes in preferences for difference types of assets can result from many factors, but a major one is the changes in relative interest rates in different countries. Indeed, this relationship explains why the budget deficit and the trade deficit are linked. As the U.S. Government increased its demands for funds, U.S. interest rates rose relative to interest rates in other countries. The result was to make capital investment in the U.S. more attractive causing more capital to flow in from abroad. Higher U.S. interest rates also made foreign investments less attractive to U.S. citizens, causing a reduced cap- ital outflow. This increased demand for dollars and reduced supply caused the price of the dollar to appreciate. The higher price of the dollar made U.S. exports more expensive and foreign imports cheaper, resulting in an in- CRS-4 TABLE 1. Estimated Relative Price Effects on International Trade by Industry due to the Tax Reform Act of 1986 (percentage change in price) INDUSTRY PRICE CHANGE Agriculture 0 6 Mining 0 3 Oil Extraction 0.0 Construction 0 3 Manufacturing Wood Products Stone/Clay/Glass Metals Fabricated Metals Machinery Electronics Motor Vehicles Other Transportation Equipment Instruments Miscellaneous Food Tobacco Textiles Paper Printing Chemicals Petroleum Rubber Leather I I OOOOOIHOOOCDOOOOOOOCO I O $0‘!-*\ll\>CO®O-I-‘O‘\lbOb-*®(.4JbJ«bI-0 Transportation Communications Electric/Gas Trade Services I or--baLa.>I-u O00 Moaxuxo 0-" 0 @ General Price Change I F" 0 \I'| Exchange Rate Change Source: Congressional Research Service CRS-5 creased trade deficit. Another way of thinking about this is that in order for foreigners to make real investments in the United States, they had tc>make a real transfer of resources in the form of greater U.S. imports than exports. The tax changes enacted in 1986 also had the potential for affecting capital flows. Because investment becomes less attractive, firms demand less capital and as a result the interest rate falls. The fall in the in- terest rate causes U.S. investment to become less attractive and reduces net capital inflows into the country. This effect would result in a deprecia- tion of the dollar, making U.S. exports more competitive, and causing the trade deficit to contract. Over the long run this effect on the trade deficit would reverse. In the short run, investment in the United States is being reduced. In the long run, however the smaller quantity of investment by foreigners in the United States will mean that their earnings (net of reinvestment) will be smaller. Earnings on capital investment are effectively paid to foreigners by providing them more exports than they provide in imports (a trade sur- plus). As these earnings fall, the trade deficit would actually expand (or a surplus become smaller). This long run effect is likely to be quite small because the net of earnings over reinvestment is likely to be very small compared to the initial investment flows themselves, and this long run will take many years to occur. The magnitude of these effects would be likely to be relatively small as well. A simulation was prepared, assuming a unitary elasticity of demand for capital (that is, that a 10 percent increase in price would lead to an equivalent 10 percent decrease in quantity). This elasticity is likely to be relatively high over the short term. We estimated the maximum change in the exchange rate assuming that capital inflows were reduced by enough to keep the interest rate constant. The projected maximum effect on the exchange rate in the short run would be a reduction of 2.2 percent. In the long run, the effect would be an appreciation of the dollar of an estimated 0.5 percent. These numbers are relatively small as well. It is possible that the increased taxation of the corporate sector would reduce the savings rate, at least in the short run. Corporations in- itially are likely to save a higher fraction of their cash flow. The tax change reduces this cash flow, at least in the short run. Thus, the shift in income from corporations to individuals would reduce the overall level of savings, if individuals save a smaller fraction of their income than the corporations. This effect, if it occurred, would increase the exchange rate by driving up the interest rate. Even under the extreme assumption that all of the corporate tax increase reduced saving while none of the individual tax cut reduced saving, the effect would be to appreciate the dollar by only 1.6 percent. This effect, too, is fairly negligible. CONCLUSION S This analysis suggests that the tax reform act would be most likely to have little effect on the international competitiveness of U.S. indus- try. The estimates presented in this study represent the upper limit of magnitude of effect because they assume a fixed interest rate, which is un- CRS-6 likely to occur both because of imperfect substitution between assets and because the United States is such a large country that its own policies can affect worldwide interest rates. Even these estimates are, however, rela- tively small. Moreover, even though the tax proposal might reduce the trade deficit in the short run, it would do so at the expense of reduced in- vestment, a policy option which would probably not generally be embraced as a desirable means of reducing the trade deficit. The one way in which a tax change would reduce the trade deficit and be consonant with other U.S. objectives is to increase revenues so as to reduce the budget deficit. A reduction in the budget deficit would lower interest rates, reduce capital inflows, and cause exports to be more competitive. If there are important consequences to tax revision, those consequences arise from the effects on the budget deficit. jag UBRARY OF 4 WASHINGTON UNIVERSITY ST. LOUIS - MO. T‘ ,