Why the ‘border tax’ is a bad idea

The Trump administration’s border tax has been trumpeted by legions of supposedly pro-market pundits in the right wing media for months now. It is relatively simple to dissect this misguided policy:

First, it’s necessary to get past the obfuscatory language – ‘border tax’ is essentially a glorified term for a tax on imports, or tariff (border tax sounds more exciting though, doesn’t it?). A tariff’s intended effect is to make (presumably cheaper) foreign imports at least relatively (if not, absolutely) more expensive than the same domestically produced goods in order to prop up domestic firms. Since imports become more expensive as a result of the tax, the level of imports drops and more domestic goods are purchased since they become cheaper than foreign goods. Another less obvious effect of the tariff is, since the equilibrium price is not being attained and production does not reflect consumer preferences, a decrease in allocative efficiency/overall societal economic benefit. In other words, the marginal benefit to the consumer of consuming the last unit of a good is less than the marginal cost to the producer of producing the last unit of said good and consumers end up with a burden of taxation/loss of economic benefit/utility (necessarily) in excess of any increase in economic benefit to producers. This is illustrated by this graph:

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As you can see, value to consumers is lost in two areas where trade with the tariff does not take place – from QC1 to QC2 under the demand line and from QS1 to QS2 under the supply line. The overall loss in consumer surplus (the difference between what a consumer is willing to pay for a good and what they end up paying on the market) is expressed by the area composed of producer surplus above P-world, tax revenue and societal loss. Part of the loss in consumer surplus is canceled out by gains accruing to producers (because of the increase in the market price of their good and increased production) and part of the loss is recouped in the form tax revenue, but some of the lost consumer surplus is irretrievable and accrues to no one (hence the overall “loss” in societal benefit).

It is important to note that this example is of a market for one specific good. If we were to extend this out to the entire economy, an even greater societal loss would likely occur as a result of some of almost all firms’ producer surplus being canceled out by increased costs of inputs caused by the tariff.

So, already we have a loss in economic efficiency and overall well-being. However, this is only a first-order effect. Now we must observe any second-order effects of the so-called border tax:

Assuming international trade always means that different currencies are traded/purchased as means of payment for foreign goods, a crucial identity holds in the long-run: value of imports = value of exports. Let’s flesh this scenario out further and see why this holds:

Since foreign goods are now more expensive than domestic goods as a result of the tariff/border tax, the level of imports decreases. In order for firms in one country to import goods from another country, it must purchase said foreign goods with foreign money (in practice this is done for them by international banks). Foreign money is purchased on the foreign exchange market at the prevailing exchange rate between the domestic and foreign currency, then used to purchase foreign goods. The foreign exchange market functions like any other market for goods or services (more or less) – it follows the laws of supply and demand.

Since less foreign products are purchased after a tariff is implemented, demand for foreign currency decreases and less domestic currency is supplied into the foreign exchange market. The effect of this is to increase the value of domestic money relative to foreign money (or, conversely, decrease the value of foreign money relative to domestic money since currency A’s exchange rate relative to currency B = 1/currency B’s exchange rate relative to currency A).

figure8-1

This makes domestic products more expensive for foreign firms to purchase because domestic currency is now more expensive to purchase on the foreign exchange market, and so less domestic goods are imported by foreign countries. So, ironically enough, the border tax not only cuts imports, but it also cuts exports (hurting domestic producers) commensurately. Imports = exports. So, the final result is a decrease in overall trade and an increase in prices (both representing significant loss of economic gains), which is indisputably bad for the economy and population as a whole.

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