Who wins and who loses from a border-adjusted cash flow tax like the one proposed by House Republicans? Fabio Gaertner, Jeffrey Hoopes, and Edward Maydew seek to shed light on that question by examining stock market reactions to news about the House Republicans’ plan. Their topline result is that on days when news events make a border-adjusted cash flow tax look more likely, share prices of firms in high-import industries perform worse than the rest of the market.
Gaertner, Hoopes, and Maydew contribute to a fast-growing literature on the trade balance effects of border-adjusted cash flow taxation. I imagine that most readers of this blog have been following that debate, but for those who haven’t, a brief primer: A pure cash flow tax would tax businesses on revenues minus expenses. A border-adjusted cash flow tax allows an exemption for revenues from exports but denies a deduction for the cost of imports.
On first glance, one might think that this would stimulate exports and discourage imports. But if border adjustment leads to a flood of U.S. exports and fewer imports, then demand for the dollar will rise and supply will fall. Foreigners will want more dollars to buy up U.S. exports, and Americans will want to exchange fewer of their dollars for Euros, yen, etc., because they are importing less from abroad. This will lead the dollar to appreciate, making U.S. exports more expensive for foreigners and imports cheaper for Americans. In an ideal world, appreciation of the dollar perfectly offsets the immediate effect of border adjustment, so that exporters are no better off and importers are no worse.
The authors set out to test whether investors believe this exchange rate offset story. Using data from Google Trends, the authors identify days in January and February 2017 when the term “border adjustment tax” generated an unusually high volume of searches. On three days, the spike in traffic appears to be associated with President Trump or his strategist Steve Bannon speaking positively about border adjustment. On two days, the increase in interest appears to be linked to a negative news story: Trump criticizing the proposal as “too complicated” or meeting with retail executives opposed to the idea.
The authors find that on days when increase in interest was associated with an event that made border adjustment appear more likely, firms in industries with high import-to-export ratios experienced negative abnormal returns, and firms in industries with low import-to-export ratios experienced positive abnormal returns. When the news event was one that boded poorly for the House Republicans’ proposal, share prices of firms in the import-heavy industries gained relative to the rest of the market, while net exporters lost ground. Retail-sector share prices were the most sensitive to border adjustment-related news: they experienced abnormal returns of -3.65% on days of good news for the border-adjusted cash flow tax and +1.09% on days when the news related to border adjustment was negative. These results, the authors say, are “consistent with the market expecting less than full currency adjustment”—and “consistent with the market expecting that . . . retailers and importers would be adversely affected” by the House Republicans’ plan.
There are a number of reasons why we might not expect exchange rates to fully offset the effects of border adjustment. For one, other factors such as interest rates influence exchange rates; if, for example, the Federal Reserve cuts interest rates or the European Central Bank raises them, then the euro-for-dollar demand triggered by U.S. border adjustment might be offset by the dollar-for-euro demand resulting from interest rate carry trades. For another, the exchange rate effects of border adjustment might take time—and the lag might affect the profitability of importers and exporters (negatively for the former, positively for the latter).
But while I think it’s entirely plausible that—as the authors conclude—investors don’t expect exchange rates to adjust fully, it’s also difficult to derive that conclusion from share price movements. Border adjustment is not the only salient feature of the House Republicans’ proposal—and not the only feature that might generate different effects across industries. The House Republicans’ proposal would reduce the corporate rate by 15 percentage points and replace depreciation with expensing for almost all corporate investments. The latter element would likely benefit capital-intensive industries more than others. We can’t yet be sure whether investors are responding to the border adjustment aspect of the House Republicans’ plan or to other features. (Note that the authors do not control for capital intensity.)
Moreover, the fact that import-heavy industries experience negative abnormal returns on days of good news for the border-adjusted cash flow tax does not necessarily mean those industries will be harmed by the House Republicans’ proposal. First, investors who are selling or shorting shares of firms in import-heavy industries might turn out to be wrong. Second, the authors focus on abnormal returns: the one-day raw return for firms in each industry minus the market return. If most or all public companies stand to gain from the border-adjusted cash flow tax but exporters gain more than importers, then we would expect importers to experience negative abnormal returns (i.e., returns below the market average) on days with good news for the House Republicans’ plan, but it would not be correct to say that importers are “adversely affected.”
Third, investors might believe that if the border-adjusted cash flow tax is defeated, then Congress is likely to pass a more conventional corporate tax cut that reduces rates without radically altering the treatment of imports and exports. In that case, negative abnormal returns for firms in import-heavy industries on days of good news for the border-adjusted cash flow tax might reflect an expectation that firms in those industries would benefit more from a conventional rate cut than from the House Republicans’ plan. In that sense, importers might be “adversely affected” by a border-adjusted cash flow tax, but again, they still might be better off under the House Republicans’ plan than under the status quo.
In sum, just as it is difficult to determine how a border-adjusted cash flow tax will affect importers and exporters, it is difficult to determine how investors think a border-adjusted cash flow tax will affect importers and exporters. Nonetheless, the paper by Gaertner, Hoopes, and Maydew is the best market-based evidence we have so far of the shareholder wealth effects of the House Republicans’ plan. The authors’ empirical strategy is clever, and their contribution is extraordinarily timely. While theirs is unlikely to be the last word on the matter, it’s an important first cut.