Taxes, Prices, and the Exchange Rate in the Destination-Based Cash-Flow Tax (DBCFT) System

Introducing a destination-based cash-flow tax (DBCFT) in the United States would dramatically change the tax base for businesses. Depending on how it is implemented, it could also affect prices, wages, and the exchange rate. We analyze the DBCFT using a simulation model of the US economy. First, we specify scenarios in which there is full adjustment. In these scenarios, the equilibrium is trade neutral. Depending on which prices are “sticky” (slow to adjust), markets can adjust via the exchange rate or via domestic prices and wages. We analyze three scenarios with different types of price stickiness, drawing from cases considered by Buiter (2017), Freund (in chapter 7 of this Briefing), and Freund and Gagnon (in chapter 9), and Martin (2017). In all these scenarios, with full adjustment the economy achieves a trade-neutral equilibrium in the long run, but the changes in the price system are large, differ across scenarios, and would be expected to lead to serious adjustment problems. Second, we consider what happens if the DBCFT is not fully implemented—the tax is not passed on to markets and/or the exchange rate is sticky and the trade balance rather than domestic prices adjusts. We consider three scenarios of incomplete adjustment, drawing from the literature. In these scenarios, the equilibrium is not trade neutral, with strong effects on trade incentives, exports, and imports that differ across scenarios and may raise concerns about consistency with international trade agreements. In scenarios where the trade balance adjusts, real domestic consumption declines, suggesting that the DBCFT can leave consumers worse off.