Choose your own American protectionist adventure, part 2

This post is a fictionalised thought experiment. YOU and YOU ALONE are in charge of what happens in this story. There are tradeoffs, choices, policies and consequences. YOU must use all of your big-league talents and much of your yuge intelligence. At any time, YOU can go back and make a different choice, alter the path of your story, and change its result.

Your name is, um, Ronald Grump (sorry everyone), and you’re the president of an alternate-universe version of the United States.

In this alt-world, you’ve promised to close your large negative current account (basically, your trade balance with the rest of the world). You look at the US’s trading partners. China’s your biggest, so you start sabre-rattling. Canada is closer, but, well, you like maple syrup.

And then there’s Mexico. One of your major campaign promises was to build a wall to secure your country’s southern border. Oh, and you kinda told everyone that you would make Mexico pay for it. But the Mexican president says he’s not willing to help you at all.

What do you do?

One: Nothing. The House Republicans’ corporate tax reform proposal basically makes Mexico pay for it, so you’ll leave it to them.

Two: Impose a tariff against Mexico.

Three: Threaten to withhold remittances to Mexico from the US, as previously promised.

Choose wisely.

ONE: Support the House’s tax reform plan

Your press secretary fumbles the delivery of your plan to the press, and briefly makes it sound like you’re imposing a tariff on Mexican imports.

You let that sit a while, because you so love to watch the “dishonest media” freak out. Then you make your flack fix the record for you.

The speaker of the House, Ryan Paul, calls to thank you! The Mexican president still isn’t happy, since his country is a net exporter to the US, but the disagreement is fairly civil. And sure, it’s not clear whether the tax revenues from Mexican imports will actually cover the cost of the wall. But this way you can at least pretend it was Mexico — you know better than anyone that balancing a federal budget is a sucker’s game.

What’s more, your choice has made the US’s tax system more like the rest of the world, anti-globalisation be damned. Of course, in typical American style, your colleagues in Congress take a decent idea and then mess with it until it runs into legal trouble — but more on that later.

First things first. This alt-world tax plan follows the blueprint from the real world, where House Republicans are proposing a “destination-based cash flow tax.”

To boil it down, that means companies pay tax on domestic sales minus costs, instead of where their income is reported (like the territorial tax system in the UK) or where they’re based (like the current US system, of worldwide taxation).

You’re essentially taxing corporate income, of course. But wording matters a lot. The World Trade Organization doesn’t allow border adjustments for income taxes, since they’re considered “direct” taxes, according to a helpful paper from Scott Lincicome and Richard Eglin, of White & Case.

Luckily for you, the House understands that. It looks like a twist on Japan’s “subtraction method” of value-added corporate taxation, which has a clean-as-a-whistle record of only 15 complaints against it at the WTO. (In Europe, value-added tax is calculated each time there’s a sale or purchase, but US lawmakers know that voting for an extra tax charge on every receipt would be used as a bludgeon by their political opponents. In Japan, companies calculate their tax liability once a quarter by calculating the difference between domestic purchases and sales.)

The Senate approves the bill, and you sign it into law!

Now, Mexican goods sold in the US include a 20-per-cent tax — alt-world taxes tend to get passed on to consumers, just like the real world — but aren’t taxed in Mexico. The price of US goods sold in Mexico now include that country’s 16-per-cent value added tax, and their US taxes are rebated. Of course, if US hiring and wages don’t pick up as a result, you’re in trouble, since the tax is somewhat regressive, but you think that greater domestic investment will make up for it.

“That wall is good as paid for!” you shout. But Mr Paul doesn’t even crack a smile. In fact, he looks worried.

“Have you seen what’s happened to the dollar?” he asks.

Since the tax was imposed, the dollar has risen an additional 25 per cent, as companies shift investment back into the US from abroad. That’s a bigger rally than the (real-life) analysts at BCA Research Inc expected. They predicted a 15-per-cent trade-weighted dollar rally over 12 months if a border-adjusted tax is introduced for corporations.

You frantically search for the analysts’ Jan. 23 note, where they went through potential economic effects of a border-tax-prompted dollar rally. Ah, here it is:

Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.
…consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed.
If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance.

There are some side effects, but the trade balance is closing, and that’s what you care about.

Before you can really relax, you get a call informing you that the European Union has filed a dispute against you at the WTO.

The center of the dispute, you learn, is a raft of tax deductions for domestic businesses that international companies can’t get. That same problem could surface in the real House’s tax plan, Mr Lincicome of White & Case said in an interview.

“If you throw in deductions that are only available to domestic producers, as you go through the chain, the tax base keeps shrinking,” he said. “You’ll end up with a lower effective tax rate… Then you’re going to run into discrimination issues” at the WTO.

You don’t like the WTO, but a few members of your cabinet tell you that it’s an easy fix, though. You ask Congress to amend the bill to remove the problematic deductions.

Now leaders of emerging-market countries with dollar pegs are complaining that the strength of the dollar is hurting their economy, like BCA Research predicted:

…a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts.

What’s more, those country’s economic struggles are fomenting unrest there. You ignore it, because your general lack of imagination makes it difficult to see how instability in dollar-pegged economies could affect the US.

But one thing’s for certain: Life in those countries is going to get more brutal, thanks to you.

TWO: Impose a tariff on Mexico

Good thing that, in this alt-world, you’ve torn up the North American Free Trade Agreement, because this is totally not allowed under those rules. But hey, you’re already negotiating one-on-one with Canada, and you know they aren’t willing to give up their sweet ~$15bn trade surplus (of goods) with you.

Your tip-top priority is getting that wall up and shrinking the negative $50-billion balance of trade (for goods) with your southern neighbor. The legal efforts to overturn your executive orders on immigration will serve as a nice distraction for everyone while you work it out.

Of course, Mexico’s president still isn’t cooperating. And Congress isn’t helping you, either. They keep saying things like: “This wall will blow a hole in our budget,” and “Fiscally irresponsible,” whatever that means, and “Where’s the revenue for this?”

Finally, you’ve had enough. You don’t need the help of Congress, or Mexico, or anybody.

…well, you do need your Commerce Secretary, who in this alt universe is named Wilber Russ, and the head of the new White House office overseeing trade, Pieter Navaro (it’s unclear why his first name is Dutch. The alt-universe is a strange and bad place).

You decide it’s time for Mr Russ to investigate the national-security effects of importing anything from Mexico — if he finds out that the imports have a negative effect, you can impose restrictions or regulations to offset that impact.

You get a little nervous when you’re told Mr Russ needs to consult with the widely respected Secretary of Defense during the process, who might try to talk him out of it.

But once we’ve suspended our disbelief entirely, Mr Russ comes out of the meeting completely certain that Mexican imports are a threat to national security, and sends you a recommendation to impose tariffs.

You put a 20-per-cent tariff on Mexican imports.

“That border wall is as good as paid for!” you shout, after some quick back-of-the-envelope calculations. (20 per cent of $295bn is $59bn, which should more than cover it, right??)

But Mr Russ hasn’t even cracked a smile.

“Have you seen the peso?” he asks.

The dollar has climbed 20 per cent against the peso. That’s not the academic-predicted gain of 25 per cent in a similar situation, since Mexico exports some dollar-denominated goods into the global marketplace, but it’s enough to mean that Mexican goods are not, in fact, much more expensive than they were before. The government still gets some revenue, but the balance of trade hasn’t much improved.

And Mexico immediately files a dispute at the WTO, which you haven’t exited yet. It’s pretty clearly a banned discriminatory tax measure, and the panel looks like it’s getting closer to ruling against you. You’ve threatened to withdraw if you don’t get your way, but the lawyers know you need Congress to do that, and you’ve used up a lot of political capital in various brawls over immigration.

“Ha! Well we don’t have to cooperate,” you tell Mr Russ. You’re the biggest economy in the world, and if Mexico doesn’t have to pay for the wall, you certainly don’t need to pay a penalty for charging them for it.

Mr Russ clears his throat uncomfortably.

“So, have you heard about what happened with Antigua?” he asks. “They said they could suspend $21m of our intellectual property rights each year until we comply.”

It’s a small sum, to be sure. But it gives the WTO a method of enforcement of that’s mostly outside of your control — they can essentially take US intellectual property until they’ve been compensated. Of course, that would be a difficult penalty to implement. Determining the value of intellectual property is a fuzzy business, as reports have shown.

And, what do you know, the WTO imposes penalties on you for the Mexico policy, and unlike Antigua, Mexico actually starts collecting them. After news gets out, a slim majority of the public turns against the organisation (with the help of Breitbart and Fox News) and you now have enough political support to withdraw from the WTO altogether.

Multinational companies’ shares take a big hit, with the worst of the losses are suffered by firms that use materials made in Asia. Many firms — US investment managers among them — start moving offshore.

Of course, there are plenty of US-focussed firms, as Goldman Sachs pointed out in a January note, and even some of them that are listed abroad benefit:

…the European stocks with the largest US sales exposure (ticker: GSSTAMER) typically own US-based businesses, rather than selling into the US from abroad, and thus remain relatively insulated from trade or border-tax risks. Since the election, the basket has outperformed European equities ex-Financials by 6 percentage points while the USD has strengthened by 4% vs. EUR…
In addition to tailwinds from US economic strength and a rising dollar, the most domestic-facing US stocks should benefit from their insulation from potential trade conflicts. From 2011 through 2015 the performance of our US sales basket (GSTHAINT) vs. our foreign sales basket (GSTHINTL) matched the path of the trade-weighted USD. In 2016, however, the series began to diverge (see Exhibit 3). Although the US sales basket outperformed by 4 pp as the dollar surged during the month post-election, the strategy has declined by 3 pp since the start of December.

For a while after your exit, you play the other members of the WTO off of one another by offering access to your sizeable market for their cooperation.

But eventually, the WTO falls apart altogether. Global trade negotiations get more brutal, thanks to you.

THREE: Withhold remittances until Mexico agrees to pay

You’ll withhold remittances until Mexico pays for the wall, like your initial proposal said.

You clear the high legal bar it would require to impose such a rule, and remittances are officially halted. Human-rights advocates are furious. Personal remittances are actually a relatively small proportion of the country’s total GDP (less than 5 per cent), but they do affect the economies in the poorest parts of Mexico, which have been estimated to get about 19.5 per cent of their income from remittances.

While the poorest parts of Mexico don’t have the technological infrastructure to use Bitcoin or other kinds of non-dollar money transfers, activists start building a “Dark-Web Railroad” to transfer money. Payment systems (“the cyber“) become increasingly central in the national security debate.

What’s more, the halting of remittances doesn’t actually affect the US balance of trade, as Matt Klein has covered. Still, the Mexican government eventually agrees to send $15bn (1.3 per cent of its yearly GDP) to the US.

That gives a reason for you and Congress to impose a border tax as well, and Mexico’s economy does take a hit from that. Before you built the wall, you had a large number of undocumented immigrants and remittance payments, but the net balance of migration was negative (more were leaving the country than entering it.)

Now, you have a wall, but you also have additional economic problems in Mexico, which you could expect to give more of its citizens a motivation to migrate to the US. Tunnels proliferate wherever the border patrol isn’t watching — and this time, thanks to a domestic effort to resist the Trump presidency, you’ve got US-based activists helping.

The constant game of immigration whac-a-mole at the US’s southern border has gotten more brutal, thanks to you.