Why Mexico will pay for the wall and not mind doing it

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By Michael Knox

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Chief Economist and Director of Strategy

Date posted:

13 February 2017, 8:55 AM

In recent weeks, I have been doing presentations on the economy. I find that many of the people who come to these presentations share a similar problem. They have woken up in a parallel universe in which Donald J Trump, billionaire, is President of the United States, and they want me to explain to them what he is doing.

Donald Trump campaigned for President on the platform that he would "Build a wall" and "Mexico would pay for it". He recently signed a directive to begin planning to build the wall. Speaker of the House, Paul Ryan, said that this would be paid for by the US. Trump, when interviewed, said that Mexico will pay for the wall because they would face "a big 20% import tax". What is Trump talking about?

When Trump ran for President he also promised to reduce company tax to 15%. Paul Ryan, in a more structured and planned program, promised to reduce company tax to 20%. Ryan showed an illustration on the website abetterway.speaker.gov that compared the corporate tax system as like a Swiss cheese. Various lobbyists had arranged to have big areas of tax deduction included in the tax code in return for campaign contributions. He argued that eliminating all of these tax deductions or "carve outs" would allow the corporate tax to decline from the current rate of 35% down a much lower rate of 20%.

The Border Adjustment Tax

One of the tax deductions that Ryan wanted to remove (perhaps surprisingly to Australians) was a tax deduction on imports into the US made by corporations. If this tax deduction is removed, and the company tax rate stands at 20%, then businesses would face an effective 20% increase in import prices. This is called the border adjustment tax. This is the tax that Trump was talking about. We note that all countries exporting to the United States would face this, not just Mexico.

Although imports would no longer be tax deductible, all expenses involved in exporting products from the US would be tax deductible. The result is to push up import prices but subsidize export prices. Most economists believe that this would generate an improvement in the US balance of trade (see footnote).

Transfer Pricing

There is another important result of the border adjustment tax. Right now America has a problem with US companies moving outside the US and setting up in tax havens. Some tax havens have corporate tax rates as low as 12.5%. An example is the Irish Corporate Tax on Trading Income.

US Corporations may set up subsidiaries in tax havens and generate a high level of "value added" in the tax haven. They then export products back to the US, pricing those products to include the high level of "value added". The advantage is that the income generated is taxed in the tax haven. These high priced imports are then tax deductible to the US parent corporation. This whole process reduces US corporate tax receipts and increased tax haven tax receipts.

The incentive to engage in this process is removed by the Border Adjustment Tax, because imports into the US are not tax deductible. The incentive will be to import products or services into the US at the lowest possible price. This reduces the income that ban retained in a tax haven. Because the products are imported into the US at the lowest possible price, this maximises the income that is earned by the US parent corporation in the US and therefore maximises US domestic corporate tax collections.

The border adjustment tax firstly improves the US balance of trade. Secondly, it increases domestic tax receipts because it removes the incentive for US corporations to locate in tax havens.

Conclusion

The border adjustment tax is part of the program designed by Paul Ryan to allow the US to reduce its corporate tax rate to 20%. It was not designed to fund the building of the wall but Mexico will pay this tax and the wall will be built. So if Trump says Mexico is paying for the wall, who are we to disagree?

This should be no problem from Mexico's point of view. China will face more border adjustment tax than Mexico. Germany will face more border adjustment tax than Mexico. Mexico will face the border adjustment tax at the same rate as everybody else. What is there for Mexico to be unhappy about? Even Donald Trump will be happy – maybe.

Footnote: There is a broad discussion on exchange rate effect of this improvement in the US trade balance. In theory, an improvement in the US trade balance should push up the $US. We find there is little evidence that this happens in practice. For example, the Euro Area has persistent trade surpluses. The US has persistent trade deficits. If trade balances were important, then the $US would be weak and the Euro would be strong. In practice, the reverse can be seen to be the case.

More information

View more analysis by Michael Knox by clicking on 'economic strategy' in the popular topics list to the right of this page.

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