What is it about?

Fifty years apart US Administrations have blamed other countries for overvaluations of the US dollar that it sees as damaging the US economy by reducing US exports, making imports overly competitive with its own domestic production, and increasing unemployment in places like the ‘rust belt’. The way the dollar gets overvalued is that investors in foreign countries are happy to buy lots of US Treasury securities. Foreign central banks hold about $7 trillion of them and foreign private investors another $14 trillion. Together this equals the value of US gross domestic product. Now, to buy these securities foreigners have obtain dollars with their own currencies, and this demand raises the value of the dollar on foreign exchange markets. A bit of history is relevant: in the Smithsonian Agreement of 1971, the US achieved an internationally agreed depreciation of the dollar. In the more recent episode, the Trump Administration levied tariffs on countries it named as “currency manipulators” and US rethinking seems not to have entirely abandoned this tariff policy. Let be clear, in the earlier episode, the Nixon Administration met an exchange rate issue with an exchange rate policy – get other countries to appreciate their currencies. This was what economists call a ‘first best’ policy because it directly corrected the distortion that was affecting US trade. No other distortion was introduced. In the ongoing episode, the US has gone off the rails by meeting an exchange rate issue with a trade policy, the imposition of tariffs. There is a big problem here because tariff policies are themselves distortionary. So, today, instead of just one distortion – the overvalued dollar, there are now two – the overvalued dollar and the distortions to the prices of goods and services that the US imports and exports. The tariff distortion works this way: first, since US import tariffs are not levied equally on all trade partners, US imports tend to get switched to countries facing the lowest or no tariffs at all. But in this process imports tend to get switched from low to higher cost sources. You can bet that US consumers and US firms at the top end of value chains do not love this. Secondly, import tariffs do nothing for US exports, when, of course, depreciation of the dollar would help to increase them. And, thirdly, these US tariffs have provoked retaliation, such that US exports have fallen to some markets. If payments deficits remain a problem for the US, what is needed is a policy that directly helps to depreciate the dollar. Such a policy is a tax on the interest earned by foreign holders of those $21 trillion of US Treasury securities. By reducing the net return on these securities, the demand for them would fall, and since this would reduce the demand to buy dollars (to buy the Ts) on the foreign exchanges it would weaken the dollar. This is the first best policy all over again. Moreover, taxing international transactions in securities by the US has been done before. This was the interest equalization tax of 1963-1974. Back then the US was trying to stem capital outflows initiated by US investors, something that was undermining the post-war international monetary system. The tax proposed here is aimed at stemming capital inflows. Ok, different objectives but, if back then, a tax system was workable, there is no reason why it would not work today.

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Why is it important?

This paper offers up a better policy to correct US payments deficits that would not be so disruptive to world trade as have been its tariff policies introduced by the Trump Administration and not yet entirely abandoned. In short, this paper shows why taxing the interest income earned by foreign holders of US Treasury securities is better than its tariff policies.


This paper uses important theories in international finance - causes of payments deficits, and international trade - the theory of second best, to show just how wrong were the Trump Administration's tariff policies. It goes on to argue that the first best policy to correct US payments deficits is a tax on the interest income earned by foreign holders of US Treasury securities. This policy echoes the US interest equalization tax that was in force 1963-1974.

Paul Hallwood
University of Connecticut

Read the Original

This page is a summary of: Correcting US payments imbalances: Taxing foreign holders of its treasury securities is better than import tariffs, World Economy, March 2021, Wiley, DOI: 10.1111/twec.13113.
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