In June 2016, House Speaker Paul Ryan proposed a destination-based cash flow tax (DBCFT), a type of national consumption tax, as part of the "A Better Way" tax reform blueprint. One component of the DBCFT proposal is the implementation of a border adjustment. Were the United States to adopt a DBCFT with a border-adjustment tax (or BAT) it would only tax production that is consumed in the United States—domestically produced goods and services sold abroad would not be taxed. This treatment would be a departure from the current corporate income tax system. The proposed change has attracted considerable interest from policymakers and the general public in determining the relative costs and benefits of a switch to a DBCFT and the accompanying BAT. Although there are many important issues surrounding a BAT that would require careful consideration before implementation, the response of exchange rates is one that has received substantial attention. Standard economic theory predicts that under certain conditions exchange rates would react to a BAT in a way that would leave exports and imports unchanged. That is, exchange rate movements would offset the effects of the tax, leaving the U.S. trade balance unaltered. Some observers, however, have speculated that such a response may not occur in a timely fashion or that exchange rate movements may not completely offset the tax. If either of these two situations were to occur, or if impact across industries was asymmetric, there could be implications for U.S. businesses and consumers, and as a result, the U.S. trade balance. This report provides a basic framework for understanding how and why exchange rates could respond to a BAT. It first describes a BAT and uses several examples to illustrate how one works. It then summarizes the standard economic theory of how exchange rates should respond to a BAT, as well as the arguments against the theoretical predictions. Finally, this report reviews the existing literature that has empirically investigated the relationship between exchange rates and BAT systems in other countries. Information on other issues related to taxes with a border adjustment or that share economic features similar to the "A Better Way" proposal may be found in the following CRS products: CRS In Focus IF10583, Border-Adjusted Taxes: A Primer , by [author name scrubbed] CRS Report R44342, Consumption Taxes: An Overview , by [author name scrubbed] and [author name scrubbed] A border adjustment is typically a component of a national consumption tax (including the DBCFT) that applies differently to imports into a country and exports out of a country. The border-adjustment system that has appeared in recent congressional debates would impose a 20% tax on all goods and services imported into the United States and would impose no tax on exports. Additionally, American companies that produced and sold their goods in the United States would also be subject to the 20% tax. Such a tax is often referred to as being "destination based" because the levy of the tax would depend on where the goods or services are consumed; at home or abroad. Were the United States to adopt a destination-based system of taxation, only those goods and services consumed in the United States—whether produced domestically or abroad—would be subject to the tax. While the exact mechanics can differ depending on the particular destination-based system adopted, any such system will require a process of "adjusting" business taxes at the border to ensure imports are subject to tax and exports are not. A few general examples may clarify how a BAT functions. In each of the examples below, it is assumed that the tax rate would be 20%, the tax would apply broadly to all domestic consumption, and that it would be fully adjustable at the border. The examples below begin with the simplest cases of how the tax would apply and then explore more complicated situations. A Japanese firm produces $1 million worth of goods in Japan, which it then sells in the United States. The firm would pay a 20% tax equal to $200,000 on the $1 million in sales. An American firm pays $200,000 for domestically sourced inputs to produce $1 million worth of goods which it sells exclusively in the United States. In this case, the firm would be allowed to deduct the $200,000 in production costs (because they are domestically sourced) and then would pay a 20% tax on $800,000 ($1 million minus $200,000) or $160,000. An American firm pays $200,000 for domestically sourced inputs to produce $1 million worth of goods which it sells abroad. This firm would pay no tax on the $1 million because all of its sales occur overseas. Additionally, because production occurred in the United States using domestically sourced inputs, the firm's costs would be fully deductible and result in a tax loss of $200,000. With full border adjustment, the firm would be entitled to a tax refund or credit equal to $40,000 (20% multiplied by $200,000)—the value of its tax "loss" position. An American firm pays $200,000 for domestically sourced inputs to produce $1 million worth of goods. Half of the firm's sales are to customers abroad and the other half are to customers in the United States. In this case, the $500,000 in foreign sales would be exempt from tax. Because the firm's inputs were entirely domestic, their costs would be fully deductible against the $500,000 in U.S. sales. The firm would pay a 20% tax on $300,000 ($500,000 minus $200,000) or $60,000. An American firm produces $1 million worth of goods using $100,000 of inputs sourced domestically and $100,000 of imported inputs. Half of its sales are abroad and the other half are in the United States. Again, the $500,000 of foreign sales would be excluded from income and free from tax. However, only the value of domestically sourced inputs would be deductible against the $500,000 in domestic sales. The firm would pay a 20% tax on $400,000 ($500,000 minus $100,000) or $80,000. Note that not allowing a deduction for foreign-sourced inputs is the same as taxing the inputs when they are imported but allowing the firm to deduct their cost from domestic sales. Economists generally agree that traditional economic theory predicts exchange rates will adjust to offset price changes arising from the implementation of a BAT in the United States. As a result, a BAT should have no direct effects on the trade balance. The standard theory rests on two important assumptions—flexible U.S. exchange rates and a full border adjustment. The full border adjustment assumption simply means that all imports are taxed at the same rate, and that all exports are completely excluded from taxation. Since the United States has a flexible exchange rate regime, the analysis below will only discuss the implications of the tax when it is not fully adjusted at the border. Before analyzing the exchange rate adjustment process more closely, it is helpful to review the logic of the standard theory regarding exchange rates and a BAT. Understanding how exchange-rate adjustments can offset the effects of a BAT requires understanding supply and demand in the foreign exchange markets. Implementation of a BAT would initially make U.S. exports more attractive to foreigners. This increased demand for exported goods would increase the foreign demand for dollars to purchase U.S. products and push up the value of the dollar relative to other currencies. At the same time, the BAT would initially make imported goods and services less attractive to American consumers and businesses. This reduction in demand for foreign goods would reduce the supply of dollars on the market—when Americans import foreign goods and services they must supply dollars in exchange for foreign currency. It is the combination of increased demand for dollars by foreigners to buy U.S. exports and decreased supply of dollars stemming from a reduction in imports that is the mechanism through which the dollar's exchange rate value would increase. Specifically, the standard economic model predicts that the dollar should appreciate in value by t /(1- t ), where t is the BAT rate. For example, the "A Better Way" proposal calls for a BAT of 20%, implying that if the dollar fully adjusts to offset the tax then the dollar will appreciate in value by 25% against other currencies. If this appreciation occurs, there will be no changes in the trade balance resulting from tax. While most economists believe that exchange rates will adjust to offset the tax, there is debate over how fast the adjustment will occur. Some have argued that the adjustment should occur almost instantaneously or even before the tax is enacted if markets price in the impending policy change. Others have argued that there may be real-world frictions that would slow the adjustment process and could result in a situation where the trade balance improves for a number of years until the exchange rate fully adjusts. For example, there may be some contracts already in place that are denominated in dollars that will prevent the exchange rate from adjusting until they expire. In the end, however, the BAT cannot permanently lift exports over imports because economic accounting constrains a country's aggregate present-value trade balance to be zero. It is important to remember, however, that a country's aggregate trade balance is the summation of trade surpluses and deficits with every other individual country in the world. Additionally, countries can run bilateral trade surpluses and trade deficits for quite some time. There can be direct trade-balance effects in the case that the tax is not fully adjusted at the border. Less than full border adjustment could occur in at least one of two ways. The first is if either not all imports are uniformly and identically taxed or if not all exports are completely exempted from tax. If either one of these situations were to occur, it could prevent the exchange rate from fully adjusting or alter the pattern of trade. In short, full border adjustment requires that if imports are subject to taxation, then exports must be completely exempt.