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With President Trump’s administration taking office little more than a week ago, financial market participants are eyeing what policies he’ll prioritize and implement.
Perhaps the most anticipated of all is comprehensive tax reform, a big piece of which involves lowering the corporate tax rate to 20%, as specified in Congressional Republicans’ policy initiative ‘A Better Way‘. While the blueprint includes significant overhauls across the tax code in addition to lowering the corporate tax rate, a ‘border adjustment’ tax has stood out recently amongst its various provisions. The provision aims to promote exports while taxing imports, which would align with President Trump’s stated priority of revitalizing the U.S. manufacturing sector.
What exactly is the border tax?
The border tax will ban U.S. companies from deducting the cost of imports that go into products that they sell domestically. At the same time, businesses will be able to deduct revenue from exports while calculating their taxes. Since the U.S. imports more than it exports, the provision would raise revenue (essentially by taxing the trade deficit).
This is not exactly a tariff since it applies an existing tax to imports and exports – a border adjusted tax – and so it is unclear whether it would run afoul of World Trade Organization (WTO) rules. Proponents have likened it to a value added tax (VAT) that several other countries implement. Technically, a VAT would not allow businesses to deduct payroll but the current plan maintains this. As Tony Nitti at Forbes notes , allowing deductibility of wages may cause huge problems with WTO if the proposal is passed as is.
The border tax is vital to the overall tax reform plan since it is estimated to raise $1.2 trillion over the next ten years, offsetting some of the corporate tax cuts. The White House has also floated the border tax as a possible revenue source to cover the cost of building the border wall with Mexico.
This is obviously a major attempt to change how the U.S. economy but we thought it would be worthwhile to illustrate the impact using a simple stylized example. I’ve borrowed examples from Kyle Pomerleau at the Tax Foundation and Dylan Mathews at Vox.com , with some changes.
What the border tax will mean for U.S. companies?
Let’s consider three U.S. based companies:
1. TaxiCorp, which makes all its money domestically, with no imports or exports,
2. SweaterCorp, which makes all its money by importing sweaters from abroad and selling them locally,
3. PaperCorp, which manufactures a special kind of paper in the U.S. but does all its sales outside the country.
Let’s say each business makes $1,000 in revenue, with $800 cost of goods sold and $100 in wages for their domestic employees, both of which are deductible under the current tax code. That would leave each company with a taxable income of $100. With the current corporate tax rate of 35%, all three companies would see a net profit of $35.
Now, say the corporate tax rate is reduced to 20%. As the next table shows, the only thing that changes, albeit a big one, is that each company sees its tax liability fall to $20. This leaves all three businesses with a larger net profit of $80.
As you may have noticed, reducing the tax rate from 35% to 20% means that tax revenue sees a large drop as well. At a tax rate of 35%, tax revenue from the three companies would add up to $105, whereas at the lower rate it would be $60, more than 40% lower.
This is where the proposed border tax comes in. Let’s modify the previous table to now account for a border tax. Nothing changes for TaxiCorp, which has only domestic operations. However, SweaterCorp, which imports $800 worth of sweaters, will not be able to deduct this cost from its taxable income. The only item it can deduct is the $100 in wages for its domestic employees.
At the same time, PaperCorp can not only deduct its cost of goods sold and wages, it can completely exempt its foreign sales revenue.
The border tax results in SweaterCorp paying out all its profits in taxes and then some, resulting in net loss of $80. At the same time, PaperCorp gets a rebate of $180 from the government, leaving it with a net profit of $280.
If SweaterCorp wants to remain profitable, they would have to raise their prices. In fact, they would need to raise prices by 20% to get back to their prior level of profitability. One can begin to see why under such a scenario, importers would lose out and exporters would gain, thus incentivizing the latter.
Will exchange rates adjust to balance the border tax?
Supporters of the border tax, along with several economists, maintain that the above situation will not occur since foreign currencies will depreciate against the dollar if the U.S. implements such a tax. This would make imports cheaper for U.S. consumers and exports more expensive.
To see how this works, let’s go back to our example and assume foreign currencies depreciate 20% against the U.S. dollar.
Once again, nothing changes for TaxiCorp. However, the cost of imported sweaters for SweaterCorp will fall by 20%, from $800 to $640 (but still not a deductible expense). At the same time, PaperCorp will see its revenue from overseas sales fall 20%, from $1,000 to $800. As the table below shows, the net effect of this is that all three companies will make exactly the same level of profit ($80) as they did if the border tax did not exist. The appreciation in the U.S. dollar balances out the effect of the tax.
Interestingly, in our particular example, PaperCorp does not even make a gross profit based on its sales outside the country. It only nets out a profit thanks to a rebate/subsidy offered by the government.
Since the presidential election on November 8th 2016, the U.S. dollar index has climbed 2.7% (as of January 27th 2017). It does not appear that currency markets are moving towards adjusting for a potential border tax in a significant way, at least not yet. However, let’s take a look at the individual countries that have the largest trade relationships with the U.S. and see how their currencies have depreciated against the dollar since the election.
Exports/imports for the U.S. and its top five trading partners and currency depreciation for each country versus the U.S. dollar between November 8th 2016 and January 27th 2016. Source: Census.gov , XE.com .
Other than Mexico’s peso, none of the other currencies have fallen more than 10% against the dollar during the post-election period, with Canada’s currency even appreciating. Note that the trade deficit with Canada is the lowest amongst America’s largest trading partners.
The U.S. will not be implementing a border tax in a vacuum. America’s trading partners may not want to see their currencies fall 20% against the U.S. dollar, and their central banks may act to prevent such a large depreciation – especially emerging countries that also have to worry about inflation. Mexico’s central bank had to intervene in early January to halt the slide in the peso, lifting the currency off its record lows against the dollar. Despite the U.S. having an outsized trade deficit with China, the yuan has fallen only 1.5% against the dollar post-election, and this was probably an engineered depreciation by the Chinese central bank.
A country like China, which is trying to manage its own economic transition , may not be keen on seeing even more disruption to its export industry. This could result in retaliatory measures that may hurt several U.S. sectors, including the food and agriculture industry, which relies heavily on export markets like China.
So what happens if the dollar fails to adjust as much as the expected 20%. Let’s go back to our example with the three businesses. Only this time we assume that the foreign currency depreciates just 10% against the U.S. dollar.
As you may have expected, PaperCorp, which sells all its goods abroad, comes out far ahead if exchange rates do not move enough to balance out the border tax.
SweaterCorp, the importer, ends up making a loss. Either they lay off their employees and reduce costs and/or raise prices – by 10% if they want to maintain their original profit margin. If consumers resist buying their sweaters after the price hike, choosing instead to buy sweaters from a domestic company whose prices are lower (though higher than what they pay under the current tax regime), SweaterCorp may have to close their business.
As our example illustrates, a border tax can incentivize domestic manufacturing and exporters, effectively subsidizing them, if exchange rates fail to adjust completely. Consumers may also be looking at higher prices, not to mention significant churn and disruption in the domestic economy.
Retail companies, including Walmart, Target and Home Depot (amongst the nation’s largest importers), fear large tax increases under this plan. Members of the National Retail Federation have warned that the import tax could be as high as five times their profits – this is an industry with net margins lower than 5% .
We have only discussed what is an extremely stylized example, to walk through the mechanics of a border tax. In reality, trade is not quite as simple as this.
Different parts of the production process take place in different countries across intricate supply chains. As the economist J. W. Mason points out , most cross-border trade is not for end-consumption, but for inputs into the production process. For instance, the total share of consumption in U.S. imports from Mexico is less than 35%. The rest are industrial inputs (oil, auto parts, etc.) and investment goods (computers, vehicles, machinery, etc.). A tariff on Mexican goods will probably result in higher input costs for U.S. companies, including U.S. exporters, rather than only leading end-consumers to substitute Mexican-made goods for American ones. The complexity of global trade raises the possibility that a border tax may not ultimately improve the competitiveness of domestic manufacturers as much as normal analysis would predict.