US Watch – US border tax adjustment: a failed attempt?

by: Maritza Cabezas

  • A border tax adjustment (BTA) is part of the House of Representative’s tax reform plan
  • This proposal would be an import source of revenue to offset the impact of proposed tax cuts
  • We have included corporate tax cuts, but a BTA is not part of our base case
  • A BTA would represent an upside for the USD and a risk to inflation in the near term
  • President Trump proposes to cut the corporate tax rate to 15%, but considers a BTA as ‘a bad deal’
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170206-US1Reasons for implementing a border tax adjustment

The border tax adjustment (BTA) was included in the tax plan of the House of Representatives (GOP plan) “A Better Way”, which was presented in September 2016. The proposal would tax imports at the corporate tax rate and exempt income earned from exports. The GOP proposal focuses mainly on addressing weaknesses in the US tax code, which taxes firms on their global income at a much higher rate than other countries do (please see box). On top of this, the GOP BTA proposal would raise USD 1.2 trillion over the next ten years. This would pay part of the decline in revenues resulting from the reduction in the corporate tax rate, which would fall from 35% to 20% in the proposal.

President Trump not a strong supporter of a border tax

Although President Donald Trump mentioned the implementation of a border tax during his campaign, his tax proposal did not include any details on how this would be implemented nor any estimates. He did, however, discuss imposing a border tax (35%) on companies that move jobs overseas. He added that no tax would be imposed on companies that stayed put. More recently, President Trump has assumed a more sceptical tone with regard to the border tax, calling the BTA “too complicated” and saying that it could be a “bad deal”. This would suggest that the likelihood of this proposal being implemented is slim. However, we do not discard the possibility completely since additional revenues will have to be raised to make the tax proposal revenue-neutral as has been announced.

A tax and not a tariff?

Under a border tax, goods produced using imported inputs would be subject to a tax and exports would be exempted. Although it looks and sounds like a tariff, according to the GOP proposal, it is a move toward a cash-flow tax approach for business, which reflects a consumption based tax. This difference makes it compliant to international trade rules (WTO) and international trade agreements. Indeed, the WTO does not permit border adjustment taxes on exports with respect to income; it only allows taxes with respect to consumption. This is why most countries opt for value added tax (VAT). It is likely that this proposal will lead to a long discussion with the WTO.

Economic impact

The uncertainty surrounding the impact of the estimates is large given the unorthodox nature of this policy. From a trade perspective, economic theory suggests that this type of tax will improve the US trade balance and strengthen the US dollar. At the same time, it would worsen the trade balance of its trading partners. The lower the appreciation of the US dollar resulting from this tax policy, the more unfavourable for US consumers given the higher import prices. Indeed, import prices would rise as a result of the border tax, and this would lead to higher inflation. However, it is uncertain how firms and consumers would adjust. In theory, the demand for import products that are relatively elastic will likely drop, while that of inelastic products could remain resilient. Where Mexico and China are concerned, we have looked at the detail of products; computers, electronics and transportation account for a large share of the trade flows. At a first glance, these imports could be easily substituted with “made in America” products. However, these products are likely to have American inputs, which makes matters more complicated.

In addition, the increase in import prices will also depend on the willingness of firms to absorb some of the additional costs with lower profits. Moreover, in time, some firms would likely re-shore their production given the lower corporate tax. However, some products are simply not produced in the US, including some agricultural and soft commodities, while others require complex production processes that cannot be easily substituted, for instance in the case of oil refineries. These firms would be punished and so would consumers because they would be forced to pay higher prices. All in all, the impact of the BTA on the US trade balance is positive, but the scale of this impact remains uncertain and depends on the degree of appreciation of the US dollar.

Direction of US dollar not only up

In time, the stronger dollar resulting from a higher demand for US exports and lower demand for imports will eventually offset the trade dynamics resulting from a border tax. The appreciation of the dollar would make imports cheaper and exports more expensive. The magnitude of the US dollar appreciation in this adjustment process will depend on several factors, including the level of the tax on imports and the demand reaction for these imports. However, the US dollar not only responds to trade movements. It is the most liquid currency in the financial markets and the value of the US dollar greatly depends on investor behaviour towards the US dollar. In the current environment, the US dollar is supported by cyclical factors such as expectations about US economic growth, Fed rate hike expectations and expectations about nominal and real yields. So if expectations about US economic growth and Fed rate hikes increase, the US dollar rises in an environment of positive investor sentiment. If investor sentiment were to deteriorate somewhat this will weigh on the US dollar in an initial stage. A sharp deterioration in investor sentiment could result, however, in a higher US dollar because it is also a safe haven currency (like the Japanese yen). So the question is whether investors want to be invested in US Inc and if President Trump’s policies and actions result in a deterioration in sentiment. If the dollar rises too sharply, it is likely that the Fed will hike interest rates at a slower pace and this would limit the upside of the US dollar again.

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Our view

There are costs and benefits of adopting a BTA. Switching from worldwide to destination taxation means that the US government will not have to collect taxes on US firm foreign operations and this would remove the incentive to move their headquarters abroad where taxes are lower. Moreover, taxes would be more accurately measured in a territorial based system. On top of this, BTA plan means raising revenues enough to partly fund the tax cuts to 20%. This would bring the GOP closer to the intention of implementing a revenue neutral tax policy.

However, we think the impact of this measure is uncertain and will depend on the exchange rate adjustment. This means that the stronger the US dollar, the less it would represent a subsidy for exports and an incentive for imports and the less distortions this tax would have on the economy. For instance, if the process of the US dollar adjustment is slow, then a border tax would come at a loss to US consumers and have a likely offsetting impact on GDP growth and result in higher inflation. Retailers in the US that import products would also be hurt.

President Trump has already said that the BTA is too “complicated”. Moreover, his tax proposal incorporates a lower corporate tax, which would have a similar effect (a 35% to 15% tax cut), since US corporates would face a more competitive tax in the US. However, President Trump’s favours a case-by-case approach to border taxes such as a warning that 35% tax will be imposed on US firms that move jobs abroad. As a result, a border tax adjustment is not part of our base scenario. However, the corporate tax cut to 20% is part of our scenario. In our view, a BTA could lead to trade wars and have unintended consequences if not sufficiently clear, so the Republicans may have to review their proposal. In this sense, President Trump is right to think that this could be a “bad deal”. Given that this proposal is part of a large overhaul of the tax system, it will require some negotiation even within the Republican Party. The entire tax overhaul may take longer to approve than just this year.

*  Source: A Better Way, Tax Policy Centre, press quotes President Trump, ABN AMRO