Weekly commentary from Wells Fargo Investment Institute on international topics in the news.
Peter Donisanu, Global Research Analyst
Global Implications of a U.S. Border-Adjustment Tax
- Last year, members of Congress proposed a border-adjustment tax (BAT) as part of a comprehensive tax-reform plan.
- If implemented, a BAT would not only increase the cost of imported goods; it would bring into question the current world order of international trade.
What it may mean for investors
- If the U.S. dollar appreciates as a result of the BAT, we would expect the impact to weigh on emerging-market bonds, commodity prices and potentially the value of U.S. assets held overseas.
U.S. House of Representatives Speaker Paul Ryan and House Ways and Means Committee Chairman Kevin Brady in a policy paper published in June 2016 proposed a border-adjustment tax as part of their broader U.S. tax-policy reform.1 While President Trump has not officially endorsed the policy proposed by these members of Congress, the president has recently indicated support for a broad border tax. If implemented, a BAT would lead to a significant revision of U.S. corporate-tax law that could have significant near- and long-term implications for global trade and financial markets.
As part of a broader initiative, implementation of the proposed border-adjustment tax in the U.S. would change the jurisdiction of taxation for U.S. companies. Currently, U.S. firms are taxed by the federal government based on income generated all around the world. Tax reforms proposed by Paul Ryan and Kevin Brady would focus corporate taxation only on income that is generated in the United States. This is where the BAT comes in. There are three key features that define this portion of the proposed reform.
First, for tax purposes, U.S. companies would no longer be able to deduct expenses related to the cost of goods and services sold (COGS) sourced from foreign suppliers. Second, domestic firms would be able to claim a tax rebate on goods and services exported from the United States. Third, the proposed tax reform would reduce the statutory federal corporate tax rate to 20 percent from the current rate of 35 percent.
Section two of Table 1 provides a simple illustration of how a border-adjustment tax could work in practice. In Section 2-B of the table, an importer who sources all of its inputs from a foreign supplier would not be able to deduct the $75 COGS for tax purposes, raising their taxable income. On the other hand, as illustrated in section 2-C, an exporter would receive a $75 tax rebate from the federal government, assuming all inputs are exported. Section 2-A of Table 1 illustrates a higher after-tax profit as a result of a lower corporate tax rate (relative to section 1-A) for a U.S. company that does not engage in importing or exporting.
Proponents of the BAT have argued that lower U.S.-firm demand for imports (as a result of a 20-percent tax) could lead to a 25-percent increase in the value of the U.S. dollar as fewer dollars leave the country to pay for imports. As a result, a stronger dollar would make the price of goods heading into the U.S. cheaper, potentially offsetting the 20-percent effective corporate tax on imports. This is illustrated in Table 1, section 3-B as the COGS decreases for an importer and in section 3-C, where revenue falls for an exporter.
Another argument in favor of the BAT is that the new tax policy could help close the U.S. trade deficit as the amount of goods that U.S. firms import from abroad falls as prices rise. In other words, demand for imports may decline if a stronger dollar fails to offset higher prices for U.S. consumers as a result of the tax on imports. At the same time, U.S. export volumes could potentially increase as domestic firms are incentivized by favorable changes to the tax code to sell more goods and services abroad.
Over the long term, this new tax policy also could benefit the U.S. economy by incentivizing firms to maintain their headquarters in the U.S. versus the trend of merging with foreign companies located in favorable foreign-tax domiciles (inversions). Such an approach would encourage firms to bring income earned abroad back home (given a lower tax base) and to invest it in the United States. Nevertheless, the implementation of a BAT in its current form is expected to have negative near- and long-term implications for international trade, potentially setting the stage for a host of trade disputes.
We expect the BAT to have a negative effect on earnings of foreign companies if the policy leads to lower U.S. consumer demand for imports. In 2015, the U.S. imported $1.3 trillion worth of goods and services from its five largest trading partners: China, Canada, Mexico, Japan and Germany. As a result, we believe that leaders from these countries are highly unlikely to stand by and allow U.S. policies that affect international trade to go unchallenged. One venue to voice this dispute is through the World Trade Organization (WTO), in which the U.S. is a member.
In its current form, the border-adjustment tax proposed by Ryan and Brady is likely to run afoul of WTO regulations. Current WTO rules prohibit a member government from issuing export-related tax rebates to companies, linked to income (the WTO does allow tax rebates on specific export products). On this basis, we expect a challenge against the BAT at the WTO. That said, we would expect the seeds of a host of international-trade disputes with the U.S. to be planted if the WTO challenge is rebuffed by the U.S. government and Congress passes into law the proposed tax reforms in an unaltered form.
A border adjustment tax is likely to lead to an equal share of winners and losers. The likely impact on growth for the U.S. economy is hard to predict with certainty if the BAT is implemented as Representatives Ryan and Brady had outlined in their June 2016 proposal. However, over the long term, if the dollar does not appreciate by the full 25 percent, the proposed policy would put international exporters at a disadvantage, leaving the U.S. open to retaliation from its trading partners. We believe that the chances of a trade war are low, and we expect the proposed BAT to face several revisions prior to implementation, given the international backlash to the proposal this week. Nevertheless, if the proposal is implemented in its current form, we anticipate economic gains for the U.S. to be offset by international losses as trading partners impose their own protectionist trade policies against the United States.
From an investment perspective, a narrowing of the U.S. trade deficit could cause the Federal Reserve to raise interest rates at a faster-than-expected pace if inflationary pressures rise, further supporting a strong U.S. dollar. This could result in financial challenges for issuers of U.S.-dollar-denominated debt as the cost of servicing this debt increases with the value of the dollar, renewing market concerns about fragile credit conditions in emerging-market economies.
We also would expect commodity prices in U.S. dollars to fall in value as a result of a strengthening dollar. As the U.S. dollar strengthens, it takes fewer greenbacks to buy gold and crude oil in international markets. Finally, a stronger dollar would reduce the value of foreign investments in the near term. As a result, foreign investments denominated in foreign currencies that are not hedged would fall in value for a U.S. investor.
1 Policy Paper: A Better Way–Our Vision for a Confident America; Paul Ryan, Kevin Brady, June 2016.
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