Our first post in this series discussed lowering corporate taxes given the current political will to reduce the relatively high US corporate income tax rate and encourage companies to repatriate overseas profits. However, lower taxes mean less revenue for the government and deficit hawks in congress are concerned about growing debt levels. The House GOP leadership is proposing a solution to offset the cost by transforming the current tax system into a destination-based taxation with border adjustment (DBTBA) or border adjustment tax (BAT) for short. This proposal would change the US corporate tax system by basing taxes more on consumption and less on income. It would be similar to the majority of OECD countries that currently use a consumption based value-added tax (VAT) structure.
When a US based company exports to a country with a VAT system the company pays the US corporate tax rate and a VAT rate. One of the goals of the proposed BAT system is to level the playing field for international trade. However, it could have far reaching ramifications for the global economy and financial markets; think stronger dollar, higher inflation, a boost to net exporters (like aircraft manufacturers) and a drag on net importers (like apparel or computers). Additionally, some details of the proposal raise the question of compliance with World Trade Organization (WTO) rules.
A BAT would essentially subsidize exports and tax imports. Companies would no longer pay taxes on total income net of total costs. Instead a BAT would tax only income earned domestically and allow companies to deduct only domestically sourced costs. The table from Goldman Sachs illustrates how BAT
would be applied to foreign and domestic sales.
But, there is a problem here. Under this plan, domestic goods would be cheaper than imports and US companies would earn more from exporting than from selling domestically. So, the key to this tax overhaul is the dollar. In theory, the dollar would appreciate enough to fully offset the increase in import prices caused by the tax, while raising the cost of exports to foreign buyers offsetting the tax subsidy. The dollar would need to appreciate approximately 25% to fully offset the impact of a 20% BAT. Some importers are worried the dollar may not appreciate enough leaving them with no choice but to pass on the cost to consumers in the form of higher prices. This concern is valid as many factors influence the value of the dollar, not just trade flows! The Bank Credit Analyst notes that less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade of goods and services.
Is a BAT system “protectionist”?
Although the BAT proposal is similar in some ways to existing VAT systems abroad, US trading partners and the WTO would probably view the current proposal as protectionist. The primary reason is that the current blue print plan still allows U.S. companies to deduct wages while countries that operate under a VAT cannot. As US wages account for more than 68% of company expenses, the ability to deduct them would arguably amount to an unfair advantage to domestic firms.
Is the market pricing in a BAT?
APCM Investment Analyst, Kirsten Halpin, notes that the markets are forward looking and recent returns can be evaluated to gather information about expectations from market participants. She conducted a simple analysis by creating two baskets of stocks, one basket of companies that derive their earnings from exports and another that derive their earnings from imports. The group of exporters were primarily manufacturing companies such as Boeing and General Electric while the group of importers were retail focused companies such as Walmart and Nike. From the election through the end of last quarter, the group of exporters returned 17.8% while the group of importers returned 8.4% and the S&P 500 returned 11.3%. While there are numerous factors that affect the movement of stock prices, the market certainly seems to be pricing in a tailwind for exporters and a headwind for importers, possibly due to a BAT.
A border adjustment tax would have many implications for the markets. If the idea receives further traction volatility would pick up due to implementation risks and potential trade disputes. There would also be upward pressure on the dollar and it would take some time for the dollar to adjust. If prices don’t adjust quickly, the U.S. trade deficit would decline in the short run. If the dollar does not appreciate enough to offset the import tax and export subsidy, companies could pass on the cost in the form of higher prices forcing the Fed to raise rates faster than anticipated. A rising dollar also weakens emerging market economies who have issued dollar-denominated debts such as Turkey, Malaysia and Chile. In its current form, the biggest risk of a BAT would be an increase in trade tensions between the US and the rest of the world that ignites a trade war. This is not priced into the market today.
Despite its shortcomings, a BAT would discourage companies from shifting profits around for tax reasons. And, in the short-term it would boost tax revenues to help offset the cost of lower tax rates. It would also push the US tax system towards a greater reliance on revenue generated through consumption and less on income. However, many hurdles remain for a border adjustment tax to become law and there are also alternatives. Policy makers could accept an increase to the deficit, the current BAT proposal could be altered, or a VAT system could be used. Tax policy will remain an important item to watch as these policies are developed in the coming months.
Brandy Niclai, CFA®
Chief Investment Officer