Publications
Partners
Cape Town – The new US administration under President Donald Trump’s tax reform plan, which includes promoting domestic manufacturing by discouraging imports, could have broad implications for global trade, says Michael Hastenstab, chief investment officer at Templeton Macro.
It could however also spur growth and investment and result in better productivity.
In a company note, Hastenstab points out that there has been controversy around the US tax reform plan, favoured by the House GOP (Republican Party), which could also entail the introduction of an imported-targeted “border adjustment tax” (BAT).
“Eventually some form of a BAT could come with a different name tag such as a ‘reciprocal tax’,” he says.
A BAT would generate considerable revenues and would help pay for substantially lower statutory rates, paving the way for an ambitious tax reform.
“Clearly, given its impact on exports and imports, the BAT could also have potentially broad implications for trade. Assuming that trade tensions would be kept under control, the greatest impact would likely come from the improvement in the business environment, which should spur investment and result in faster productivity growth and accelerating economic activity,” Hastenstab notes.
How a BAT would work
In the new corporate income tax envisaged in the GOP reform blueprint, the border adjustment would work as follows:
- revenues from exports would be exempt from the taxable base for corporate tax;
- the cost of domestic inputs would be subtracted from the tax base, but the cost of imported inputs would not;
Overall, the reform would shift from a worldwide system to a territorial system, based on where consumption occurs rather than where production takes place. There could also be a shift from a system that allows interest deduction to one that largely ignores financial flows, and from a tax on income toward a tax on consumption, Hastenstab notes.
“Although border adjustment would be a new feature for the US tax system, most other countries already have it in the form of a value added tax (VAT) – a consumption tax that has a border adjustability component,” says Hastenstab.
In terms of its economic impact, the BAT would be equivalent to adopting a VAT while eliminating payroll taxes.
Why the BAT is controversial
Hastenstab says the BAT is controversial because for the following reasons:
- all tax reforms create winners and losers, but the border adjustment aspect raises the stakes for exporting and importing sectors.
- its economic implications are uncertain: The economic adjustment could potentially be disruptive to prices, profits, supply chains, trade flows and exchange rates. Templeton, however, points out that all other advanced economies already have survived the imposition of border-adjusted consumption taxes (VATs), and have adjusted.
- it raises questions about compliance with the World Trade Organisation’s (WTO) rules: The WTO currently allows border adjustment for indirect taxes but not for direct taxes. The border-adjusted corporate income tax would therefore seem to be in violation of WTO rules, which could trigger complaints and retaliatory measures.
However, the GOP proposal would be exactly equivalent to a VAT, which the WTO allows, plus the elimination of the payroll tax, a purely domestic tax decision that the WTO would have no jurisdiction over. WTO objections would therefore seem to have no defensible economic basis.
Impact on exchange rates and prices
“Economic theory tells us that a border-adjusted tax, such as a VAT, should have no long-term impact on trade flows,” Hastenstab says.
The trade balance by definition equals a country’s savings-investment balance. While a VAT, as a tax on consumption, would encourage savings, it would also encourage investment. The same argument applies to the BAT proposal, Hastenstab says.
READ: IMF head: Trump good for US economy - for now
“In theory, over the long term the net impact on the savings-investment balance will be neutral, and the exchange rate will appreciate so as to offset the extent to which the BAT would make imports less competitive (and exports more competitive).”
In the long run, the US dollar-exchange rate should appreciate to offset the competitiveness impact of the tax. In the short and medium term, however, the adjustment would likely be only partial. This partial exchange rate adjustment would result in an increase in the price of imported goods, with a temporary boost to inflation that Templeton estimates could be around one percentage point.
Impact on domestic sectors and trade flows
Following the immediate price response, domestic production and trade patterns will adjust as companies respond to the new tax and competitive environment.
Although the benefit from a lower corporate statutory rate would be broadly shared, the BAT would have a differential impact across industries and sectors, such as:
- profits of US importers would be squeezed, while some exporters and import-competing firms would benefit.
- foreign competitors would likely reduce pre-tax prices and accept somewhat lower profits in order to maintain their share in the US market.
- there would likely be some immediate disruption to supply chains (especially with multi-border crossings). US companies would try to substitute domestic for imported inputs where possible.
- the valuation impact on the dollar and foreign-denominated assets would hurt Americans with foreign assets or foreigners with dollar-denominated debt.
The actual impact on a company’ bottom line will depend on many factors and will vary greatly within sectors, says Hastenstsab.
READ: Trump considers breaking up large banks
In Templeton’s analysis, the relatively small product categories of apparel, leather and allied products and textile mills and textile product mills are the big losers.
“Additionally, motor vehicles and parts dealers as well as computer and electronic products — both much larger product categories — are among the notable losers in terms of the immediate impact of the reform.
“On the other hand, sectors such as other transportation equipment (including aircraft) and chemicals would benefit.
The longer-term macro impact
As a momentous change in the US tax system, the tax reform would have an important longer-term macro impact, Hastenstab says.
The overall fiscal reform has several positive attributes that would potentially improve the business environment, boosting productivity, competitiveness and growth, such as:
- lower taxes: An ambitious tax reform would see a significant reduction in the statutory corporate tax rate. Personal income taxes may also be cut.
- greater efficiency: A successful reform would simplify and improve the efficiency of the US tax system, which is often perceived as highly complex and wasteful.
- repatriation: A territorial system would diminish the incentives to keep profits overseas. A one-time low tax rate is likely to induce the return of untaxed accumulated profits held abroad, which could lift domestic activity. It has also been suggested that the tax liability on repatriated profits could potentially be offset by tax credits designed to serve as an incentive to investment in infrastructure projects.
Although the US economy already stands poised for a cyclical recovery in investment, a successful corporate tax reform would go a long way in promoting the incentives for real investment over the long term.
READ: US economy expands at slowest pace in three years
Since weak investment has been identified as a potential drag on productivity growth since the global financial crisis, this shift in incentives could have strong and long-lived benefits.
Increased competitiveness
Implementing a BAT should bolster the competitiveness of US firms, eliminate the existing incentive to keep profits offshore, and raise the revenue needed to fund a substantial cut in the statutory corporate income tax rate, which is currently the highest among Organisation for Economic Co-Operation and Development (OECD) countries.
In addition, it would be equivalent to adopting a VAT, which most US trading partners already have. It would therefore level the playing field.
“Trading partners, however, would likely appeal to the WTO and might launch retaliatory measure, though we believe the risk of all-out trade wars is limited,” Hastenstab says.
