Trump World: Border Tax, One More Time. Understanding the cash-flow border tax is a bit like peeling an onion. It has many layers, and just when you think you’ve finished exploring all the issues, another layer appears. Like peeling an onion, the complexity of it all is enough to warrant a tear or two.
In an effort to delve ever deeper into this hot topic, Jackie rang James Lucier, co-founder and managing director at Capital Alpha Partners, a non-partisan research shop that analyzes the policies coming out of Washington DC and their impact on financial markets. Jim leads Capital Alpha’s energy, environmental, and tax practices research. He has studied tax issues for more than 30 years. Jim’s interview is available in its entirety via podcast and transcript, and the Reader’s Digest version is below.
We’ll try not to make you cry.
(1) Change is needed. Sometimes, it’s important to take a step back before moving forward. So we started with a look at why corporate tax reform is necessary. The current statutory US corporate tax rate, at 35%, is the highest in the world, Jim explained. Most other countries have a tax rate closer to 20%. The US also has the “world’s leakiest tax system,” which means that cadres of lawyers have dreamt up ways to avoid taxes. Companies use intercorporate debt to shield their US earnings from taxation, patent portfolios are sent overseas, and intellectual property payments are used as a tool for earnings stripping. Finally, most other countries have territorial tax policies, like the value-added tax (VAT), whereby goods, including imports, are taxed when they are sold but exports are not taxed. It’s one of several factors that has encouraged companies to move manufacturing outside of the US. The political pressures to fix this convoluted system have been mounting, and certainly contributed to the election of Donald Trump.
(2) Will it happen? While President-elect Trump has proposed cutting the federal statutory tax rate to 15%, it’s House Leader Paul Ryan who has a detailed plan on how to achieve a 20% corporate tax rate on a revenue-neutral basis. His plan includes eliminating the deduction for the cost of goods sold for imported goods, eliminating the net interest expense deduction, and allowing the immediate deduction of capital expenditures. It also allows for the repatriation of earnings from foreign subsidiaries on a tax-free basis.
Jim believes there’s a 75% chance that we’ll see some form of corporate tax reform passed and a 40% chance that tax reform will include a border adjustment. Those odds have improved dramatically from a year ago, or even six months ago, when the plan would have been a nonstarter, he said. Before the election, a border-tax plan would have been considered too radical to gain passage. Economists would argue that a border tax wouldn’t incentivize companies to keep manufacturing in the US because any benefit to producing goods domestically might be offset by a rise in the dollar. And lastly, the border tax looks a lot like a VAT, a retail sales tax, which companies, like retailers, might pass on to consumers through higher prices. That normally would be deemed regressive and considered politically unpopular.
But then Trump arrived on the scene. “Donald Trump is really the counterintuitive candidate, in his emphasis on making America great again, rebuilding American manufacturing, focusing first on domestic US employment,” explained Jim. “The fact that he’s tapped into such a vein of support, in particular from blue-collar voters in the US, suggests that maybe this idea of a border-adjustable tax could be sold as [a way to support] US domestic employment and US domestic manufacturing industries. If so, then Trump is probably the only salesperson who could make it happen.”
Trump has a good partner in Paul Ryan, who has spent a lot of time working with individual congressmen in small groups to sell his vision. “When [Ryan] was chairman of the budget committee, he came up with these budgets that were very radical by historical standards. But he got Republicans to support them by virtually planning ahead a year in time and meeting with members of the Republican conference in groups of twos and threes, and literally selling it, personally … He’s done basically the same thing with the tax reform exercise. They have spent a lot of time meeting with members, building consensus, selling the individual Republican members on the House side. I think he’s got a strong team there.”
The nation’s fiscal health may provide the urgency needed to get tax reform passed. “On Capitol Hill there’s a real sense of nervousness about the coming demographic tidal wave, as Americans get older and sicker as they move into their retirement years, to put a positive spin on it. The debt and deficit and fiscal situation in the United States is obviously going to become much more challenging over time. We’ve already moved to a government debt-to-GDP ratio that’s north of 70%, and we’ll be at 100% before too long ... With this situation coming at us, like the proverbial train coming down the tracks, to use another metaphor, I think members of Congress realize that this may be the last best chance to do some significant structural tax reform in the US on a reasonably revenue-neutral basis while we still have, as a nation, the balance-sheet flexibility to do it.”
And don’t underestimate the pressure put on Congress by the market’s recent rally. “The markets are really, really betting very heavily that tax reform succeeds. That means that Paul Ryan and Donald Trump and the other members of Congress, including New York Senator Chuck Schumer, who is the Democratic leader in the Senate, all of these guys are under a lot of pressure to deliver right now because the markets have already baked in, I think, a favorable result,” concluded Jim.
(3) How to pay for it. Certainly, not everyone will be happy, but Jim’s betting that a tax cut to 20% will be just what it takes to get companies to compromise. Companies know that the reduction in the tax rate can only occur if the leadership can find offsetting ways to massively increase revenue. The Tax Foundation estimates that taxing imported goods and services raises north of $1 trillion dollars in revenue. “You need big revenue-raisers … to make revenue-neutral tax reform even remotely possible,” Jim explained.
(4) Importers worried. As we’ve discussed before, retailers won’t like the inability to deduct the cost of their imported goods sold from revenue. “You have to think about the retail industry as a low-margin business that’s very competitive and has a limited ability to pass price increases onto the consumer. They are quite nervous about having a tax in effect placed on their cost of goods sold,” said Jim.
Refiners won’t like the inability to deduct the cost of their imported oil. The US imports about 7 million barrels of crude oil a day, making it the country’s third-largest net import. The first two are transportation and computers & technology. If the tax change goes through, refiners could pass the tax on to consumers, which would mean higher prices at the pump. But they might not have to raise prices if much of the tax increase is offset by a stronger dollar.
He explained: “One of the things economists have studied for a long time is the effect of floating exchange rates, to adjust to varying price levels in different countries. If you do a border adjustment the way that we’re proposing here, where you effectively put 20% tax on imports, but also apply an equal and opposite 20% tax credit on exports, economic theory would suggest that the dollar also strengthens by about 20%. In static terms, retailers or refiners would have a lot to worry about, [but] I think that exchange-rate effects will probably mitigate quite a few of these tax increases.” The dollar has already strengthened by 5.4% since the election. Perhaps some of that gain anticipates the tax change or expects stronger economic growth from a more efficient tax system.
(5) Tax dodgers on alert. Multinational companies that have used the discrepancies in the international tax system to lower their tax rates face big changes as well. Some companies in the tech and pharma industries have been parking their intellectual property in foreign countries with low tax rates. Under the Ryan proposal, sales these companies make in the US would be taxed, but their foreign sales would go untaxed by the US.
“I think that the [proposed tax changes] would end many tax-avoidance strategies used by sophisticated multinationals, including those with a lot of intellectual property. On the other hand … they could adapt to [the changes] well,” said Jim. “They would, number one, not have this issue with unrepatriated foreign earnings because what they make from their patent portfolios in a foreign country would be excluded from the US tax system. On the other hand, if they tried to bring stuff back into the US from overseas, they would be paying taxes on it, so they do have that incentive to locate their production, their R&D, other opportunities in the US, to basically serve the US market that way. They would have a much more rational tax system, at the end of the day.”
The Ryan proposal, with a 20% corporate tax rate, should also reduce the incentive for companies to move their headquarters overseas in search of a lower tax rate. Likewise, it may reduce the number of foreign company acquisitions of US companies. Right now, foreign companies have an advantage when making acquisitions of US companies because they can pay more than a US acquirer since they pay lower taxes.
(6) Good-bye, leverage. Industries that depend on debt financing--like power utilities, commercial real estate developers, and private equity shops--won’t be happy about the elimination of the deduction of net interest expense proposed in the Ryan plan. However, the pinch from this proposal may also fade as the debt markets adjust, just as the currency markets are expected to adjust. “The economic argument is that over time, once you do tax reform, interest rates will also rebalance. They will reflect the new supply and demand conditions for credit.” The elimination of a tax subsidy could reduce the amount of debt sold, and that could drive down interest rates.
(7) International backlash? One of the biggest questions around the Ryan proposal is whether the World Trade Organization (WTO) will oppose the changes. The WTO’s rules were written with the European tax model in mind. It permits countries to collect sales tax on goods that are sold in their own countries but not on exports. The idea was to eliminate multiple layers of tax that would accrue on an item that was manufactured in multiple countries before resulting in a finished good.
“The destination-based, cash-flow tax [in the Ryan plan is] clearly, absolutely not consistent with WTO rules as they’re written … [However,] structurally, it’s close enough,” concluded Jim. “The definition of the tax base is close enough to a VAT that this should really be considered the equivalent. Ultimately, the issue of whether or not the WTO is going to reject this or not is something of a red herring. The US does have a good, substantial case on the merits, that yes, this is economically the equivalent to the VAT. It should qualify. Frankly, times change. You wrote that definition of border-adjustable taxes, which qualify under WTO rules, 30 years ago.” In addition, there’s the growing attitude that America needs to do what’s best for America, and, if countries do object, it will be many years before the WTO case is resolved.
If all else fails, the US could consider going to a VAT system. However, the Ryan plan would be easier to administer than a VAT tax, and it looks similar to a traditional corporate-income-tax system. Also, there historically has been opposition to a VAT because it’s a straight-forward sales tax. Liberals don’t like it because it weighs heavily on low-income tax payers, and Republicans don’t like it because it’s a “hidden” tax that tends to get increased over time. “Once Democrats realize it’s a money machine, and Republicans realize it’s regressive, then maybe we’ll get it,” said Jim.
A cash-flow tax would avoid the VAT tax problems and be much simpler to implement. We’ll keep in touch with Jim to see whether the folks in Washington DC can pull it off.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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