US equity markets have rallied strongly since the election of Donald Trump as the 45th president of the United States, with investors largely choosing to focus on the prospective positive aspects of his administration and the scope for large corporate tax cuts, as well as a reduction in regulation. However, as we have detailed in previous articles, given Trump’s apparent protectionist instincts and anti-immigration views, there are also potential negative aspects associated with his presidency- which, broadly speaking, financial markets have chosen to ignore.
In particular, a “border adjustment tax” currently being proposed by the Republican-controlled congress appears to be gaining considerable support across the political spectrum, and may ultimately be enacted as part of the broader tax reforms which have been proposed (a reduction in the corporate tax rate). The proposed border adjustment tax will have a significant short and medium-term impact on a large number of US companies and more than likely, the overall economy.
Very simply, the new policy proposes exempting export revenues from income tax, while disallowing a tax deduction for imported goods sold in the US. Even if the corporate tax rate is reduced to 20% from 35% as has been proposed, a border tax along the lines described will have a very significant short term impact on the US corporate sector. For large importers (such as retailers like Walmart), the tax proposal could lead to a drastic reduction in earnings, as shown below.
In the example above, where a retailer imports 100% of what it sells and its cost of sales account for 60% of sales, the decline in earnings would amount to 70%. Conversely, the impact on exporters would be very positive leading to large increase in after-tax income.
Apart from the impact on individual companies, the key question we need to ask is what impact will such a border tax have on the overall economy? On the surface, many proponents of the tax suggest that imports would decline while exports would increase, helping to eliminate the US trade deficit (which would not be positive for the US and global economy in any event, given the US Dollar’s status as the world’s reserve currency).
However, the reality is likely to be different. Rapid import substitution cannot happen overnight. You won’t suddenly find investors building a large number of clothing and textile factories, as an example. It would take time and an enormous amount of money (not to mention additional labour in an economy essentially at full employment) to build a sufficient domestic manufacturing base to support the vast amount of imported goods sold by retailers such as Walmart across the US.
Furthermore, given the very large wage differentials (see chart below) that exist between the US and key exporters to the US such as China and Mexico, it is doubtful that a border tax would be sufficient to make US labour more competitive on its own.
The most likely outcome will be for import-dependent companies in the US to raise their selling prices. The prospect of accelerating inflation and some reduced demand for imports is also likely lead to a renewed appreciation in the US Dollar, particularly if the imposition of a border tax and associated increase in domestic inflation causes the Federal Reserve to become more aggressive in raising rates. In fact, it is likely that the ultimate impact of the proposed border tax will be to lead to a combination of higher prices, higher interest rates and a stronger US Dollar.
Such a dynamic in the context of an economy where wage growth is already starting to accelerate could be highly inflationary over a 1 to 2 year cycle following the imposition of the border tax. A tightening of immigration laws and policies that discourage cheaper labour from coming to the US will also be inflationary. Already, the US construction industry is grappling with a shortage of workers (pushing up building and housing costs) that have placed the profit margins of several listed homebuilders under pressure. It is unlikely that even after the recent upward move in the US interest rate curve that markets are fully pricing in such a scenario.
How large or significant would the impact on inflation and the US Dollar be? Well, one way we can gauge the potential impact is to assume that in order for the system to return to equilibrium, a retailer’s after-tax profit would have to return to their prior after-tax levels, before the imposition of the border tax. However, it is impossible to predict how much of the adjustment would occur via further US Dollar appreciation as opposed to retailers increasing their selling prices (i.e. inflation).
Very simply, if we assume that the currency (given that is freely traded in a deep and liquid market) would adjust by a larger magnitude than the change in selling prices (inflation), one combination that would restore retailers after-tax profits to the same levels prior to the imposition of the border tax is to assume a 10% increase in the US Dollar, and a 5% increase in selling prices of an inflation rate of 5%.
What are the longer-term implications of the proposed tax? We believe that there will be very little net impact on the economy over the long-run once the “once-off” adjustments in inflation and the US Dollar pass through the economy. There is, nevertheless, a risk that the Federal Reserve will need to be more aggressive in terms of raising rates in order to contain inflationary expectations, which may become somewhat “unanchored”, even if the increase in inflation would be seen as cyclical. This risk could be amplified if labour shortages lead to even faster wage growth, as a result of tougher anti-immigration laws.
There may be a marginally positive impact on some export-orientated industries and a modest increase in exports. However, as we have detailed, the very large differentials in wages between the US, China and Mexico and given that the US Dollar may absorb a large portion of the “adjustment” to the border tax, a 5% rise in imported prices will certainly not be sufficient to make US labour competitive with labour in China and Mexico, or at least in terms of the products that are currently being produced and imported from those countries.
Furthermore, the tax may actually distort domestic pricing for raw materials or intermediate raw material in the US. Very simply, a company producing a product that is easily exportable (such as say steel) would seek to export its product rather than sell to a local manufacturer (say a vehicle manufacturer like Ford). As such, the domestic manufacturer would have to pay a premium in order to obtain the steel, with the premium likely being equal to the tax benefit the primary producer of the steel would have derived from exporting the steel. The introduction of this tax will thus, likely push up domestic prices for primary and intermediate commodities or materials across the supply chain. This will further diminish any benefit that local exporters may obtain from the introduction of the border adjustment tax.
Unfortunately in four years’ time, Donald Trump will be faced with having significantly disappointed some of the new voters he won over in the US Rust Belt or Industrial Mid-west. His only victory may be the “symbolic” gestures that some of the larger US corporates may engage in, such as relocating or opening a small but largely irrelevant (in terms of total production) plant or factory to the US Mid-west.
The key question then is can Trump get even more aggressive in terms of his protectionist policy, apart from implementing or supporting the proposed border adjustment tax? Yes, he can, but it will be challenging given the checks and balances within the US system of government. Trump likely has the power to withdraw unilaterally from the North American Free Trade Agreement (NAFTA), since the existing treaty allows a member country to do that (with a 6 month notice period).
However, a withdrawal from NAFTA would only result in an additional 5% tariff on say, imported Mexican goods (the WTO default apparently). This is still unlikely to be of a sufficient magnitude to have any real long-term impact on the structure of the US economy. In fact, given the recent depreciation in the Mexican Peso, Mexican goods are still probably cheaper at present compared to two years ago, even with a border tax and 5% tariff.
Current legislation does allow a US president to implement additional temporary tariffs on countries that violate existing trade treaties, environmental standards or are branded a currency manipulator. However, if these tariffs are imposed without any real grounds for such a policy move, it will be challenged at the WTO. It could also probably be challenged by a US corporate at the US Supreme court.
In the final analysis, any new trade treaty as well as any federal spending needs to be approved by Congress. Trump will not get the funds to build his wall without approval from Congress and will not be able to enter into any new bilateral trade deals (the administration’s apparent preferred manner of engaging in trade policy). Many Republican congressmen would likely strongly oppose more radical protectionist policy such as withdrawing from the WTO.