In late December, we explained why of all Trump economic proposals , the "border tax adjustment", while most controversial, could have the biggest impact on US assets.
As a quick refresher, the proposal would tax US imports at the corporate income tax rate, while exempting income earned from exports from any taxation. The reform would closely mirror tax border adjustments in economies with consumption-based VAT tax systems. If enacted, Deutsche Bank predicted that the plan would be especially bullish for the US dollar, sending it higher by as much as 15%. What’s more, it would have a transformational impact on the US trade relationship with the rest of the world. Consider the below:
- A “border tax adjustment” would, roughly speaking, be equivalent to a 15% one-off devaluation of the dollar. Imports would be 20% more expensive, because corporates would have to pay the new 20% corporate tax rate on their value. Exports would be roughly 12% “cheaper”, because for every $33 of earnings earned from $100 of exports (we use the 33% gross margin of the S&P), there would be a 12% tax cost ($33 earnings*35% current tax rate) that would no longer be imposed on corporates. Taking the average impact on the prices of exports and imports is equivalent to a 15% drop in the dollar.
- A border tax adjustment would be very inflationary. The price of exports doesn’t affect the US consumption basket so would have no impact on CPI. However, the cost of imports would go up by 20%, which based on a simple relationship between import PPI and US inflation would be equivalent to a 5% rise in the CPI. Corporates may of course choose to absorb part of the rise in import costs in their profit margins. But either way, the order of magnitude is large.
- A border tax adjustment would be very positive for the US trade balance. Similarly to the dollar calculations, a border tax adjustment would be equivalent to an across the board import tariff of 20% and an export subsidy of 12%. Keeping all else constant and applying standard trade elasticity impact parameters to an average of the two estimates results in a more than 2% drop in the trade deficit equivalent to more than 400bn USD, or equivalently, an almost complete closing of the US trade deficit.
In other words, should the "border tax proposal" pass, it would not only send inflation soaring, while eliminating the US trade deficit - a long-time pet peeve of Trump - it would also be the trade-equivalent of a 15% USD devaluation, even as it leads to an offsetting surge in the actual value of the dollar.
To be sure, the "should it pass" part is a significant wildcard. As Goldman wrote in a note yesterday, explaining "what policy changes is the equity market expecting", Goldman said that "on the tax side, the equity market appears to expect corporate tax cuts, but the evidence that a switch to a border-adjusted tax is even partially priced is only mixed."
A reason for that within the GOP ranks, a fight has emerged - funded by powerful Koch interests - against the border tax proposal, as it would cripple non-export driven businesses such as importers, apparel makers, big retailers, and various core Koch businesses as described recently by the FT.
So while the passage of the controversial Border Tax Adjustment is far from assured, overnight Credit Suisse released an analysis which analyzed the various winner and losers from the array of proposed Trump Tax Reforms, among which companies impacted by the Border Adjustment.
While the Swiss bank hedges early, noting that it is still "too early to determine winners/losers as new information is surfacing daily…and the legislative process needs to run its course this year" and that "reforms (complexity) could impact the effective tax rate, cash taxes, and/or possibly COGS (border adjustments)", it nonetheless does quantify who the various winners and losers from the BTA would be, which it frams as follows:
Here is Credit Suisse' answer:
- Companies with a majority of their input costs contained within the U.S.
- Potentially lower tax rate of 20% on sales and full deduction for input costs, potential examples: Health Care Service Providers, U.S. Cable/Telecom, Oil Refiners that source from the U.S., U.S. based manufacturer.
- U.S. Exporters: as export revenues are not subject to U.S. tax.
- Products, services, and intangibles imported into the U.S. will be subject to the border adjustment.
- Bottom up exercise to determine global supply chain (Automakers, Oil and Gas, to Retailers can be impacted).
- U.S. Multinationals that have relied on aggressive tax planning to shift earning overseas.
- Financial Statement effects: Unknown at this point but could result in a higher effective tax rate or COGS, lowering net income in particular for US companies that are net importers.
CS then looks at which specific companies could find border adjustments a potential positive, among which:
3M (MMM) Analyst Meeting – 2017 Outlook: There's three points on the border adjustment portion.
- One is, yes, we are a net exporter, so that clearly plays to our favor …
- Second is commodities …There is not a materially amount of commodities that we are bringing over the border into the U.S. Much of how we manufacture is about often wanting to have our commodity source locally.
- Third point is our own strategy around intellectual property. 3M's intellectual property is owned in the United States, and then under the current discussions around border adjustment that also would be a benefit for 3M. But as you started out saying, it's early.
General Electric (GE) Investor Meeting – December, 2017: We're a big exporter and not a big importer.
- Tax reform…based on everything that the new Secretary of Treasury said, the President-elect has said, leader – Speaker Ryan has said, I can never dictate the puts and takes, but I think there is – if you're a net exporter, manufacturer, stuff like that, I think there's opportunities…It is a huge incentive and it is a – it's accretive to the company.
And then, a potential negative:
- Michael Kors (KORS) 10K: In fiscal 2016, by dollar volume, approximately 97.2% of our products were produced in Asia and Europe….We primarily use foreign manufacturing contractors and independent third-party agents to source our finished goods.
- Nike (NKE) 10K: Virtually all of our footwear is manufactured outside of the United States by independent contract manufacturers who often operate multiple factories. In fiscal 2016, contract factories in Vietnam, China and Indonesia manufactured approximately 44%, 29% and 21% of total NIKE Brand footwear, respectively.
- Target (TGT) 10K: In addition, a large portion of our merchandise is sourced, directly or indirectly, from outside the United States, with China as our single largest source.
- Emerson (EMR): We manage businesses with manufacturing facilities worldwide, a majority of which are located outside the United States, and also source certain materials internationally.
The bank next points out that companies already “manufacturing” (at least partially) in the U.S. could be in a better position under tax reforms:
A factor here would be the domestic manufacturing deduction (DMD):
- Although subject to complex rules, the DMD provides a tax break for certain U.S. based manufacturing and production activities.
- Those activities can range from basic manufacturing to the production of software and can include products that are partially “manufactured” outside the U.S..
- Note that this benefit could go away under new U.S. tax reforms. Nevertheless it provides an indicator that companies have some U.S. based manufacturing and could be in a better position to avoid border adjustments.
On the other hand, companies with high levels of foreign earnings and very low foreign tax rates, are at increased risk:
- Having international exposure is not a risk under pending reforms and could actually be a benefit (no U.S. tax on exports, territorial system).
- However, the location (i.e. low tax country) of multinational profits will be under continued pressure by the OECD, EU, and U.S. tax Reforms.
- Companies with high levels of foreign based earnings relative to foreign sales and unusually low foreign tax rates could be at risk to global tax reforms (U.S. Border Adjustments, EU, OECD,).
Finally, here is a practical example of how BTA might work in real life: