Two Wars Are About To Break Out Over Border Adjustment Tax

When it comes to the future of the US economy, capital markets, the strength of the dollar, and tax policy in general, few proposals are likely to have as much of an impact as the border adjustment tax, or BAT, which as we profiled before, could have a significant impact on the value of the dollar, pushing it as much as 15% higher, and leading to dramatic changes in global trade patterns. As a reminder, House speaker Paul Ryan is the primary advocate of the BAT, arguing this effective $1.2 trillion tax on imports is the only way Congress can pay for Trump's proposed massive tax cuts.

Since the BAT stands to greatly benefit exporters, who would pay no taxes on exports, thereby dramatically boosting their bottom line, it is obvious why export-focused US businesses are heavily for the proposal. Among them are the "American Made Coalition," a coalition of more than 25 American businesses. Two corporate titans playing a leading role in the push for BAT are GE, which has hosted coalition partners at its D.C. offices recently, as well as Boeing, which also has much at stake in this fight. Other industries include manufacturing, high tech, software, medical device production, agriculture, energy production, biopharmaceuticals and information services.

Furthermore, in addition to Paul Ryan and the House GOP leadership, Steve Bannon has also opined in favor of the border tax and, in recent days. Trump himself has dismissed the cornerstone of the House GOP plan as "too complicated" and has been touting a 35% levy on imports as an alternative. Yet his spokesman appeared to put the tax back in play last week by proposing a 20% tax on goods from Mexico and "other countries we have a trade deficit with" to pay for a border wall. So far, Trump's position on BAT is "fluid."

Meanwhile, as AP reports, a powerful lobbying force has emerged on the other side of the argument, and assures a war in the coming months as the fate of the border tax adjustment is determined in Congress.

Meet the "Americans for Affordable Products", a coalition of more than 100 retailers including Wal-Mart and Target as well as key trade associations, aimed at fighting a Republican proposal on how imports get taxed, a measure they believe would harm their businesses.

The National Retail Federation, along with the American International Automobile Dealers Association, the National Grocers Association and others are joining forces to form Americans for Affordable Products, which will run a campaign to educate consumers and show lawmakers that the so-called Border Adjusted Tax plan would lead to higher prices of as much as 20 percent on everyday items including clothing, food and even gas. The diversified group, which also includes such companies as Nike, Best Buy, luxury conglomerate LVMH and Dollar General, is trying to make their opposition heard even while Congress and the president try to sort out exactly what adjustments to put forth.

"There's a rush to get this done in Congress. We want to make sure our voices are heard," said David French, chief lobbyist for the National Retail Federation, which has been dispatching members to meet with different levels of the new administration as well as lawmakers. Details of the consumer campaign are still being worked out, according to a spokeswoman at the retail trade group.

Since nearly all retail items bought by U.S. shoppers are either wholly or partly produced overseas, as companies have sought the cheapest way to make goods, the risk of an inflationary shock as prices are ultimately passed through to consumers is all too real. And with online competition and shoppers trained to find the best deals, U.S. retailers haven't had the power to raise prices on many goods for several years.

"I'm losing sleep. I am scared out of my mind," said Rick Woldenberg, CEO of Learning Resources, which has signed on to the coalition. It is a family-owned company based in Vernon Hills, Illinois that makes educational toys and employs 150 people in the U.S.  He estimates that under the GOP plan his federal tax rate would soar to 165 percent from 39.6 percent, he would have to raise prices by 10 percent to 15 percent to stay viable, and would have to lay off employees.

Retail industry leaders have gone so far as to "describe it as an existential threat," said Stephen Lamar, executive vice president at the American Apparel & Footwear Association, another member of the  coalition. "When they crunch the numbers, it really affects things like solvency and profits."

Lamar said companies would likely have to pass along higher prices to shoppers, who wouldn't tolerate it. Companies say they also would have to try to squeeze suppliers for more savings and fear they might even have to lay off workers or close stores. He also said a shirt label saying "Made in China," doesn't tell the whole story. Seventy percent of the value of the garment supports U.S jobs in areas like design and logistics, he said.

More improtantly, other groups also oppose the border-adjusted tax, including Americans for Prosperity, a conservative organization backed by billionaires Charles and David Koch, who typically donate generously to Republican campaigns. And with such wealthy backers, it is only logical that this particular war will be waged where it counts: in Congress, and it is there that a problem for the Border Tax emerges.

While both sides of the fight have gamed it out the same way: they think Ryan and the House Ways and Means chair Kevin Brady can probably squeeze the plan through the House, the Senate is a different ball game. As Axios notes, even if Trump loudly supports border adjustability — and that's a big if — he'll have a tough time convincing Senators who fear him far less than House members do. And senators from states home to big box retailers, those with the most to lose should the law pass, have compelling reasons to oppose border adjustability.

GOP Senators being targeted by opponents of border adjustability:

  • Arkansas Senators Tom Cotton and John Boozman (Walmart)
  • Georgia Senator Johnny Isakson (Home Depot)
  • North Carolina Senators Richard Burr and Thom Tillis (Lowe's)

GOP Senators who have already said they don't like border adjustability:

  • Senator David Perdue of Georgia is a former CEO of Dollar General who has a deep understanding of the effects of border adjustment on retail. He said on CNBC: "In my view, it's regressive. It just hammers low-income and middle-income consumers, and it really doesn't foster growth."
  • Senator Mike Lee of Utah told Koch network donors: "This ends up becoming a VAT-like substance and I think it would end up having a lot of the negative characteristics of both a VAT and a tariff ... I really don't like it."
  • Senator John Cornyn of Texas is known to be concerned about border adjustment's effect on gasoline prices. Last week he tweeted: "Many unanswered questions about proposed "border adjustment" tax."

Since tax reform will likely be done through reconciliation, which requires a majority vote, Republicans can only afford to lose two senators on border adjustability.

Ultimately, the biggest question for both sides of this fight is whether Trump will weigh in forcefully on behalf of border adjustment. Trump's chief strategist Steve Bannon is on board and believes it's an American nationalist tax, however Trump has expressed less interest in the past. And the House GOP — supported by an outside coalition — is wisely making their pitch in nationalist terms. Axios cites a source, who favors border adjustment, as saying: "It is safe to say that the retail giants and the Koch brothers have jumped out to a head-start in this debate, but the political environment is tailor-made for the manufacturers and a strong 'American jobs' message."

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Finally, if the BAT does ultimately pass, leading to major changes for US trade and tax policy, its adverse impact on the rest of the world would be far greater. In a new note by Deutsche Bank's George Saravelos and Robin Winkler, the economists have calculated the amount of trade with the U.S. that countries stand to lose if they face a 20% penalty at the border. Mexico is the obvious biggest loser, but Canada and Asian manufacturing economies including Vietnam, Malaysia and Thailand would also be in line for a big hit. In fact, anyone who exports to the US would see a major hit to their GDP almost immediately.

For those who are unfamiliar with the basis, Bloomberg explains that a border tax essentially places a levy on imported goods with the aim of narrowing the trade deficit and making the exports of domestic producers more competitive. The extent to which a country's trade with the U.S. would be impacted is partly determined by how elastic demand for their products in the U.S. is. If the elasticity is higher, they suffer more. In other words, if Taiwanese-made electrical machinery sold in the U.S. suddenly becomes, say, 10 percent more expensive -- after suppliers absorb some of the tax themselves -- and potential buyers can find a domestic substitute easily, then price becomes the defining factor. Bad luck for the Taiwanese, in this example.

While the program would help the U.S. cut its trade deficit and on its own terms would likely be successful, it may not play well with trading partners.

For one, U.K. Prime Minister Theresa May should take an interest, as without a special deal the U.K. stands to suffer a serious reversal, according to Winkler and Saravelos. As demand for the U.K.'s exports to the U.S. is highly elastic, a border tax could turn a surplus of around $1 billion into a deficit of around $19 billion, almost a fifth of gross trade between the two countries.

And, as DB explained back in December, what would all this do to the dollar? Push it up, through increased demand for U.S. products and reduced American demand for goods from the rest of the world, although not immediately and not in a predictable way, the report argues.  Even if a rise in the U.S. currency were to offset some of the competitive advantages that domestic exporters were to gain through the tax, the policy would still “severely undermine bilateral trade relations,” Winkler and Saravelos write.

In short, BAT would lead to a trade war due to a deterioration in terms of trade, even if Trump never actually launched a trade war.

As DB concludes, "while currency adjustment would be gradual and incomplete, even a fraction of the theoretically implied 25% adjustment would be material for the dollar and would leave ample scope for border tax adjustments to severely undermine bilateral trade relations. Mexico, Canada and Asia would be most severely hit by US border taxes while commodity exporters, Latam, and most of Europe would be less affected. The magnitudes of the damage would be enormous in our view."

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To summarize: two wars are about to, or have already broken out, over the Border Adjustment Tax: one is domestic, and involves exporter (GE and Boeing) vs importer (WalMart and Koch Brothers) alliances and trade groups; this war will shift into the Senate, where Republicans can afford to lose at most 2 Senators, yet where as many as 6 are on the fence already (with 3 voicing a negative opinion toward BAT). The second war is one which would break out after the BAT is passed, and it would hammer - at least in the first few years - America's biggest trading partners. And since the impact of the latter would be to force prices of the vast majority of retail goods sold in the US to soar, leading to a big jump in core inflation, eventually leading to a surge in the US Dollar - even if one ignores the diffuse effects and pervasive on global trade - the BAT would have an immediate impact on Fed policy, interest rates, and ultimately, prices of risk assets.