Trump\'s tax package: Implications of border tax

Muhammad Mahmood | Published: February 11, 2017 19:53:27 | Updated: October 23, 2017 04:34:33

Donald Trump is on the saddle and his party controls both Houses of the Congress. He can now push through his tax plan. His tax package has apparently two major components - a cut in corporate tax rate from 35 per cent to 20 per cent or even to 15 per cent and a "border adjustment tax" or a "destination tax''. The former (35 per cent corporate tax) is considered to be the highest among developed countries (e.g.,  20 per cent in the UK or average 24 per cent in the European Union). This tax is imposed on domestic profits and foreign earnings when repatriated back home. It has been argued that this has caused many major corporations like Google and Apple to relocate their operations overseas and  use complex transfer pricing mechanisms with their foreign subsidiaries to accumulate huge amount of profit. 
The plan now is to reduce the corporate tax rate to 20 per cent slightly above 15 per cent proposed by Trump during the election campaign. To boost investment which has been rather very sluggish since the Global Financial Crisis, capital investment may be written off immediately instead of depreciating over time. But net interest payments will no longer be eligible for tax deduction. This was aimed at discouraging debt financing. Even the plan stipulates measures never tried before anywhere in the world, such as less tax on domestic production while more on foreign production. Under such a scheme domestic production expenses, including wages, would be tax deductible but not overseas manufacturing undertaken by retailers and technology firms. 
All these are aimed at restoring US manufacturing back to the USA; therefore stimulating employment.  That is the idea, anyway. Closely linked to this is the objective of the latter - a "border adjustment'' tax.  This proposed tax has already created a great degree of controversy. A border adjustment tax would treat domestically purchased inputs differently from imported inputs. Companies under this arrangement will not be eligible to deduct cost of imported inputs from their taxable income while export revenue will be exempted from tax. The idea is to encourage exports.  It is considered as similar to a VAT-payroll tax swap which will raise the cost of imports while subsidising exports. 
This is all about to enhance the USA's competitiveness. The use of fiscal policy instrument to achieve trade competitiveness is not new.  But the method chosen here is rather very unique, not yet tried anywhere else.
However, Trump has even more ideas on what to do at the border:  slap a 35 per cent tax  (tariff ) on Mexican and Chinese goods coming into the USA. But the Republican party favours a 35 per cent tax on US businesses that locate production facilities overseas such as Mexico and China rather than such a tariff.  So it will not look like protectionist. Both China and the USA impose tariff on each others' goods, the former imposing 5.0 per cent and the latter, 2.9 per cent. This 2.0 percentage point difference can not be the cause for imposing 35 per cent tariff on all goods made in China. This is a recipe for a trade war which will cause trade mayhem around the world.
If Trump prevails, a 35 per cent tax on Chinese goods of which half those goods are exported by US subsidiaries in China and also Mexico for that matter, it will open a  very  strong possibility of a  trade war. So to avoid that Trump is now targeting goods imported from US-owned subsidiaries. Again, this is all about to bring back manufacturing back to the USA.  That being the case, this will definitely put those US companies at a competitive disadvantage in the US market relative to foreign-owned companies. Now, according to Trump's logic, they will now come back home to the USA. Even if those companies come back home goods produced in the USA will still cost are factored in - they will still remain non-competitive with foreign imports.
Under those circumstances, Trump would  practically skew the market in favour of foreign owned companies and therefore he would make the playing field very uneven for the US-owned subsidiaries. This will neither benefit the US companies nor US consumers. It is now a moment of further strategic decision making for US multinationals with subsidiaries in Trump's target countries. For example, electronic industry in particular and many other industries have developed a very highly developed Asia-centric supply chain spread around mostly in East Asia. That equation is not going to change for US multinationals now producing in the USA. It will cost a lot more now to produce those goods in the USA and sell them at higher prices in the fortress USA.  The simple result is rise in price levels i.e. inflation. To stem the rising inflation, interest rates must now also rise causing investment to fall. This is not good news for  the working people in the USA whose cause he is purported to champion. As these corporations are allowed to move freely between 50 states, some states may  dilute laws relating to organised labour to attract these companies. The organised labour movement is already very weak in the USA - estimated to be only  around 7.0 per cent of  the working population. Not good news for working people in the USA.
And where are we? Of course, the consequences are very clear. The strategy is most unlikely to work simply because the USA also has a flexible exchange rate regime which  under the circumstances will  cause the dollar to rise as some economists estimate up to  20  to 25 per cent. This will immediately wipe clean any gains in competitive advantage. The changes in tax liability looked from a theoretical perspective will be offset by price adjustment resulting from the dollar appreciation. Then add on to further compound the problem, it is likely to impact negatively on the net foreign asset holdings of the USA.  We have not yet factored in the likely costs of any trade retaliatory measures.
But most serious issue is, it will make many US multinational corporations think  about some serious alternatives.   They might jump the ship altogether by moving their headquarters overseas  or acquiring a foreign company and adopting  a new homeland which will effectively  mean   denying US citizenship to avoid paying  US taxes. Such corporate inversions are not uncommon rather it might under the proposed border tax regime gain popularity to avoid punitive and discriminatory tariffs.
It is estimated that the proposed border adjustment tax system will raise US$1.0 trillion over the next decade. But overall, the new tax regime will not have any positive impact on gaining competitive advantage, therefore, on the US trade balance, trade deficits will continue.  The fundamental problem will remain unresolved. The situation may even get very murkier if it ignites trade retaliations as well, a possibility that can not be ruled out. 
The writer is an independent economic and political analyst.

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