The Pitfalls of Corporate Tax Reform

A few weeks back, my father, Banyan Hill’s own Bob Bauman, took me to task for something I’d written in Sovereign Investor Daily (not for the first time, either).

I’d said, in regard to the American tendency toward harsh judicial punishment, that “we like it that way.”

“Who’s this ‘we,’ Lone Ranger? Count me out, son … and probably lots of your readers, too. Not all of us like the fact that the U.S. has the highest incarceration rate in the world.”

Mea culpa. Dad was right. In this case, I fell into a trap I usually warn against … generalizing. It’s lazy thinking.

Nevertheless, it’s true that in general the United States is a low-information society.

It’s not because we’re dumb.

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It’s because many of us are awash in biased, incomplete and badly presented information about critical issues.

Sometimes the media does this intentionally … but more often they condescendingly think we “can’t handle the truth.” Or maybe those highly paid talking heads just don’t know how to explain things because they don’t understand them.

Right now, there’s a topic in circulation that’s especially badly presented by the media … which is a pity, since it has important implications — bad and good — for all of us…

In the November edition of The Bauman Letter, I predicted that no matter who ended up in the White House, corporate tax reform would be atop the congressional agenda.

I was right, but not in the way I expected.

White House Press Secretary Sean Spicer threw the proverbial cat amongst the pigeons by suggesting that Trump wants to pay for the “Great Wall of Mexico” by imposing a 20% tax on that country’s exports to the U.S.

Chipotle shares nosedived as the potential impact on the nation’s guacamole supply rippled through the markets.

But Spicer wasn’t referring to a 20% border tax … he meant House Republicans’ comprehensive corporate tax reform plan, proposed last June.

The GOP plan is a “destination-based” tax system with “border adjustment.” It only taxes economic activity within the United States, like most other countries. Without going into the theoretical details, this has two implications:

  • When a U.S. company sells goods or services overseas, that revenue is ignored and is therefore excluded from U.S. corporate tax calculations.
  • When a U.S. company buys goods or services overseas, that expenditure is ignored and is therefore not a deductible expense when calculating U.S. corporate tax.

But … the GOP also wants to lower corporate taxes from 35% to 20%. That means under “border adjustment,” U.S. firms that import would mathematically pay 20% more corporate tax than firms that buy American. That’s where the uninformed talk about a “20% border tax” comes from.

Another Dollar Bump?

But the second half of the story is almost universally ignored — as are its implications for the rest of us.

Most economists agree that as soon as the GOP system is in place, foreigners would rush to snap up now-cheaper U.S. exports. That would drive up the value of the dollar … until the dollar’s rise offset the new tax effects and everything returned to “normal.”

U.S. importers would be no worse off, because the dollar’s greater buying power would balance their 20% tax disadvantage. Imported goods from Mexico or anywhere else wouldn’t cost them any more than before in real terms. The stronger dollar would likewise nullify U.S. exporters’ 20% tax advantage, so they’d be no better off since U.S. exports wouldn’t be any cheaper than before in real terms.

Bottom line: The so-called 20% border tax isn’t an import tax, and in the long run, it wouldn’t change trade much.

But it would have some very significant short-term effects.

To offset the impact of border adjustment, the trade-weighted value of the U.S. dollar would have to appreciate by at least 15% to 25% relative to other currencies. Whilst that process is underway, that could mean:

  • A sharp spike in the nominal price of imports … especially basic consumer goods with inelastic demand.
  • A sharp fall in the profits of U.S. firms that sell imported goods.
  • Reduced U.S. investor income from foreign assets, in proportion to the rise of the dollar and an anticipatory sell-off of those assets by U.S. investors … compounding the dollar’s rise.
  • An $8 trillion payment shock for foreign dollar debtors, causing an emerging market crisis.
  • Potential retaliation by other trading countries.

Then there’s the short-term impact on U.S. firms’ tax burden.

Under the GOP plan, if your company imports $200,000 of foreign inputs and $100,000 of domestic inputs, and sells the resulting product for $350,000, it could only deduct the $100,000 from U.S. taxes. It would then pay corporate tax at the lower rate of 20% on $250,000 — $50,000.

Under the current system, however, your company could deduct the costs of imports as well as local expenses, and then pay 35% in taxes on $50,000 … about $17,500.

That’s a 186% increase in effective tax.

One small-business woman whose company sells imported goods told The Wall Street Journal: “We do not have the cash cushion to absorb this adjustment. It would put us out of business if we can’t pass it on to consumers immediately.”

Of course, any increase in U.S. interest rates would compound the effects of border adjustment.

Timing Is Everything — Even Interesting Ones

If the dollar doesn’t rise fast enough, the implications for import-dependent firms with poor cash positions and lots of debt — and in this low-interest-rate environment, that’s a lot of them — could be devastating.

In fact, historical research by Citigroup shows a consistent five-year lag between changes in the U.S. current account balance and exchange rate shifts. A five-year “adjustment” could mean “bankruptcy” for many U.S. businesses.

Learned economists say that “overall, there is little reason to think that a border adjustment would raise prices for consumers in the long run.”

As Keynes said, however, in the long run we are all dead.

We live in “interesting times,” as the Confucian curse puts it. That why it’s so important to seek out informed advice based on the full picture — exactly what we at Banyan Hill set out to do.

So, here’s a Banyan Hill tip from me: A border-adjusted corporate tax system would lead to a rapid rise in the dollar value of gold … say, 15% to 20% … almost overnight, since I suspect the market would price in future currency adjustments immediately.

The more gold you have when that happens, the better off you’ll be.

Kind regards,
The Pitfalls of Corporate Tax Reform
Ted Bauman
Editor, The Bauman Letter