Border Tax: The Consequences And Investment Implications

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Includes: DIA, IWM, QQQ, SPY
by: Ranjit Thomas, CFA

Summary

The proposed Border Adjustment Tax is a bad idea that will distort the economy.

Large parts of the economy will face upheaval, with many winners and losers.

This article tries to isolate the impacts so investors have a framework to guide their actions.

The Border Adjustment Tax (BAT) being proposed by House Republicans is in my opinion one of the worst economic ideas put forth by Congress in many decades. It has been glibly described as a tax on imports but not on exports. However, a more accurate description is that it is a tariff on imports paired with a subsidy on exports, sneakily achieved through the corporate income tax. In other words, it is a double-barreled protectionist measure. Sadly, even Republican politicians and economists who claim to believe in the virtues of free trade are being seduced into believing that it is a good measure, especially as it is being paired with a proposed reduction in the corporate tax rate from 35% to 20%.

Perhaps the biggest misconception is equating it to the value-added tax (VAT) in other countries and claiming that it levels the playing field. A VAT is a sales tax that applies to all goods consumed in a country. It is not charged on exports, just like a sales tax is not levied on US exports. Similarly, it applies to imports just like a sales tax does in the US. Importantly, a VAT is applied to goods produced and sold within a country as well, and is a true consumption tax, but the border tax leaves out this significant part. Curiously, the same people who crow about American exceptionalism have no problem wanting to copy the failed economic policies of other nations.

The argument offered by proponents is that the dollar will appreciate by 25% to make up for the measure. This is an academic viewpoint that ignores real-life effects. In reality, there are second-order dampening effects. Yes, the dollar will appreciate, but not to the full extent. Freely trading currencies do not appreciate by 25% overnight. Also, due to the complexities of global trade, most imported goods have input costs other than labor that are priced in dollars. So its price is not going to drop to match an appreciation of the dollar. One just needs to look at the price of historical imports in relation to the strength or weakness of the dollar to know this. An iPhone that is imported at a cost of $500 is not going to magically drop to $400 because the dollar appreciates versus other currencies. As an extension, one can also simulate trade with another country that uses the US dollar as its functioning currency to know that this is not going to happen.

A currency does not appreciate without any pressure on it. In this case, the pressure will be a shrinking trade deficit. The trade deficit will shrink, and so will our capital surplus to match it. The academic viewpoint, expressed by Martin Feldstein in the Wall Street Journal, is that the dollar will appreciate to the full extent as savings and investment will be unaffected. This is not true, destroying the nub of his argument. As the capital surplus shrinks, leading to lower capital inflows from abroad (to fund the budget deficit, for instance), domestic savings will have to rise to fill the gap.

Long-term contracts are not going to be amended because of this change. Boeing (NYSE:BA) is not going to give a discount to the Iranians because they get handed a subsidy after a deal is signed. It finally may pay to ship coal to Newcastle from the US because of the export subsidy! Can you imagine the havoc in the global economy if commodity prices were to fall 20%? Most producers have dollar-denominated costs in the form of debt repayments, maintenance contracts, etc., and have invested in assets bought with dollars (many of the owners are American firms).

Brick and mortar retailers with thin margins, already under pressure from customers shifting to the Internet, will be devastated. A few prominent retailers are bound to go bankrupt. Macy's (NYSE:M) filing for Chapter 11 isn't going to make for a good headline, and US Steel (NYSE:X) is unlikely to take over the sponsorship of the Thanksgiving Day parade. Apart from the direct job losses, there will be knock-on effects like mall owners being adversely affected. Some of these firms have borrowed liberally over the last few years and are heavily indebted and may not be able to survive the financial strain. The problems will spill over into the commercial mortgage-backed securities (CMBS) market, and could spiral out of control.

It will be a gift to a few, especially US manufacturers who compete with imports, like oil producers. The government will effectively be picking winners and losers in the economy. Multinational companies will find a way to recognize foreign revenues as exports. With a 20% subsidy, there will be a powerful incentive to do so. And do not underestimate the power of incentives. People will find a way to disguise capital inflows as trade exports to claim the subsidy. As a result, the measure will raise far less revenue than anticipated, while handing out far more. Proponents of dynamic scoring for tax cuts are curiously in favor of static scoring on this one. Claims that the tax will raise $100 billion a year rely on a simplistic analysis that assumes nothing will change with the status quo. Corporate tax collections will plunge, leading critics to blame the reduction in the headline rate from 35% to 20%. Creative revenue and cost accounting will be a growth industry, and the IRS will have a hard time battling companies over these allocations.

It is unclear if and how the tax will apply to services. If not, it will put the US exporter of services at a disadvantage and lead to a surge in US imports of services. And services are a much larger part of the economy. Take the case of the foreign tourist who comes to Disneyland. Does she get a discount for her hotel stay and park tickets? You could have a curious situation where a hotel room booked from Europe would be subsidized, but the same room paid for with cash would not. Ditto for a foreigner booking an air ticket on a US airline. And if this airline were to buy fuel at a foreign airport, would this be a non-deductible expense? The travel and tourism industry in the US will be adversely affected, and so will retailers. Foreign tourists weighed down with shopping bags in the US will be a thing of the past. Instead, it will be the opposite, with Americans preferring to vacation abroad, returning with a Rolex on each wrist. Ultimately, this will lead to less investment in the sector and fewer jobs.

Another major flaw in the implementation is whether the adjustment will apply to pass-through entities like LLCs that are not subject to the corporate tax but pass their income on to individuals. If it does not apply (and as a corporate tax it shouldn't), then it will put such exporters at a disadvantage and allow imports to be funneled tax-free through such entities. If it does apply (as people making the revenue calculations are assuming), then the tariff and subsidy will fall at the individual income tax rates or as high as 39.6%. This would put such importers at a disadvantage and provide an incentive for exports to be done through LLCs.

It will lead to less specialization, lower scale of production and less trade. Inflation will rise, and so will interest rates. Will the Federal Reserve be truly data-dependent and raise short-term rates in the face of high inflation? Or will it punt by assigning the blame to the external tax factor? Never mind that it kept rates low in the past in the face of subdued inflation due to globalization.

What will an exporter do with the tax losses it generates, since it won't count the value of exports as revenue? Surely, as a corporate tax, it isn't going to be refundable. This will provide an incentive for net importers to merge with net exporters so that they can then import goods without the border tax. A Lockheed (NYSE:LMT)-Wal-Mart (NYSE:WMT) merger would not be out of the question. It will cause a substantial divergence between the tax accounts of a business and those presented to investors according to GAAP.

The implications for various sectors are detailed below.

Winners are mainly exporters and import substitutors:

Defense firms like Boeing, Lockheed Martin, Raytheon (NYSE:RTN), Northrop Grumman (NYSE:NOC) and General Dynamics (NYSE:GD).

Chicken producers/exporters like Tyson (NYSE:TSN), Sanderson Farms (NASDAQ:SAFM) and Pilgrim's Pride (NYSE:PPC).

Soybean and nut farmers. These aren't public, but possibly a processor like Archer Daniels (NYSE:ADM).

Domestic oil producers like Continental (NYSE:CLR), EOG Resources (NYSE:EOG) and Pioneer (NYSE:PXD).

Fertilizer makers like CF Industries (NYSE:CF).
Chemical producers like Lyondell Basell (NYSE:LYB) and Eastman Chemical (NYSE:EMN)

Firearms and accessories makers like American Outdoor (NASDAQ:AOBC), Ruger (NYSE:RGR) and Vista Outdoors (NYSE:VSTO).

Airlines with international operations like American (NASDAQ:AAL), Delta (NYSE:DAL) and United (NYSE:UAL).

The dollar. A way to play this is to buy the Powershares US Dollar Index Bullish Fund (NYSEARCA:UUP).

Treasury Inflation Protected Securities (OTC:TIPS).

Volatility, which can be purchased through an ETF like Proshares Ultra VIX (NYSEARCA:UVXY), though over time I believe this is one of the worst investments in the world.

A mixed or neutral impact on multinationals and those whose input and output compete with imports:

Refiners like Valero (NYSE:VLO), Marathon Petroleum (NYSE:MPC) and Tesoro (NYSE:TSO).

Integrated oil companies like Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX).

Multinational banks like Citigroup (NYSE:C), Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS) and JPMorgan (NYSE:JPM).

Consumer products companies like Pepsico (NYSE:PEP), Kimberly Clark (NYSE:KMB), Kellogg (NYSE:K) and Hormel (NYSE:HRL).

Global pharma companies like Amgen (NASDAQ:AMGN), Allergan (NYSE:AGN), Pfizer (NYSE:PFE), Biogen (NASDAQ:BIIB), Gilead (NASDAQ:GILD) and Celgene (NASDAQ:CELG).

Tech companies like Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Cisco (NASDAQ:CSCO), Netflix (NASDAQ:NFLX) and Facebook (NASDAQ:FB).

Auto manufacturers like General Motors (NYSE:GM) and Ford (NYSE:F).

Losers will be those whose fortunes are dependent on imports:

Retailers like Macy's, Wal-Mart, Target (NYSE:TGT), Dollar General (NYSE:DG), Dollar Tree (NASDAQ:DLTR), Costco (NASDAQ:COST), Tiffany (NYSE:TIF) and even Amazon (NASDAQ:AMZN) to some extent.

Consumer product manufacturers like Apple (NASDAQ:AAPL) and Nike (NYSE:NKE).

Mall REITs like Simon Property (NYSE:SPG), Taubman (NYSE:TCO) and Macerich (NYSE:MAC)

Tourism focused companies like Disney (NYSE:DIS), Wyndham (NYSE:WYN), Hilton (NYSE:HLT) and Hyatt (NYSE:H).

Semiconductor manufacturers like Broadcom (NASDAQ:AVGO) and Skyworks (NASDAQ:SWKS).

Luxury real estate, due to the dearth of foreign buyers.

A large loser also will be the overall US economy. Of late, there has been a stampede into index funds and sector ETFs by individuals who had sat on the sidelines for years. It is clear that these people do not know what they are buying but are merely chasing what has gone up. If the market were to start declining, these flows could quickly reverse. ETFs will become price-insensitive sellers, and we could see a lot of stocks gap down. Therefore, if the border tax were implemented, I would be a seller of the market through ETFs like SPDR S&P 500 (NYSEARCA:SPY), Powershares Nasdaq 100 (NASDAQ:QQQ), SPDR Dow Jones (NYSEARCA:DIA) and Ishares Russell 200 (NYSEARCA:IWM).

The above is meant to be a representative, not a comprehensive list. Also, I should caution against jumping into an investment right now based on the above list for a few reasons:

1. Many of the stocks have already moved in anticipation of the measure. These moves could reverse if it does not ultimately pass.

2. After enactment of the law, but before it takes effect, we could actually see the opposite of many of the impacts e.g.. a weakening dollar as imports surge to meet the deadline and exports are held back.

3. There will gradually be a dampening effect on the winners. The strengthening of the dollar will negate some of the benefit, foreign nations will have less dollars to buy these goods, and they may impose punitive tariffs on some products.

4. If the impact on the economy is as negative as I have portrayed, there will be public pressure to roll back the measure. Declining property values negatively affecting the net worth of a highly leveraged real estate mogul is not going to go down well at the White House.

Disclosure: I am/we are long AAPL, AMGN, BIIB, C, DAL, DIS, GILD, GS, JPM, LYB, SWKS, UAL, WYN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.