Tariffs, with Some Guesswork11/30/-1 Author: Dr. Charles Lieberman, Chief Investment Officer
The Chicken Littles of the world expect a wholesale imposition of tariffs on imported products into the U.S. to set off a trade war that badly hurts the global and domestic economy. This is possible, but highly unlikely, given the lessons learned in the 1930s and widely accepted economic theory that favors free trade. It is just typical fear mongering. But, a border equalization tax, BET, seems likely to be proposed as part of a wider tax restructuring plan and it will be hard to unravel the consequences of the BET from the rest of the package, even after the fact. But some conclusions seem likely.
As noted widely, most countries around the world already have some sort of border tax in place, so the U.S. would merely be joining the game, thereby placing our companies on a more equal footing. Getting rid of the current tax structure, whereby U.S. companies are taxed on their profits wherever they are earned anywhere in the world, but only if those profits are remitted back to the U.S., would free up capital for our companies and it would remove the incentive to relocate their headquarters to a foreign country to reduce their tax bite. It is even possible that some foreign companies could choose to relocate here for the protections afforded by our legal system and the access enjoyed by our companies to foreign markets. If a 20% tax rate were applied to imports, it would raise about $500 billion, providing much of the financing needed to pay for tax cuts or infrastructure spending without blowing up the budget deficit. These are very significant positive features of a BET.
Corporate profits taxes currently raise about $350 billion. So if the tax rate were reduced by 20%, companies would save about $70 billion, but this would also improve rates of return on investment, which should stimulate capital investment, improve productivity, and increase hiring. Only the last effect, increased hiring demand, would be problematical at the moment, because the unemployment rate is already extremely low. So, increased incentives to hire are more likely to drive up wage rates and inflation. But this might be welcome at other stages of the business cycle. In contrast, increased investment and productivity would be particularly beneficial now, given the poor productivity record of the past few years.
A decline in corporate tax rates would also render stocks unambiguously less expensive and might make them cheap. Some people argue that stocks are expensive now, because the estimated 2017 P/E ratio is around 17.5 for the S&P 500. But if tax rates fall by 20%, the market’s P/E would decline overnight. Taking the tax rate from 35% to 28% implies that retained earnings would go from 65% of pre-tax profits to 72%, a gain of nearly 11% and reducing the P/E to 15.6. When he ran for office, Trump advocated for a reduction in corporate tax rates to 15%, yet a far smaller reduction would still have a very large effect, as shown.
What is much less clear is how much trade flows might be affected by the BET. No doubt, exports would be stimulated directly by these lower tax rates, while imports would be curtailed by higher tax costs of the BET. But the reduced trade deficit would also place more upward pressure on the dollar, offsetting much of benefits of the tax effects on trade flows. And it would quite specifically hurt our multinational companies with large operations overseas. Those profits would translate into fewer dollars when remitted home. And domestic companies that rely most heavily on imported products, notably including many retailers, would also suffer a decline in sales and profits, since their cost of goods would rise. Still, netting this all out should produce some sort of net positive for domestic business.
Proposals like the border export tax are sure to attract harsh attention. Companies likely to be hurt by the BET will complain loudly, while those that are helped are sure to be much more discreet. So it will be no easy task to get any such legislation through Congress. Historically, Democrats have fought against free trade and been far more inclined to protect domestic business against less expensive imports. This time, Democrats might find themselves more closely aligned philosophically with the President on his trade policies, while Republicans worry free trade is being undermined. How this shakes out with votes in Congress remains to be seen. But if implemented, it is likely to marginally help businesses that are domestically based, increase hiring needs and provide significant support for equity valuations, especially of domestically based firms.