United States

Border adjustment tax would mean sweeping change for middle market

Most significant change to US tax code since 1986

INSIGHT ARTICLE  | 

In the March 10, 2017 issue of The Real Economy, RSM Chief Economist, Joe Brusuelas, examines the implications of the proposed border adjustment tax and its effects on retail, fashion, consumer products companies and other middle market businesses. The following is an excerpt from that issue. For more information, read the full edition of The Real Economy.

Most change in public tax policy is conducted at the margin in order to minimize disruption to ongoing commercial activity. This will not be the case if the sweeping corporate tax reform and destination-based cash flow with border adjustment being put forward by the U.S. Congress is implemented. In short, it would be the most significant change to the U.S. tax code since at least 1986, and quite possibly since the 1913 inception of the income tax. In one swift move, the plan would substitute a tax on cash flows for corporate entities, instead of the current tax on income, and reduce the corporate tax to 20 percent from its current level of 35 percent. This carries with it significant implications for middle market businesses with exposure to the global supply chain across industrial sectors. Given that the destination-based cash flow tax (DBCFT) would apply to all businesses, we assume that it will apply to all firms—whether they are pass-through entities or not— thus this issue focuses on the business impact from the proposed tax changes.

MIDDLE MARKET INSIGHT:

Middle market businesses should take a close look at their supply and value chains to identify potential border adjustment tax (BAT) disruptions.


Whether the border adjustment becomes law or not, the idea of such a radical shift in the tax code presents an opportunity for middle market businesses to get reacquainted with their supply and value chains, which may be disrupted and distorted in the aftermath of any border tax implementation or the imposition of selective trade tariffs.

The goal of the BAT is to create the conditions for a quicker pace of economic growth (current U.S. trend growth is 1.9 percent) in the near-term and to make room for rising productivity (currently at 0.4 percent per year). The reform would also simplify and make more transparent the tax system while protecting the integrity of the U.S. tax base.

Corporate tax revenue today is equal to about 2 percent of U.S. gross domestic product (GDP), so the proposed tax reduction would be equal to 1 percent of GDP, or approximately $190 billion. This should serve as an incentive to increase capital expenditures on the part of domesticallybased firms and encourage the repatriation of corporate profits held abroad, while serving to stop corporate inversions designed to take advantage of lower corporate tax jurisdictions overseas. Moreover, it would make the United States a more attractive corporate tax location and act as a magnet for new investment and capital flows.

MIDDLE MARKET INSIGHT:

Taxing cash flows rather than income favors near-term risk-taking by middle market businesses.


Taxing cash flows rather than income significantly reduces incentives to engage in tax avoidance, therefore, broadening the U.S. tax base. By aligning the incentives to both source materials and produce goods domestically, it would tip the tax code in favor of domestic firms with little or no exposure to the external sector. Moreover, it gives preference to an immediate depreciation of investment on capital expenditures and incentivizes the development of intellectual capital. In our estimation, this favors risk-taking by small and middle market businesses by permitting them to take immediate advantage of business opportunities rather than the current system’s unintended consequence of encouraging firms to spread risk and costs out over time.

From an economic point of view, the substitution of a cash flow regime for an income-based regime represents a shift to what is essentially a value-added tax with deductions for wages. (See: Border adjusted tax proposals may impact exporters and importers). This shift carries with it the capacity to pay for about two-thirds of the $190 billion-dollar corporate tax cut, from 35 percent to the GOP’s proposed 20 percent, on a static basis. U.S exports and imports account for about 15 and 12 percent of GDP, respectively. Since the difference is approximately 3 percent of GDP, under conditions of an effective 20 percent import tax and export subsidy, the new tax regime should raise about 0.6 percent of GDP, or about $120 billion a year, that would mostly be paid for by foreign firms. Given the probable growth in the economy that would follow from the tax cuts, it would likely pay for much more. If the BAT were set at 30 percent, it would likely pay for itself.

In our view, without the anchor of the border tax arrangement, the current tax reform proposal would likely either flounder in Congress or if enacted, create far larger deficits than that currently assumed by the Congressional Budget Office, the GOP or the White House. There is simply no amount of dynamic scoring that could be employed at the Congressional Budget Office that would bring down the corporate tax rate much below 30 percent without significantly altering the budget outlook in a negative fashion.

What is a DBCFT with border adjustment?

The current proposal would effectively abolish the corporate income tax in favor of a value-added approach that will be easy to administrate and, which would likely be a substantial revenue generator during the next decade. The DBCFT should generate about $1.2 trillion in revenues over the next decade at the proposed 20 percent rate.

In theory, a DBCFT should treat equity and debt equally given the elimination of interest on debt as a deduction. That said, with favorable treatment of debt stripped from the tax code, firms would likely move toward issuing equity as a form of capital raising. As a result, this would likely boost private equity and venture capital firms during the first few years of implementation.

The DBCFT is not a de facto trade policy. If currency markets adjust perfectly (an estimated 25 percent), a BAT will not reduce the trade deficit nor will it alter the price level in the economy. Rather, imports and exports would face paired and equal adjustments that, ideally, would create a level playing field for both domestic and external competition. If the U.S. dollar does not adjust perfectly, then the DBCFT, at least in the near-term, would favor exports over imports.

Middle market impact

If a DBCFT is implemented and the dollar doesn’t perfectly adjust, first-order effects in the middle market will be felt most immediately in the retail complex, with footwear and apparel suffering disproportionately. In particular, middle market businesses that feed into the Target, Walmart, and Home Depot and economic ecosystems would be at risk of adjusting to microeconomic distortions and macroeconomic disruptions. These are firms that typically import as much as 95 percent of their inputs and which face notoriously thin margins due to competitiveness pressures.

Any incomplete adjustment of the U.S. dollar, less than the anticipated 25 percent, would result in narrowing margins and necessitate passing along price increases downstream to customers. Moreover, in an environment where firms attempt to pass along price increases, they would likely see Amazon increase its competitive pricing with the confidence that losses would be compensated for by its profitable cloud business and result in those aforementioned ecosystems profit margins narrow further.

MIDDLE MARKET INSIGHT:

In addition to footwear, apparel and those businesses that feed into major retailers, auto, air and energy, as well as firms with narrow profit margins, are also at risk.


Middle market businesses that feed into the auto, aerospace and oil complexes also will see a noticeable increase in operating costs if there’s an incomplete adjustment in the dollar. Firms with higher-end imported food stuffs, commodities and communications equipment could also see an increase in prices.

How to prepare for a border adjustment tax

Middle market businesses, and those advisory entitles that service them, should prepare to disaggregate both supply chains and value chains to pinpoint potential places of supply disruption and to protect portions of the value chain that impact costs and profits. Firms need to engage in the rigorous identification of value extraction from supply chains to both obtain alternative sourcing at reasonable pricing, and to begin disaggregating each value chain to locate specific areas of primary and support activities where value is located.

While supply chains, or a system of organization that is involved in moving products or services from supplier to customer, are generally easy to identify, value chains are generally more industry-specific. Firms should move to quickly identify areas of inbound logistics, operations and outbound logistics involved in the process of procuring and moving materials, parts, the conversion of those materials and parts into final goods, products and services and the transport of those goods and services to final users.

Supply chain examples

Wolverine World Wide manufactures and markets branded footwear and performance leathers. The firm’s products include shoes, slippers, occupational and safety footwear, and performance outdoor footwear. Wolverine’s footwear brands are sold in 200 countries. The U.S. accounts for about 72 percent of the firm’s 2016 fiscal 2016 sales. If the border adjustment tax is implemented, Wolverine may face direct supply chain disruptions and higher prices due to its supplier Delta Galili Industries, and indirectly from the suppler Talon Industries. 

cp_wolverine_supply_chain_graphic_2017

Guess? designs, markets, distributes and licenses a collection of casual apparel accessories and related consumer products. The firm operates 1640 stores across the global economy. The company’s retail operations in the Americas account for 44 percent of its revenue. Guess may see noticeable price increases if the border adjustment tax is implemented due to the direct imposition of the import tax on three of its major suppliers and indirectly via three others. The Guess value chain may see disruption unless it is willing to pass costs downstream to customers.

cp_guess_supply_chain_graphic_2017

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