Skip to main content
logo
Financial Professional Login
Welcome
Log in for exclusive access and a personalised experience
Log in Sign up
Benefits of creating a free account
  • Customise Guide to the Markets to create a version with your favourite slides
  • Utilise our adviser-only Digital Portfolio Insights tool
  • Unlock expert commentary from Michael Cembalest and access our annual Long-Term Capital Market Assumptions
Hello
  • My Collections
    View saved content and presentation slides
  • Portfolio Analysis
  • Funds
    Overview

    Fund Listing

    • Mutual Funds
    • ETFs
    • ETF Range
    • How to Invest

    Capabilities

    • Alternatives
    • Equities
    • Fixed Income
    • ETF Investing

    In Focus

    • Investing for Income
    • Investing for Fixed Income
    • Investing for Growth
    • Investing for Sustainability
    • Investing for Alternatives
  • Insights
    Overview

    Market Insights

    • Market Insights Overview
    • Guide to the Markets
    • Guide to Alternatives
    • Guide to Investing in Asia
    • Weekly Market Recap
    • On the Minds of Investors
    • Podcasts
    • U.S. Policy Pulse Hub
    • Solving for Fixed Income
    • Eye on the Market

    Portfolio Insights

    • Portfolio Insights Overview
    • Guide to ETFs
    • Global Asset Allocation Views
    • Global Equity Views
    • Global Fixed Income Views
    • Sustainable Investing
    • Alternatives Insights
    • Long-Term Capital Market Assumptions
  • Investment Ideas
    Overview
    • Latest ideas
    • Alternatives Outlook
    • Sustainable investing
  • Resources
    Overview
    • Multimedia
    • Insights App
    • Digital Portfolio Insights
    • Announcements
  • About Us
    Overview
    • Awards
    • Diversity, Equity and Inclusion
    • Spectrum: Our Investment Platform
    • Our Leadership Team
  • Contact Us
  • Role
  • Country
Hello
  • My Collections
    View saved content and presentation slides
  • Portfolio Analysis
  • Log out
Financial Professional Login
Welcome
Log in for exclusive access and a personalised experience
Log in Sign up
Benefits of creating a free account
  • Customise Guide to the Markets to create a version with your favourite slides
  • Utilise our adviser-only Digital Portfolio Insights tool
  • Unlock expert commentary from Michael Cembalest and access our annual Long-Term Capital Market Assumptions
Log out
Search
Menu
Search
You are about to leave the site Close
J.P. Morgan Asset Management’s website and/or mobile terms, privacy and security policies don't apply to the site or app you're about to visit. Please review its terms, privacy and security policies to see how they apply to you. J.P. Morgan Asset Management isn’t responsible for (and doesn't provide) any products, services or content at this third-party site or app, except for products and services that explicitly carry the J.P. Morgan Asset Management name.
CONTINUE Go Back
  1. Big border tax

  • LinkedIn Twitter Facebook

Big border tax

12/01/2017

Andrew Norelli

The tone of the policy discourse has shifted, I hope temporarily, away from fiscal stimulus and structural reforms, and toward protectionism and mercantilism. You need look no further than @realDonaldTrump to see this, but beyond the impressively punchy tweets, there is a deeper policy discussion brewing at the intersection of corporate tax reform and US trade policy. As a result, I want to make two points: 1) contrary to the prevailing policy narrative, the systems of Value Added Tax (VAT) used by many of the United States’ trading partners do not disadvantage foreign producers to the benefit of domestic ones – VAT is “trade neutral” and does not need to provoke any “response,” and 2) a Destination-Based Cashflow Tax, a once-buried aspect of the House Republican corporate tax reform plan, is similar in many ways to a VAT but in contrast, its proposed form does appear to create potential trade distortions. Now, if you’re about to stop reading, try to stick with me. These topics are complex, important, and it’s a challenge to explain either in a short discussion. At least humor me to see if I can do it.

Most US trading partners raise a portion of their tax revenue through VAT, which works like a national sales tax, though there is one major difference: sales taxes are, in theory, levied only on final goods and services, whereas VAT is levied at each stage of the production process. The goals are the same – in each system, final consumers bear the burden of the tax, but the VAT regime reduces the challenge faced by a sales tax in identifying only final goods for taxation. In a VAT system, firms pay the VAT rate on the inputs to production, say raw materials, and then receive the VAT rate on the value of the output they produce by the final consumer. Each producer remits to the government only the net of VAT received minus VAT paid, but the total amount received by the government equals the total amount paid by final consumers. In a sales tax regime, the inputs to production are not taxed, and the entirety of the sales tax paid by the final consumer is remitted to the government. If this were the whole story, countries with VAT would disadvantage their domestic producers versus foreign producers, because domestic producers have paid VAT on their inputs – in a sense this is an advance on downstream consumption taxes – whereas foreign producers (potentially) have not.

In order to correct for this, a VAT regime will specify a “border-adjustment” for importers and exporters. In practice, exporters receive a payment at the border (a rebate of VAT paid during production) as goods move out, and importers must pay VAT at the border as they bring goods in. When viewed in total isolation, these border payments smack of exporter subsidy and importer taxation, and often policy debate focuses on the border adjustments without also considering how VAT remittances work. The border adjustments are actually necessary to create a level playing field, from what was otherwise uneven. Under this arrangement as described, for domestic firms and foreign firms who are able to produce identical goods with identical pre-tax efficiency, profit margins and consumption tax burdens embedded in domestic consumer prices will be identical. That is the essence of trade-neutral tax policy, and VAT with border adjustment is WTO-compliant as a result.

What’s not equal are the post-tax earnings to the shareholders of the domestic firm and foreign firm, if their respective home-country corporate income tax rates are different. This effect, rather than create unequal competition for consumers in a given jurisdiction, tends to create unequal competition for business domiciles (i.e. corporate migration toward low-corporate-tax countries). Countries that choose to raise revenue through consumption taxes like VAT, in theory, should have lower tax burdens elsewhere including on corporate income. In practice, VAT countries tend to have a layering of consumption and income taxes throughout the corporate, investment, and personal income landscape, much like the US inclusive of state sales taxes.

Armed with the perception that foreign VAT is harming American firms, and rightfully motivated to dissuade migration of American corporations offshore for (income) tax reasons, the House Republican Blueprint for corporate tax reform introduces a Destination-Based Cashflow Tax (DBCT), with “border adjustment.” In promoting this concept, it has been described as VAT-like, or the American response to VAT regimes abroad. In its simplest form, DBCT taxes corporate cashflow rather than corporate earnings, allowing deductions for domestically-sourced input costs such as labor and raw materials. All foreign revenue is tax free, and all foreign-sourced inputs are not deductible. This differential tax treatment of cashflow and input costs depending on geographic origin is the “border adjustment” feature of the tax plan. As it stands, by my read, this tax proposal benefits exporters and harms importers. A quick example to illustrate: imagine a German car company and an American car company who can each make a car of identical quality and appeal for $15,000 which the American consumer is willing to buy for $20,000, netting each a pre-tax profit of $5,000. When those cars are sold in competition onshore in the United States, the American company can deduct the $15,000 expense, whereas the German company would owe tax on the entire $20,000 sale price. In addition, domestic producers of exportable goods are strongly incentivized to dump inventory abroad. An American-built car sold abroad would accrue zero corporate tax liability, and the deductible domestic input costs would carry forward as corporate losses, all while the company may freely repatriate the cashflow.

Advocates of the DBCT (and most economists) say that the foreign exchange market will immediately adjust via a strengthening of the US Dollar to offset the policy’s benefit to exporters over importers. I have three things to say: 1) I agree the foreign exchange pressure will be real, precisely because DBCT proposal is not trade-neutral (in contrast to VAT), 2) the theoretical adjustment would be enormous – on the order of 25% at the currently proposed tax rate, and 3) if enacted the actual adjustment would probably be partial, because much of the foreign exchange market is officially managed, and if I’m right about the lack of trade neutrality in the DBCT, the WTO may object as well as authorize members to enact retaliatory measures.

So, the nitty-gritty of the DBCT is messy and it gets more intense if you dig deeper. Even a 10%-15% rise in the USD, if abrupt, would be significantly disruptive to financial conditions, never mind a 25% rise or the potential for trade war. As a result, despite good intentions, I do not think it is likely that the DBCT moves forward in its current form, but the narrative shift we are seeing now as the debate heats up will be enough to move markets and temper some of the optimism that sprung up in the post-election honeymoon phase.

  • Fiscal Policy
  • Latest

RELATED ARTICLES

FOMC statement & potential impact on fixed income

Following the Fed's announcement, find our latest market views from the Global Fixed Income, Currency & Commodities Team (GFICC).

Read more

'Blue ripple' and the USD outlook

The ‘Blue wave’ the market had prepared for now appears to be more of a ‘Blue ripple’ and currency markets are adjusting to a different political outlook.

Read more

How green are green bonds?

With the influx of green, social and sustainable credit issuance this year, we take a closer look at whether these bonds present good value.

Read more
JPMorgan Asset Management

  • Terms & Conditions
  • Financial Services Guide
  • Privacy Policy
  • Cookie Policy
  • Investment Stewardship
  • Voting Policy
  • Unit Pricing Policy
  • Complaint Resolution
  • Sitemap
J.P. Morgan

  • J.P. Morgan
  • JPMorgan Chase
  • Chase

Please note:  Following recent amendments to the Corporations Act, where unitholders have provided us with your email address, we will now send notices of meetings, other meeting-related documents and annual financial reports electronically unless the unitholder elects to receive these in physical form and notify us of this election. Unitholders have the right to elect whether to receive some or all of such Communications in electronic or physical form, the right to elect not to receive annual financial reports at all and the right to elect to receive a single specified Communication on an ad hoc basis, in an electronic or physical form.


 

All investments contain risk and may lose value. This advertisement has been prepared and issued by JPMorgan Asset Management (Australia) Limited (ABN 55 143 832 080) (AFSL No. 376919) being the investment manager of the fund. It is for general information only, without taking into account your objectives, financial situation or needs and does not constitute personal financial advice. Before making any decision, it is important for investors to consider the appropriateness of the information and seek appropriate legal, tax, and other professional advice. For more detailed information relating to the risks of the Fund, the type of customer (target market) it has been designed for and any distribution conditions please refer to the relevant Product Disclosure Statement and Target Market Determination which have been issued by Perpetual Trust Services Limited, ABN 48 000 142 049, AFSL 236648, as the responsible entity of the fund available on https://am.jpmorgan.com/au.