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Global Trends by Martin Khor

Monday, 13 February 2017

Beware of the new US “border tax” plan

Like old wine in a new bottle, American leaders are hatching a new protectionist instrument that may even be worse than tariffs, with potentially devastating effects on developing countries like Malaysia.

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A new and deadly form of protectionism is being considered by American leaders that could have devastating effect on the exports and investments of developing countries like Malaysia as well as destabilising the world economy.

The plan, known as a border adjustment tax, would have the effect of taxing imports of goods and services that enter the United States, while also providing a subsidy for US exports which would be exempted from the tax.

The proponents’ aim is to drastically reduce imports while promoting exports and thus reduce the huge trade deficit in the US.  It fits in with US President Trump’s goals to make America great again, to buy American and hire Americans.  

On the other hand, if adopted, it would it depress the competitiveness or viability of other countries’ goods.  The prices of their exports to the US will have to rise due to the tax effect, depressing their demand and in the worst case make them unsaleable.   

And companies from the US that invested in developing countries because of cheaper costs and then export to the US may find their business affected because their products will cost more.  Some will think of relocating back to the US, and investors will be discouraged from opening new factories in the developing countries. 

The border adjustment tax is part of a tax reform bill being drafted by the Republican Party, with Paul Ryan, the speaker of the House of Representatives, being the chief advocate.

Trump originally criticised the plan for being “too complicated” but is reportedly now considering it seriously.  The proposal has however generated a tremendous controversy in the US, but also enjoys strong support and some version is expected to be tabled.

Originally, Trump favoured the simple imposition of a tariff on products from selected countries, especially China and Mexico.  But it is too blatantly protectionist and will surely trigger swift retaliation.

The tax adjustment plan would have a similar effect in discouraging imports and moreover would promote exports, but it difficult to understand. 

The tax works like this.  Firstly, as part of the overhaul of the corporate tax system, the expenses of a company on imported goods and services can no longer be deducted from a company’s taxable income.

The corporate tax rate would be reduced from the present 35% to 20%.  The effect is that a 20% tax would be applied to the companies’ imports.

Take the case of a company with revenue of $10,000 and with $7,000 imports, $2 000 local costs and $1,000 profit.  Under the present system, the $7,000 imports plus the $2,000 wages can be deducted. With a 35% tax rate, the company’s taxable total would be $1,000, tax would be $350 and after-tax profit would be $650.

Under the new plan, the $7,000 imports cannot be deducted and would form part of the new taxable total of $8,000.  With a 20% tax rate, the tax would be $1,600, so after tax the firm has a loss of $600.

The company, to stay alive, would have to raise its prices sufficiently, but that might price the product out of the market.  Some firms may close and the imports would cease.

On the other hand, the new plan allows a firm to deduct revenue from its exports from its taxable income.  This would allow the firm to increase its after-tax profit.

An article in the Wall Street Journal gives the example of a firm which presently has export sales of $10,000, cost of inputs $5,000, wages $2,000 and profit $3,000.  With the 35% corporate tax rate, the tax is $1,050 and after-tax profit is $1,950.

Under the new plan, the export sales of $10,000 is exempt from tax, so the company has zero tax.  Its profit after tax is thus $3,000.   The company can cut its export prices, demand for its product increases and the company can expand its sales and export revenues.

At the macro level, with imports reduced and exports increased, the US can cut its trade deficit, which is a major aim of the plan.

The US is a major export market for many developing countries, so the tax plan if implemented will have serious adverse effects on them.

The US is Malaysia’s third largest export market, in 2016 accounting for RM80 billion or 10% of total exports, with the most important exports being electronic products, optical and medical instruments, rubber and rubber products, palm oil and palm oil products.

An equivalent of 20% tax on these products may render some firms that use or sell them less profitable; and if the prices are forced upwards they may lose competitiveness to substitute products or similar locally-made products.   

American industrial companies are also investors in many developing countries. The tax plan if implemented would reduce the incentives for some of these companies of being located abroad as the as the parent company can no longer claim tax deductions for the goods imported from their subsidiary  companies abroad. 

According to a report in Malaysian newspaper, The Star (6 February 2017), speculation on industries relocating to the US is sparking concerns in Malaysia.  Major US factories in Malaysia producing electronics would be under watch. Also, electronic and electrical as well as garment companies in Malaysia, which are mainly sub-contractors for multinational companies, may be affected should they decide to bring back manufacturing jobs to the US.

The plan is bound to generate outrage from its trading partners, in both South and North.  They may take cases against the US at the WTO, which is likely to rule against the US.  The new tax deduction system discriminates against imports, thus violating the WTO rules of non-discrimination. The exemption of income tax for export sales would be most likely be assessed as an export subsidy prohibited by the WTO subsidy agreement.

Countries can challenge the US at the WTO.  However, it can take three to four years for a case in the WTO to be finally settled. Meanwhile the US can continue with its laws and practices and reap the benefits.

Another possibility is that Trump may make good his threat to leave the WTO, if important cases go against it.  That would cause a major crisis for multilateral trade.

There are many critics of the plan.  Larry Summers, a former US Treasury Secretary, warns that the tax change will worsen inequality, place punitive burdens on import-intensive sectors and companies, and harm the global economy.

The tax plan is expected to cause a 15-20% rise in the US dollar.  “This would do huge damage to dollar debtors all over the world and provoke financial crises in some emerging markets,” according to Summers. 

US retail companies like Walmart are strongly against, and an influential Republican, Steven Forbes, owner of Forbes magazine, has called the plan “insane.” 

 

It is not yet clear what Trump’s final position will be. If he finds it too difficult to use, because of the effect on some American companies and sectors, he might opt for the simpler use of tariffs.

In any case, whether tariffs or border taxes, policy makers and companies and employees in developing countries should pay attention to the trade policies being cooked up in Washington, and to voice their opinions.

Otherwise they may wake up to a world where their products are blocked from the US, the world’s largest market, and where the companies that were once so happy to make money in their countries suddenly pack up and return home.

 


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