According to CNBC, “Senate aides now believe at least six Republican senators oppose border adjustment. If they hold firm, that would be enough to kill the idea in a chamber where the GOP holds a bare 52-seat majority.”
This is a significant issue to follow for the performance of the stock market. Since the election of Donald Trump, the US equity markets have rallied 10%+ on the expectation of tax reform that would reduce corporate taxes from 35% to 20% according to the House tax plan. The potential reduction in corporate taxes would be a major driver to increased S&P 500 earnings, which the market is already pricing in.
In order to pay for the reduction in corporate taxes, the House is proposing a 20% border adjustment tax which would tax imports at 20% and exempt exports from this tax. This border adjustment tax would raise $1 trillion over 10 years and is expected to largely offset the loss in revenue from tax cuts.
During the State of the Union address, President Trump seemed to give a nod towards border adjustment when telling the story of how Harley Davidson motorcycles are taxed up to 100% abroad, but foreign motorcycles in the US are not taxed at all. However, Trump has also called the border adjustment tax “too complicated” in the past, so it is not yet clear if Trump has officially endorsed the border adjustment.
The bigger pushback as reported by multiple media outlets seems to be coming from Senate Republicans. Some senators are concerned about the impact of border adjustment on large retailers in their home states, such as Walmart. Critics of the border adjustment tax believe that taxing imports will result in an immediate increase in the cost of living to consumers and will disproportionately hurt industries reliant on imports, such as large retailers. Supporters of border adjustment contend that the US dollar will strengthen by enough to offset the tax.
However, the academic concept of the US dollar strengthening by 20% in order to fully offset the 20% border adjustment tax is not guaranteed, and to the extent that foreign exchange rates do not adjust, the cost of imported goods will rise meaningfully for American consumers. And in the event that the US dollar does strengthen by 20%, this would create its own issues such as making the cost of US exports significantly more expensive to foreign countries, and a stronger US dollar would also create a significant FX translation headwind to US companies with foreign sales, resulting in lower earnings.
But getting back to the Senate Republicans – if Senate Republicans do not support the border adjustment tax, the probability of success for real tax reform would be lowered significantly. Which begs the question – what will happen to the market if investors start thinking that tax reform isn’t coming?
Either way, tax reform is setting up to be a much harder and longer battle than most people seem to be anticipating currently.
Disclaimer– This article is for informational purposes and does not constitute financial or other advice. Please consult with your financial advisor before making any investment decisions. Please read full disclaimers here.