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The Bond Column

Possibilities for Tax Reform
Updated: 2017-01-16, 08:55:27 ET
Analyst: David Kelland

Corporate tax reform has become a subject of great interest ever since Donald Trump's surprise victory in the November 8 presidential contest. The incoming president and the Republican Congress are in support of bringing down the top statutory rate (35%) but they need to broaden the base to prevent eye-watering deficits. A destination-based cash flow tax still appears to be a popular plan despite heavy lobbying against the idea by Koch Industries and retailers' trade groups. While the biggest change to corporate taxation in U.S history would appear an unlikely outcome given Washington, D.C.'s strong bias towards the status quo, 'unlikely' hasn't translated well to 'can be ignored' in recent months so it is worth being informed.

The current corporate tax system taxes U.S. domiciled companies on their net income, no matter where it is earned. That incentivizes companies to move expenses to the United States and move assets that throw off income, like patents, to low-tax countries like Ireland. The current system also promotes tax regime shopping, where the U.S. should (in theory, though not in practice) be competing against other countries to get companies to headquarter themselves here.

The destination-based cash flow tax would tax all revenue earned in the United States. By definition, export revenue would not be taxed, which businesses like. Importers are very wary of the DBCFT, however, because they cannot deduct the cost of goods sold from their revenues inside the United States. As a company like Walmart, if your cost of goods sold is very close to your revenue, the DBCFT could even push you into a wide loss.

Economists like Martin Feldstein argue that this supposes a static system and that the U.S. dollar would appreciate considerably after the implementation of a DBCFT. If that happened, the cost of goods sold for U.S. companies would fall sharply relative to their revenues and they could maybe even keep prices the same while earning roughly the same amount of money.
(If you think counterfactually, were the U.S. dollar to remain stable as the importers fear, U.S. exporters would drastically ramp up production and reduce prices abroad because their revenue would be tax free. All of that exporting activity would involve somebody buying U.S. dollars to purchase those goods and that would drive up the greenback.)

Some conservative economists oppose the idea of a DBCFT precisely because it would end tax regime shopping by companies. These economists note that governments in Europe got much bigger after the implementation of value-added taxes (VATs), which are similar in many respects to the DBCFT. The cash flow system would make it easier for the federal government to raise funds without hurting the tax base.

Liberal economists are opposed to the House Republicans' plan because it is almost guaranteed to have very regressive effects. Owners of capital in the United States are taxed lightly (capital gains taxes, 401K plans, IRAs) at the individual level say people like Larry Summers and so the the DBCFT will exacerbate inequality. Any tax reform from the incoming administration and Congress was going to be regressive though, and rates can always be changed over time. Summers also notes that the surge in the value of the U.S. dollar would benefit foreign holders of U.S. assets, including countries like China (with ~$1.2 tln in Treasuries).

The complexity of the current system certainly creates deadweight losses in the form of tax engineering, a misallocation of able minds to the goal of reducing tax bills.

Ok, so now for the implications for investors. Economists estimate that the value of the dollar could go up by a fifth in FX markets when the tax is fully implemented. Considering that the entire dollar rally from mid-2014 has only been about 25%, a move of that scale would be massive. It would almost certainly provoke balance of payments crises for countries with a lot of dollar-denominated debt (corporate or official).

The effect on interest rates is unclear if markets adjust smoothly. The House Republican's plan would also include immediate depreciation for investments which could lead to a capital spending boom. That would push up rates.  As a market participant, I am not sure how to approach this issue. It makes anything position in or against foreign currency seem very risky. My strategy would be to avoid big risks until there is more clarity on the issue. It is likely that some probability for this tax is already priced into foreign exchange markets. so there is danger on the long side of the dollar as well.

In any case, this is an issue to watch closely.

- David Kelland,