By Philip Sutter, GTM Governance, United States
The 2016 U.S. presidential election was a vote to initiate change. Central to the campaign rhetoric on both sides was dissatisfaction with U.S. trade policy. It is expected that President Donald J. Trump will follow through on many of the proposed changes, and the trade industry must prepare itself. This article focuses on two of the most impactful trade policies subject to change; the future of the North American Free Trade Agreement (NAFTA) and the potential for a Border Adjustment Mechanism to replace the current corporate income tax.
North American Free Trade Agreement
NAFTA entered into force in 1994 between the U.S., Canada, and Mexico. It was controversial from the outset and remains so. In the 1992 U.S. presidential campaign, third party candidate and billionaire Ross Perot based his campaign on the negative impacts of NAFTA; his slogan was to warn about the “giant sucking sound” of jobs that would leave the United States.1 Its detractors, such as the U.S. labor unions, provide statistics that they maintain prove Mr. Perot was correct, while international companies see NAFTA as a model for global competitiveness.
Critics cite that the U.S. to Mexico cumulative current account balance (difference between savings and its investment) has gone from breakeven in 1994 to about a trillion-dollar deficit today. They also observe that U.S. productivity has steadily increased while hourly compensation has stagnated and the manufacturing base has fallen. Although conceding that overall trade has increased after NAFTA, they say this has only benefited corporate investors at the expense of worker protections in all three countries.
Proponents of NAFTA believe that the agreement has been overall beneficial to the U.S. as well as Mexico and Canada. For example, consumers have been the recipients of lower cost goods through reduced tariffs. Also, NAFTA has created an integrated North American supply chain that mitigated the loss of jobs and investments primarily to Asia while improving global competitiveness.2
Trade among the NAFTA countries has increased by 3.8 times, showing that free trade agreements benefit each nation through their comparative advantages. U.S. foreign direct investment in Mexico has risen over 700%. Mexico has been transformed through a growing economy. Despite the serious issues with drug cartels and border security, NAFTA has helped Mexico become a more modern and open U.S. neighbor.3
Is NAFTA repeal possible?
Article 2205 of NAFTA allows a Party to withdraw with six months’ advance notice. Further, Article 125 of the Trade Act of 1974 gives the president the authority to do so.
A reasonable alternative to repealing NAFTA is to update portions of it. As one of the first U.S. free trade agreements, many would agree that a refresh is needed. A renegotiation could include revisions to address investor-state dispute systems, labor and environment obligations, currency manipulation, and enforcement provisions. Also, the rules of origin of NAFTA are very complex. A rewrite could look at simplifying the rules especially for the qualification of vehicles and automobile parts. Changes can be expected, but how quickly and extensively is unknown.
Border Adjustment Mechanism
The proposed Border Adjustment Mechanism (BAM) is a potential major change to the U.S. corporate tax structure with a particular emphasis on the promotion of exports over imports. If enacted, it will convert the income tax to a form of cash flow consumption tax. The BAM seeks to reverse trends such as the decline in the number of large global companies headquartered in the U.S., which has decreased from seventeen in 1960 to just six today. The Trump Administration is evaluating plans best suited to rectify this.
According to taxfoundation.org4, the current BAM design has five major components:
- Lower corporate income tax rate from 35% to 20%.
- Allow capital investments to be treated as expenses.
- Eliminate tax on foreign profits.
- Eliminate interest expense deductions.
- Make border tax adjustment based on a destination basis.
The point is to exempt export revenues from taxes while not allowing the cost of goods imported to be deducted from revenue. The corporate tax would be centered on activity that occurs in the United States. The BAM will eliminate the tax incentive for U.S.-based multinationals to shift profitable production to low tax countries or become foreign-resident companies. Simply, the tax is applied based on where the goods are consumed rather than where they are produced.
It’s expected that once in place, the BAM will strengthen the U.S. dollar. The import tax raises the price of foreign goods and reduces domestic demand for them and thereby reduces the demand for the U.S. dollar that drives up its value compared to other currencies. Meanwhile, the export tax exemption works as a subsidy allowing U.S. producers to lower their prices driving up foreign demand which also increases the value of the U.S. dollar.5 It is complicated economic modelling, but overall its proponents say it will increase U.S. gross domestic product, wages, and employment.
Conversely, the opponents of BAM are import-heavy industries such as retailers and electronics companies. They believe their interests will be disproportionally harmed by inflation-driven consumer price increases.6 They are skeptical of the anticipated exchange rate offset which is supposed to raise their profits and negate the tax applied to imports.7
Many other countries impose value added taxes (VAT), which are considered indirect taxes. Although the BAM has a similar impact as a VAT, the World Trade Organization (WTO) may judge it to be a direct tax that favors domestic producers over foreign producers. There may arise a challenge to the BAM on that basis.8
To be sure, the trade industry should be prepared to follow NAFTA, BAM, and other 2017 U.S. trade policy developments closely, understand the impact to their business, and be ready to adjust. Change to long held policies can be harmful, however, winners will emerge from those able to adapt and recognize new opportunities.