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Market Special February 2017: The Story of Humpty Dumpty of Taxes and A Wall

Since Donald Trump won America’s presidential election investors have been excited over the prospect of lower taxes. Mr Trump has promised to cut corporation tax from 35% to 15%. The coming reforms, though, are more than just about lower rates. Republicans want to overhaul business taxes completely. This task is far from straightforward.

America’s corporate-tax rate, which reaches 39.6% once state and local levies are included, is the highest in the rich world. But a series of deductions and credits keeps the bill down.

Border-adjustment, as the planned tax is called, would change the way firms calculate their profits for tax purposes. Revenue made from exports would no longer be included. Neither would costs related to importing goods. In short, exports would be subsidised, and imports taxed.

Interestingly, most economists do not view border-adjustment as a barrier to trade. In isolation, either an export subsidy or an import tax is plainly protectionist. But, at least in theory, an export subsidy and import tax of equal size should cancel each other out. Instead of disrupting trade, they should push up the dollar to the point where exports and imports cost the same as they did before the tax.

Humpty Dumpty sat on his wall

Border-adjustment would raise a lot of money. Because America runs a large trade deficit, taxes on imports would fill the Treasury’s coffers much more than rebates to exporters would drain them. Border-adjustment would raise about $10bn a year from the trade deficit with Mexico alone, assuming a tax rate of 20%. That would allow Mr Trump to claim that Mexico was paying for his border wall

The reform would come at a cost. The dollar appreciation needed to offset the tax would be massive. Assuming a tax rate of 20% - the rate Republicans prefer -, the dollar would need to rise by 25% for the tax to have no effect on trade. This would have two negative consequences. First, it would inflate the value of dollar-denominated debts in emerging markets, endangering their economies. Second, it would transfer wealth to those with dollar assets. Ironically, this would greatly benefit China, which would see the value of its USD 3trn Treasury portfolio go up by a quarter in local currency.

In reality, it might take time for the dollar to rise. If so, American exporters would benefit in the interim. Big importers, however, would take a hit. Trade groups are already campaigning against the change. That suggests firms expect the tax to impede trade after all. Border-adjustment is a politically convenient way for Mr Trump to pay for the wall. But it will either distort trade, or push up the dollar, or some combination of both. Either way, markets could be in for a few surprises yet.

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