The week ahead should feature solid January Job gains, confirmation of a strong earnings season, very healthy global PMI indices and a Federal Reserve firmly teeing up the market for a March rate hike. However, the attention of investors will likely still be focused on Washington.
It is perhaps an understatement to note that President Trump’s first days in office have been busy on many fronts. However, for investors, his statements on trade policy may be the most consequential. So what actions are being discussed, what is likely to be enacted, and what does all of this mean for the economy and investing?
To understand why trade policy is such a hot issue, just note that last year the U.S. ran a current account trade deficit of roughly $500 billion or 2.7% of our GDP. This was a key issue in the Presidential election as it was alleged by both the left and the right that this trade deficit was just a manifestation of “unfair” trade deals, such as NAFTA, which have allegedly decimated U.S. manufacturing. As an example of this argument, in the first presidential debate, when discussing NAFTA, Mr. Trump said: “When we sell into Mexico, there’s a tax…..- an automatic 16% approximately – when they sell to us, there’s no tax. It’s a defective agreement”. The 16% he mentioned was presumably, Mexico’s 16% value-added tax or VAT – a subject to which we will return.
In prescribing policy remedies for our trade deficit, the President has argued in favor of tariffs on China in retaliation for alleged currency manipulation. In addition, the new Administration has speculated on whether a tariff on Mexico could “pay” for a wall on the U.S. border with Mexico. The President has separately proposed leaving the current corporate tax structure in place but dramatically cutting the tax rate and allowing for an even lower rate on repatriated foreign profits.
As an alternative, House Speaker Paul Ryan has proposed achieving the goals of both tariffs and corporate tax reform by replacing the current corporate tax system with a tax on corporate cash-flow with border adjustments which, for simplicity, we can call a Border Adjustment Tax or BAT.
In order to consider which policy might be adopted and what it might mean for investors, it is crucial to understand the difference between a tariff, a VAT and a BAT.
So let’s start with a tariff.
A tariff is simply a tax on imports which could raise substantial revenue for the government. Indeed, the President’s press secretary has suggested that a 20% tariff on Mexican goods and services would be one way to force Mexico to “pay” for the cost of building the wall. It should be noted that, in 2015, the U.S. imported $316 billion in goods and services from Mexico and exported $267 billion to Mexico, thus running a trade deficit with Mexico of $49 billion. A 20% tariff on goods and services imported from Mexico would, in theory, raise roughly $62 billion, far more than the total cost of the wall, assuming that the volume of U.S. imports from Mexico was roughly unchanged. Even if the volume of imports from Mexico fell, the revenue raised would be substantial.
However, economists generally regard tariffs as a terrible idea. The first result of such a policy is that U.S. consumers would have to pay more for Mexican imports, making them worse off. They would presumably also buy fewer of these imports, leading to layoffs among Mexican workers. The second result of such a policy is that Mexico would very likely retaliate with tariffs of its own, hurting Mexican consumers and U.S. workers. The volume of trade would be lower, consumers and workers would be worse off on both sides of the border and Mexican and U.S. government revenue would be higher. In short, a tariff for a tariff makes the whole world poor.
But what about the President’s charge that current U.S.-Mexico trade relations are grossly unfair because Mexico taxes our exports at the border and we don’t tax theirs?