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Posted on FEB 28, 2017

Johnson Bank Wealth Weekly Investment Commentary | Tuesday, February 28

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

BAT and You

If you are a major league baseball fan, you know that spring training has begun and games are underway. If you are a Brewers fan, you are trying to understand what “rebuilding” means. As we approach President Trump's address to the joint session of Congress today, we know that spring training isn't the only place you'll find bats; you'll likely find them in his speech tonight. In Trump's case BAT, for border adjustable tax.

The tax is a pillar of the proposed House Republican corporate tax reform plan, so it makes sense to understand its implications. The reason for its inclusion may be that it provides a revenue source to pay for the corporate tax cut that is also part of the plan.

If the tax were to be included in the bill that passes, it could also have an impact on the value of the dollar and the value of assets like stocks and bonds.

BAT Explained

The border adjustable tax is another name for a destination‐based cash flow tax. The tax is placed on imported goods, while exported goods receive a tax credit. In the eyes of tax reformers who favor the tax, it serves two purposes. The tax encourages domestic production by making foreign goods more expensive and, some believe, levels the playing field for U.S. international trade. It also encourages domestic production of parts that go into goods assembled here because foreign production of those parts becomes more expensive.

For example, my 2014 Ford F‐150 truck was assembled in Dearborn, Michigan, and the majority of its parts were also made in the U.S. That year, the F‐150 topped the American‐made car index, which requires that at least 75% of the parts in a vehicle are made in the U.S. The 2016 F‐150 didn't make the list (number one was the Toyota Camry) because, while it was assembled in the U.S., less than 75% of its parts were manufactured here. Under the new BAT, those parts manufactured in China, Mexico or Canada would be subject to the import tax levy and would therefore cost Ford more money to bring into the country, potentially raising the cost of the truck for consumers. Trucks assembled here and shipped overseas would receive an export credit.

Proponents of the tax believe that it is a way to shift taxes toward domestic consumption and away from income, which could create a more level playing field for international trade.

To date, America's largest retailers have come out against the tax while many in the manufacturing sector favor it. The National Retail Federation (NRF) has said that the tax could cost American families “$1,700 per year.” As costs of importing goods rise for retailers, the NRF suggests that those higher costs would be passed along to consumers. Proponents of the tax argue that the value of the dollar would increase, offsetting the higher cost of imported goods.

Dollar appreciation is possible because a currency's value partly reflects a country's balance of trade. The U.S. imports more than it exports, so we run a trade deficit. If the BAT reduced that deficit, the dollar could strengthen. In addition to affecting trade, this dollar strength would impact asset prices, so the outcome of the BAT debate bears watching.

While auto makers and retailers oppose the BAT, many in manufacturing favor it, particularly those that benefit most from exporting goods made here in the U.S. to overseas markets (Boeing, General Electric, Johnson & Johnson, etc.). Exporters would see a tax credit for the value of those goods exported, resulting in lower taxes. They argue that this would create a demand for job creation here in the U.S.

The reality is likely somewhere in between. The fact of the matter is that the change in the value of the currency should offset the additional cost for a retailer and the benefit for an exporting manufacturer. The real outcome is shifting taxes to consumption and away from the profits earned from trading activity, thereby reducing the corporate tax rate.

BAT and Markets

If the BAT were part of a tax reform bill, it would most certainly affect stock prices. Sectors including retail, energy and manufacturing would be most affected. Retailers would see a near‐term decline in profits as would manufacturers who use foreign parts when assembling their products here. Manufacturers who export their products would benefit.

The change in the value of the dollar would most certainly have to be reflected in the Federal Reserve's policy toward interest rates, so bond prices, too, would be affected.

BAT Politics

The House Republican tax plan includes the BAT because many in Congress know that in order to get a reduction in the corporate tax rate, they need to come up with a way to pay for that tax cut.

A BAT, paired with a 20% corporate tax rate, could raise nearly $120 billion in revenue per year, almost covering the tax reduction. Without a BAT, it is possible that the government's fiscal deficit would rise significantly. Last year, the deficit was over $500 billion, so the appetite among fiscal conservatives to add to that number with a corporate tax cut is low.

The president has said he believes that the tax is too complicated and that he isn't a fan. However, last week, after meeting with CEOs from a number of large multi‐national companies such as GE, Dow Chemical and Merck, he said he would “support a form of tax on the border.” Tonight we may get more insight into whether the Speaker of the House has been able to convince the administration that a corporate tax cut has to be paid for with a BAT. The dollar exchange rate may be the thing to watch Wednesday to see how clear the message was.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

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