Trump's Border Tax Could Be a $23.3 Trillion Headache

By Sean Williams Markets Fool.com

Image source: Michael Vadon, Flickr.

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As was to be expected in going from the Obama administration to the Trump administration, we've seen a number of notable changes during Donald Trump's first two weeks in office. For instance, Trump has signed off on legislation to ease the burdens of the Affordable Care Act, as well as removed the U.S. from entering into the Trans-Pacific Partnership.

However, with a little more than two weeks under his belt as president, Trump is faced with tackling some of his larger campaign pledges, one of which involves building a border wall between the United States and Mexico at an estimated cost of roughly $14 billion. The big hurdle in executing this massive construction project is in figuring out how it will be paid for, especially when Trump touted during his campaign that Mexico would pay for the wall -- a view that Mexican President Enrique Pena Nieto has regularly denied.

What is a border adjustment tax?

House Republicans believe they have a plan to pay for the border wall: the border adjustment tax (BAT). A border adjustment tax would completely change the way a lot of corporations pay taxes by making the location of a business no longer important. Instead, only the final destination of a good would really matter.

Here's how it would work. If a U.S. company exported a good anywhere outside the United States, it would receive a rebate that would essentially exempt it from taxation. However, goods imported into the U.S. would be hit with an import levy (estimated at 20%) that would make them more expensive. Presumably, Mexican goods would be hit by this import tax, making their products more expensive and thus paying for the border wall, in the eyes of House Republicans.

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Image source: Getty Images.

One of the perceived benefits of the BAT is that it would reduce or eliminate the need for U.S. multinationals to seek tax inversion deals. Tax inversions involve mergers and acquisitions with similarly sized businesses in overseas markets with lower corporate income tax rates, allowing the often larger U.S. business to redomicile its headquarters overseas. If U.S. multinationals were suddenly netting a tax rebate on exports, export-driven companies would presumably see significant bottom-line benefits, and the desire to seek tax inversions would be expected to wane. This, in turn, would mean the current bounty of $2.5 trillion in cash being held in overseas markets by U.S. multinationals may not grow anymore, supplying the U.S. economy with potentially fresh investment capital.

Is the BAT a bad idea?

However, the idea of implementing a border adjustment tax has its fair share of critics.

To begin with, implementing an import tax on goods only winds up increasing the price U.S. consumers have to pay for those goods. It's always possible that foreign manufacturers could choose to eat the tax and keep their prices competitive, but that seems highly unlikely. Products such as automobiles, apparel, and electronics are commonly imported goods in the U.S., meaning they could rise by an estimated 20%. Ultimately, this would mean the U.S. consumer, and not Mexico, would be paying the $14 billion for the border wall.

Second, there's always the possibility that a BAT could incite a trade war between the U.S. and other nations. In other words, the benefit that U.S. multinationals enjoy from exporting goods to other countries and receiving a tax rebate could be somewhat or entirely offset by other countries, including Mexico, retaliating and slapping an import tax on U.S. goods. Presumably, placing an import tax on U.S. products could reduce their demand and negate any effort to reduce the roughly $330 billion annual U.S. trade deficit.

Image source: Getty Images.

A border tax may also wind up being a global job killer. If businesses see reduced demand for their products because of higher prices, they may choose to cut costs and jobs. This goes for U.S. companies as well as overseas companies and U.S. multinationals.

A $23.3 trillion headache in the making

But there could be an even bigger issue at stake by implementing a border adjustment tax.

According to most economists, implementing a BAT would lead to a pretty sizable increase in the value of the U.S. dollar. If imported goods go up in price, U.S. consumers would be expected to buy less, leading to fewer U.S. dollars in foreign markets. This reduced supply of U.S. dollars would work to increase the value of the dollar. Conversely, having a tax rebate in place on exports allows U.S. goods to be more price-competitive in foreign markets, meaning consumers will need more U.S. dollars, thus driving up the price of the dollar. Most estimates peg the expected increase in the dollar to be between 15% and 25% over the course of a couple of years.

On the surface, increasing the value of the dollar might seem somewhat benign. A stronger dollar would presumably allow consumers to purchase imported goods for roughly the same "price" as they do now, even if a border adjustment tax is added.

Image source: Getty Images.

However, there's a potentially nasty surprise awaiting U.S. investors if the dollar appreciates as much as some economists have suggested. Foreign assets and investments could be crushed if the dollar strengthens against other major currencies, leaving Americans and their $23.3 trillion in foreign investments as of 2015 in deep trouble.

Based on data from the U.S. Department of Commerce, U.S. investors have more than $4 trillion invested separately in foreign stocks, foreign derivatives, and through direct investment in foreign countries. Strength in the dollar could substantially devalue foreign currencies, negatively affecting this $23.3 trillion in foreign investment, and causing a big headache for U.S. investors.

According to the Los Angeles Times, a border adjustment tax could wind up being nothing more than a gamble on the currency market. If the dollar doesn't do what economists predict, which is a distinct possibility given the unpredictable nature of markets in the near-term, U.S. investors with foreign investment exposure could face the brunt of the pain.

It's worth pointing out that the border tax adjustment is an idea at the moment and not a guaranteed to find its way into law. Nonetheless, Trump is eager to keep his campaign pledge to construct a wall between the U.S. and Mexico, and a border tax might be the solution he and Republicans arrive at. For consumers and investors, this bears close monitoring.

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