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U.S. tax reform affects trade, other economies
Black Friday, Cyber Monday, Giving Tuesday, the triple play ritual following the Thanksgiving holiday has ended. The economic engine of the holiday season is in full force. The GDP of the nation is dependent on this activity in the fourth calendar quarter. Future economic activity may be dependent on other forces currently at work.
The United States economy has changed in the past decade or two because of international trade. This trade activity impacts the economy in many ways. Many of the goods we purchase have some non-U.S. content within them. Exports from the U.S. create many jobs and investment in the country. Many U.S. companies have earned significant levels of profit outside the U.S. and have significant earnings in their foreign subsidiaries. We have seen the turmoil that Brexit has created in the European Union (EU) and the United Kingdom (U.K.). This all demonstrates the economies of the world are more interconnected than ever and often are impacted by activities and actions that didn’t occur within their own (home) country.
As the year ends, we need to be mindful of some of the activities that are occurring and their potential impact on the U.S. and world economies. All of these activities may impact our own individual economic position in one way or another.
In recent weeks, we have seen proposals in Congress dealing with tax reform. Both the Senate and the House of Representatives have had their own proposals working through their respective processes in each legislative body. As the legislation moves forward, a final package may make its way to the President’s desk for signature and enactment before year-end.
The proposed changes certainly may impact business decisions in the U.S., as well as international trade. There are many proposals that would impact business taxation. We have previously discussed some of the attributes of the U.S. tax system that place the U.S. at a disadvantage when compared to tax systems of our major trading partners.
The proposed reduction in the U.S. federal corporate tax rate from 35 percent to a rate approximating 20 percent will change the U.S. from a high tax jurisdiction to a lower tax jurisdiction. The U.S. last reduced its corporate tax rate in the major tax reform that took place in 1986. At that time, the U.S. became a lower tax jurisdiction when compared to its major trading partners. In the intervening 31 years, the U.S. corporate income rate has not been reduced while the U.S.’s major trading partners reduced their corporate income tax rates below the U.S. corporate income tax rate.
The taxation of earnings of foreign subsidiaries has been highlighted by many as one of the items in the current U.S. tax code that should be changed or modified. Both the House and Senate versions of tax reform include a one-time repatriation tax for past earnings and an exemption system for future foreign subsidiary earnings of U.S multinational groups. There also are proposed changes on how payments to foreign-related parties should be treated. These proposals are in addition to proposed changes in capital expensing and business interest deductions. The complexity and calculations with many of the proposed changes may affect taxpayers in different ways. Computing the U.S. tax liability of a multinational company may not be an easy task in future years.
Our trading partners are keenly aware of the proposed changes and the possible impact on their companies that do business in the U.S. The proposals on capital expensing and reduced corporate tax rate may impact decisions on where to locate operations, as the U.S. may look more attractive if those proposed changes are enacted. Onshoring rather than offshoring may become the trend.
Trade agreements also may impact cross-border business activity. In recent months, the U.S. has been involved in negotiations with Canada and Mexico on updating the North American Free Trade Agreement (NAFTA). The current agreement is nearly 24 years old and was completed when President Bill Clinton was in office. There have been several rounds of NAFTA negotiations in recent months.
The debate over various provisions in NAFTA may impact Michigan companies. More than 7 percent of the state’s GDP is related to goods manufactured in Michigan and sold to Canada and Mexico per a recent report published by BMO Capital Markets. No other state has a higher proportion of its GDP dependent on exports to our NAFTA partners. The report indicates 32 states currently have Canada as their largest destination for exports, and six states list Mexico as their top export market. The largest single industry that may be impacted by any NAFTA changes is likely the automotive industry since so many vehicles and components move across the U.S.-Canada border. Any changes may — and likely will — directly impact West Michigan.
Trade and tax policies and their impact on the economy also may have an impact on the currency exchange rate between the U.S. and a foreign trading partner. Fluctuations in currency exchange rates between trading countries can impact the pricing of imports and exports between the two respective countries. It may also impact interest rates and the cost of business and government borrowing.
The U.S. is not the only country having discussions on tax reform. Canada has its own tax reform under discussion. The current government in Canada recently proposed and then withdrew some proposals on the taxation of small businesses and their shareholders in Canada. Small business in Canada small business is very similar to small business in the U.S. in that it is a large driver of job creation. Any changes in tax policy in Canada will impact those businesses and their owners and likely will impact cross-border economic activity. There were numerous discussions in the Canadian business press on what U.S. tax reform will do to Canadian business and the Canadian economy. Any changes in NAFTA also will impact the Canadian economy.
Taxes and trade policy does impact business activity in a global economy. Legislative and policy changes in these areas can impact interest rates and currency exchange rates in addition to the prices of goods and services. Change is often good but does create some disruption as the change happens. The days and weeks ahead may confirm this.
William Roth is a tax partner with the local office of international accounting firm BDO USA LLP.