The Independent Market Observer

How a Border Tax Could Backfire on the U.S. Economy

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 27, 2017 3:02:50 PM

and tagged Politics and the Economy

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border taxIn the past couple of days, I’ve led a pretty optimistic quarterly call for investors, given a couple of pretty optimistic TV interviews, and written some fairly optimistic pieces here on the blog. Although I stand by all of my statements, it occurs to me that, for someone known as Eeyore, I’ve displayed an unusual amount of optimism lately. Time for a reality check.

A key assumption in looking to the future is that current conditions will continue to apply. That’s usually a pretty safe assumption to make, but events in Washington, DC, are increasingly calling it into question. One of the most interesting things about Donald Trump's candidacy was how many of his supporters believed he wouldn’t actually do what he promised. Now, with the Trump presidency, we are finding out that he can and will do exactly what he said.

Disrupting the economic status quo—for better or for worse

Currently, the U.S. is in a commanding position in the global economy. American companies have taken advantage of outsourcing to raise profits and lower costs. The U.S. is completely secure at home, job growth is strong, and the economy is growing, albeit slowly. If this continues, the next year or so should bring accelerating growth and continued favorable conditions for workers and markets.

Trump was elected to disrupt the status quo, and he appears committed to doing just that. Although there are real potential upsides to his actions, as investors, we also need to consider the downsides. When the status quo is bad, as many voters apparently felt it was, disruption is good. When the status quo is actually pretty good, as it is for the economy as a whole, the costs of disruption could rise exponentially.

The trouble with a border tax

Let’s consider the current situation with Mexico. Just days into Trump’s presidency, we face the biggest diplomatic rupture in years—possibly decades—with one of our closest neighbors, on whom we depend for border security. In response, the Trump administration has floated the idea of imposing a border tax, which is also consistent with House Republican plans. What might that mean?

Well, the U.S. auto industry depends on Mexican factories and parts. If costs go up, so do car prices. If the border becomes less efficient, so do the auto companies. This hurts U.S. workers, who will be paying more for cars, and who may be working less due to parts shortages. It hurts companies, who will be making fewer cars and less money. Of course, it will also hurt Mexico, making it a far less accommodating neighbor. Extending this strategy to China would only exacerbate the damage.

In reality, border taxes on imports would largely end up being paid by consumers. Consider Walmart, which imports about $50 billion in goods each year from China. A 20-percent border tax would cost $10 billion per year, money that would either come from Walmart’s profits or (more likely) its customers’ pockets, in the form of higher prices.

With Walmart’s sales at around $130 billion, that $10 billion would represent price increases of more than 7 percent. This would hit the poorest Americans the hardest—in many cases, wiping out the past three years of wage growth in one shot. What would this do to confidence and consumer spending growth—and by extension, the economy as a whole?

U.S. economy could end up paying

Looking at President Trump’s policies so far, and assuming that he will continue to execute on his promises, we can very reasonably anticipate higher inflation, consequent faster increases in interest rates, and decreased consumer confidence as people find their cost of living rising faster than their wages. None of this is guaranteed, of course, but it is a real possibility and one that we as investors need to keep in mind.

The foundations of the current recovery include growing consumer confidence and low interest rates, both of which could be at risk. Note also the gap between strong confidence, which is positive for the future, and weaker current data, which shows that confidence has not yet translated into actual growth. Any erosion of confidence could hurt those growth prospects substantially.

In prior years, the economy has been weak and policy has supported it. As we approach normal conditions—and we are very close—the economy has been strengthening and policy has become less relevant to how we approach our investments. Now, it looks like policy may return to center stage very soon.

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