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How a controversial GOP plan could boost the taxes on a sweater from $1.75 to $17

President-elect Donald Trump's tariff rhetoric has gotten a lot of attention, but it's actually the Republican House Ways and Means Committee's "A Better Way" tax reform proposal that's scaring the pants off clothing and shoe retailers.

The plan was proposed in June, but wasn't a focal point until it became more of a possibility under a Republican-controlled Congress and White House.

Now, retailers are nervous. Very nervous.

As expected with a corporate tax reform policy, it's complex, but it boils down to three pieces.

First, instituting a flat 20 percent corporate tax, which is a welcome change from a typical 35 percent corporate tax rate.

Second, it allows for the immediate expense of business investments, instead of over time as it is now. That's part is likely OK with many, too.

But, the third piece is the real zinger for retail. It's a border-adjustment tax for goods that are imported. About 95 percent of clothing and shoes sold in the U.S. are manufactured overseas, which means imports make up a vast majority of many U.S. retailers' merchandise. The tax is aimed at encouraging more manufacturing in the U.S. as well as raising government funds.


retail shopper
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Using very simple math to illustrate how the tax law works for retailers importing goods currently:

A retailer like the Gap buys a sweater from its overseas manufacturer for $80. Gap has an additional $15 in other expenses associated with that sweater (like transporting it). Gap sells the sweater to a shopper for $100. So tax is calculated by taking that $100 in revenue, subtracting the $80 cost of the good, subtracting the $15 other costs, leaving $5 in profit. If Gap pays a typical 35 percent tax rate on the $5 profit, its tax bill for that sweater is $1.75.

If the GOP plan was adopted as it's currently laid out, Gap pays 20 percent corporate tax on the $5 profit from the sweater, or $1. Plus, 20 percent tax on the $80 cost it paid for that sweater from the overseas supplier, or $16.

That means the tax goes from $1.75 to $17 for that sweater, more than three times the profit on that sweater. Talk about a hit to margins.

One answer is that retailers increase the prices shoppers pay. But that's going to be a hard sell. Clothing prices have actually been falling for years, and consumers are addicted to discounts. Good luck trying to sell that sweater for more.


Putting the theory to the test

Some economists argue that trade equilibrium will cause the dollar to strengthen enough to offset the above scenario. If a retailer, like Gap, has to pay import taxes, it will be less incentivized to buy those imported goods. Proponents say economic theory suggests imports are then less desirable, so in response, the overseas supplier will then sell its goods more cheaply. Thus, the dollar will be able to buy in the foreign currency at the cost of fewer dollars, so the dollar appreciates until the trade comes back into balance.

The math works out that the greenback would have to appreciate 25 percent in order to even it out for importers, and economists aren't sure how fast that will happen.

Alan Viard, economist and resident scholar at the American Enterprise Institute said, "There's no scenario in which the dollar would not appreciate" but he adds that how fast it happens is debatable. "Logically, it should be a quick, or immediate adjustment, but economics are not good at predicting speed."

Goldman Sachs economist Alec Phillips doesn't expect the dollar to appreciate as theory predicts. In a research note, he said, "It is unlikely that nominal or even real exchange rates would in fact adjust so quickly and perfectly."

Jack Kleinhenz, chief economist for the National Retail Federation, said he understands that theory suggests currency adjustment should counteract border taxes, but he isn't sure it will actually play out that way. The NRF, the retail industry's trade group, has generally been opposed to tariffs on goods.

"This is pretty old-style thinking, it is not clear that [exchange rates] will adjust, however. These days exchange rates are determined by financial flows," Kleinhenz said. Among the forces at play are "speculation, inflation rates (current and expected), interest rates, political regimes (performance and policies), level of interest rates, amount of debt" and of course, the supply and demand for dollars.

"Theoretical evidence suggests the currency appreciation evens the cost out," said JPMorgan economist Michael Feroli. But, he also acknowledged "there could be a retail profitability margin story that's not being appreciated by economists."

Retailers certainly aren't taking a lot of comfort in the economic theory of dollar appreciation.


Winners and losers

So even though there are many caveats and assumptions, analysts are trying to model which retailers could get hit the hardest if the border adjustments go through. Retailers don't have the realistic option of sourcing from here in the U.S. The facilities and skilled labor just don't exist in the U.S. to take the place of what's manufactured abroad.

Most analysts agree the tax would hit the specialty retailers the most as nearly all of the goods they sell are imported after being produced overseas.

JPMorgan analyst Matthew Boss said he expects the tax reform plan will dilute specialty retailers' earnings by an average of 132 percent. In his coverage, that includes companies like Abercrombie & Fitch, Ascena Retail and Boot Barn because each source heavily overseas and sell mainly in the U.S.

Athletic manufacturers could take a 40 percent earnings hit, but Under Armour would feel it more than Nike because Nike sells more of its goods in other countries than Under Armour, and those goods wouldn't have the extra import cost tacked on, Boss said. Department stores' earnings will take an average 14 percent hit, with J.C. Penney and Kohl's getting hit the worst, he said.

Wells Fargo's Ike Boruchow said Gap, Carter's, Urban Outfitters, Fossil and Under Armour are most at risk under the plan.

KeyBanc's Ed Yruma said he expects high-end names like Tiffany, Nordstrom and Net-A-Porter are more insulated, given the ability to pass along higher prices to their more affluent shoppers.

JPMorgan and Wells Fargo analysts both cited the off-price retailers like TJX Companies, Ross Stores and Burlington as examples of retailers that could actually see an earnings benefit from border-adjustments because they have lower levels of imports, higher domestic sales and recent strong sales performance.

There's no certainty this plan will come to fruition exactly as proposed, and if it does, exactly when. But there is a stronger chance it will be at least proposed to the House of Representatives by Ways and Means Committee Chairman Kevin Brady (R-Texas) with the border-adjustments as a key cornerstone.