A controversial proposal to tax all goods and services coming into the United States has a better chance of becoming law than many on Wall Street suspect.
The so-called "border-adjusted" tax is part of the House tax overhaul plan that also would reduce the corporate rate from 35 percent to 20 percent.
The idea is to tax goods as they come into the country from overseas, but to avoid taxing U.S. exports at all. For instance, a car imported into the U.S. from Mexico would be taxed, but the American-made steel sent to Mexico would not.
Proponents say the proposed "destination tax" would encourage more U.S. production of goods and create U.S. jobs. But opponents say it will send prices higher, unfairly cut profits for some sectors, particularly the retail industry, and could prompt retaliation. The idea is similar but not quite like a VAT, or value added tax, common in other countries.
The stock market has been celebrating promises of lower corporate taxes that could boost business spending, but it has been ignoring proposals that could sting some companies' bottom lines. Retailers, automakers and refiners are among the industries that could be hit if imports are taxed.
"I think the market is focused on the candy — lower tax rates — and not the spinach that's needed to pay for it," said Daniel Clifton, head of policy research at advisory firm Strategas. Clifton said that after Donald Trump was elected president, the odds of a border-adjusted corporate tax rose from 10 percent to about 30 percent.
Trump and the Republican Congress are expected to take a swing at overhauling corporate and individual taxes in some form, merging Trump's plan and the Congressional proposal, with the hope of making changes for the 2017 calendar year.
"Every time I look at the House Republicans saying this is going to be included, you have to take this proposal seriously," said Clifton. "The U.S. has a corporate income tax, and what they are doing is making that corporate income tax border-adjustable, so the only thing that matters is whether something is produced ... If the import comes from outside the U.S., the U.S. company is paying a tax on the item. If the company exports their product, the income from that sale will not taxable. This is why Republicans refer to it as a destination tax."
The prospect of a 20 percent corporate tax rate — from 35 percent — and a plan for repatriation of corporate cash stashed overseas have helped send stocks higher since the Nov. 8 election. The market has also been focused on a reduction in the capital gains tax rate for some investors, as Congress is expected to eliminate the 3.8 percent tax, related to the Affordable Care Act, on top of the already 20 percent capital gains tax rate.
Julian Emanuel, equity and derivatives strategist at UBS, said he expects the corporate tax rate will end up being between 20 and 25 percent, as legislators weigh tax cuts against revenues. Trump proposes a 15 percent corporate tax rate.
Emanuel said the destination tax can't be dismissed, even though for now Wall Street is not giving it high odds. "It's on the table ... if we've learned anything in 2016, it's that anything is possible," he said.
Clifton said the border-adjusted tax is a way to lower the tax rate dramatically, and without it, the corporate tax rate could not be cut as much as proposed.
"Number one, Donald Trump says he's going to do tariffs, but this is a way of doing tariffs but in a less hurtful way. It begins to create incentives for companies to come back to the U.S. It also gives you a ton of tax revenues that could be used to get the corporate tax rate lower," Clifton said.
Goldman Sachs economists also put a one-in-three chance on the idea of a destination-based, border-adjusted corporate tax gaining approval. They expect the proposal to continue to remain in the legislation as it goes through the early stages of consideration, and that could put more focus on it.
The proposal is part of an effort to keep the tax cuts revenue neutral by increasing the base. But it's already creating a stir in sectors that would be hurt most — retail, autos and refining.
"When you broaden the base, you step on many, many lobbyists' toes, and many industries get hurt by it. That means it's going to be a real feeding frenzy next year," said Citigroup head of North American economics William Lee.
As Wall Street scrambles to analyze the tax's effect on profits, economists say a border-adjusted levy could impede growth. But they also say it could trigger a rise in the dollar, and that would be a positive offset of the effects of the tax.
While it should also make imports less desirable and boost exports, there are a whole range of effects that remain unclear, like what it would do to cross-border services, such as those provided by investment firms, lawyers and others.
"It's extremely difficult to model. It's generally accepted that something like that would cause the dollar to rise, and we would note the dollar has already risen since prior to the election by a degree of magnitude that would imply an earnings headwind of around 2 percent at the S&P 500 level," said Emanuel.
Clifton said there would be winners and losers on both sides. Boeing, for instance, imports parts for manufacturing, as does the auto industry. But then what it makes and exports would no longer be taxed. Clifton said he expects to see proposals made for some industries to be exempted, possibly North American oil for one, or maybe even the entire services sector.
"When you broaden the base, you step on many, many lobbyists toes and many industries get hurt by it. That means it's going to be a real feeding frenzy next year," said Citigroup head of North American economics William Lee.
Citigroup's Lee said the House proposal to end interest deductibility is more worrisome. All companies that regularly borrow funds would see their costs rise, and those that are depend on debt in the high-yield world would feel an especially hard pinch.
"That would change the way financing is done. All this debt financing goes out the window, and it will raise the effective corporate tax rate," he said. U.S. companies have issued a record amount of new investment-grade corporate debt, totaling more than $1.3 trillion. "It would kill our [mergers and acquisition] industry in a heartbeat. It would be quite costly … that effectively raises the tax rate on all companies."
But Lee said the destination tax is still a "battle of the wonks," and it's not clear how far it will go.
"If it does happen, it will take five years to happen. The whole trick is you change the balance of trade. You lower imports and you raise exports. That means the dollar should appreciate. The U.S. is running the reverse. The dollar responds to a lot of things. It responds most to interest rate differentials. Monetary policy has the biggest impact on the dollar, and these trade effects slip in after that," he said.
Brattle Group, a consulting firm, said the price of gasoline could rise by 30 cents per gallon if imports are taxed.
The U.S. imports about 8 million barrels of oil a day, and they would be taxed under the proposal. The U.S. also produces about 8.6 million barrels a day. Most of the imports come from Canada, but also Saudi Arabia, which brings in oil to refine in the Saudi Aramco owned plant in Texas.
"It will raise the price of the consumer basket or reorient it toward domestic consumption," Lee said.
In the case of retailers, they would have to charge more for apparel, electronics and other goods made predominantly in Asia or Mexico, since the United States is not a big manufacturer of those items. Ninety-five percent of shoes and clothing sold in the U.S. is made elsewhere.
Lee said the proposal got more attention after Texas Rep. Kevin Brady, chairman of the House Ways and Means Committee, said last weekend that border adjustability is an important part of the tax plan and it would stay in.
Brady, on Squawk Box Tuesday, said the restructuring of the tax code will redesign international trade policies and create a more level playing field for U.S. companies to do business at home. Brady said people working on the proposed law are "making sure we eliminate every tax incentive to move jobs or resources or headquarters overseas."