As Republicans in the US House of Representatives eye “tax reform,” what they set out to accomplish isn’t just lowering US corporate taxes. The Trump tax is not a mere adjustment. They propose overhauling the system itself, moving from an income-based approach to a consumption-based approach. U S Rep. Devin Nunes (R-CA), a member of the House Ways and Means Committee, floated a trial balloon on CNBC Tuesday to this effect, saying there were be no tax reform if it did not include a border adjustment tax. That tax on consumption is part of a major system restructuring JPMorgan’s Michael Cembalest saw coming last February 8. The changes taking place should not be underestimated as they are structural in nature.

Trump tax
Trump tax

Rep. Nunes speaks Cembalest’s language: “We are moving to a consumption-based tax system”

What is clear now, nearly one week after Cembalest wrote his noted “Eye On The Market” report, is that the author knew the direction being enunciated by Rep. Nunes Tuesday. “We are moving to a consumption-based tax system,” he said, echoing Cembalest’s thoughts a week later.

JPMorgan’s head of asset management thinks taxing based on consumption, termed a “destination-based cash flow tax (DBCFT),” is designed to “tax output where it is consumed, rather than where it is reported.”

Trump’s tax plan isn’t just fiddling around the edges, it has wide-ranging consequences in its disruptive precept change. Cembalest boldly says it is “the most radical change in corporate taxes in over a century.” He explains the system:

This would effectively convert the US from a worldwide income tax jurisdiction to a territorial system, and adopt a hybrid of a value added tax (it differs from a regular VAT by allowing deductibility of labor costs).  The implications would be transformational: imports by US firms would no longer be deductible, export revenues of US firms would no longer be taxed, and foreign income would not be taxed1.  Supporters of DBCFT assume that the dollar would appreciate and prevent windfalls for US exporters or pain for US importers, but that may be a brave assumption in a complex world.

Trump tax
Trump tax

Market theories on the Trump tax overhaul are premature

Supporters of such consumption-based taxes say there are four primary benefits they hope to realize.

With an increasing number of corporations locating off-shore, the revised tax plan seeks to eliminate the need for a corporation to change domicile. In fact, under this consumption-based tax system, the US would become the “low-tax” jurisdiction throughout the world.

The new tax system would reverse the pattern for tax inversions while eliminating the need to “strip” income out of the US, a common accounting technique to avoid US corporate taxes. The fourth benefit of the consumption-based taxing is it would increase incentives for capital spending, not just rely on incentives to borrow, which has been central bank policy.

From a market standpoint, there are several questions and Cembalest thinks the “theoretical premise” that will help exporters and hurt importers, much of which occurs through the price of the US dollar, “may or may not play out in real life.”

Will the dollar really appreciate as anticipated?  Some US trading partners have freely floating exchange rates, while others are either fixed or managed.  …Only half of the world’s GDP employs floating exchange rates, and that figure includes the US which is ~15% of the total.  This could limit the degree of dollar appreciation in real terms.  What happens when the ECB eventually withdraws its monetary stimulus and raises rates?  And what kind of pricing responses will be adopted by individual foreign firms?  Unclear.  And if the US dollar did appreciate by 25% in real terms (i.e., how much it would need to rise to render US importers indifferent assuming a corporate tax rate of 20%), that would propel the dollar to its highest level on record.  This could in turn create problems for non-US issuers of dollar financing and other possibly unforeseen consequences.

For investors looking to play the move to a border adjustment tax, the primary beneficiaries could be small and mid-cap stocks, Cembalest says. This is particularly true of firms with minimal export/import exposure, lower leverage and who would also benefit from a meaningful decline in corporate tax rates.

The system is so new and undefined there is significant confusion, where Cembalest notes the dichotomy. Some like the consumption because they say it is not protectionist – other trading partners use similar versions of such taxes. But another group of supporters they like it because they say it is protectionist.

Trump tax
Trump tax