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This policy would effectively result in the tax authorities recognizing all sales that take place in the US (regardless of where they are produced) and all the domestic costs incurred to produce goods and services for customers (regardless of where the sale takes place). As a result, net importers (such as many retailers) would suffer, as they would have to pay taxes on their domestic sales without being able to deduct a significant portion of their costs of production. Conversely, net exporters (companies with much of their production in the US but sales outside of the US) would stand to benefit from not having to pay taxes on their foreign sales while being able to deduct a significant proportion of production costs (Exhibit 3). Purely domestic companies would be unaffected.

Exhibit 3: Illustration of border adjustment treatment of US corporate taxation

US
Sold in the US: Recognize sales
Made in the US: Deduct costs
Made in the US
Deduct costs
Sold in the US: Recognize sales

Non-US
Sold overseas: Ignore sales
Made overseas: Can't deduct costs
Sold overseas: Ignore sales
Made overseas: Can't deduct costs

Source: BofA Merrill Lynch US Equity & US Quant Strategy

Even if border adjustments are enacted, there is significant uncertainty around implementation details. For this analysis, we focus on the first order impact of border adjustments, but we recognize there would be significant second order impacts on the pricing of products, pricing within the supply chain, foreign exchange rates as well as foreign policy reactions. (We discuss many of these second order impacts later in this report.) For the current exercise, we also ignored the cost of services as the implementation of these rules would be more complicated. See the Methodology section for more details.

We estimate that at a 20% tax rate, border adjustments would detract $5-6 from 2018 EPS, with nearly 80% of the drag coming from the Consumer Discretionary and Consumer Staples sectors (roughly evenly split). This impact includes a 50% haircut to account for offsets from alternate sourcing, currency rates and pricing power. On one hand, we may be drastically underestimating the impact because we have not included the second order impacts on the supply chain. For example, many retailers source the bulk of their goods from domestic suppliers, who source their goods from overseas suppliers. So while the original retailer may not feel the direct tax hit from importing goods, the supplier that took the tax hit would likely pass along a significant portion of this via a higher cost. On the other hand, the supplier or the retailer could look for alternate domestic sources for those products, but it would largely depend on whether the cost differential of production between the US and overseas exceeded the border adjustment tax. Some key components in determining the cost differential are the foreign exchange rates (more on this below) and labor costs. In the end, the net impact of the border adjustment taxes will be driven by a complex interplay between corporate tax rates, pricing power, foreign exchange moves, foreign versus domestic availability and cost differentials.

Bank of America Merrill Lynch
Equity Strategy Focus Point | 29 January 2017
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