Lobbyists in Washington are lining up to argue for or against a proposal that the U.S. should impose a uniform 20% tax on imported goods and effectively grant exporters an equal tax break. While the outcome of this battle is still unclear, another proposal is taking shape with potentially better political prospects and its own major implications for Asian exports.
The idea of "reciprocal tax," floated by U.S. President Donald Trump and senior members of his administration, would introduce a bilateral element to the tax debate. Under a reciprocal tax framework, if Japan taxed electronics imports from the U.S. at 8%, that is the rate at which the U.S. would tax Japanese electronics imports.
Consider this: Of all the motor vehicles, trailers and semi-trailers sold in the U.S. in 2014, American content comprised only 53% of finished products. The remaining 47% of foreign materials and value-added was attributable to Japan (8.2%), Germany (6.3%), Mexico (6.3%), and Canada (4.8%), and other countries.
This is where inter-country differences in tariffs and tax rates assume significance. Under a reciprocal framework that conforms to Trump's broader thinking of introducing some form of "equalization" to eliminate tax (and tariff) disparities between the U.S. and its trading partners, countries such as Germany, with a standard value added tax rate of 19%, could be at a disadvantage compared to Japan, which has a standard value added tax rate of 8%.
In other words, American auto manufacturers that currently use both Japanese and German parts in their production processes would be incentivized to shift more of their supply chain networks to low-tax jurisdictions such as Japan instead of Germany, provided the tax benefit outweighed labor and transportation cost differences.
But Trump's "tax wall" would not only foment competition between advanced economies, it could also reshape bilateral tax and trade treaties between developing countries and the U.S. For instance, take China, where two broad trends are changing the country's manufacturing landscape. First, the center of gravity of low-cost manufacturing is moving from China to South and Southeast Asia. Second, the country is pushing its companies to automate, boost research and move up the value chain in sectors like machinery and semiconductors to compete with Germany, Japan, South Korea and other countries.
Threat to manufacturing hubs
A potential reciprocal tax in the U.S. could hurt China on both counts. Even as the country tries to retain a large portion of its low-cost manufacturing base by shifting operations to its labor-rich western and inland provinces, its value-added tax rate of 17%, compared to 10% in Indonesia and Vietnam, would accelerate the flight of low-cost manufacturing operations out of the country.
Furthermore, China's recent emergence as a major semiconductor manufacturing hub could also receive a setback because its closest competitors, South Korea and Japan, have much lower value added tax rates of 10% and 8%, respectively.
India is another country that could find the going tough under Trump's reciprocity regime. Indian Prime Minister Narendra Modi plans to boost the country's role in global manufacturing on the back of his 'Make in India' initiative and favorable demographics. But with a combined tax and tariff rate of nearly 30%, a reciprocal tax could seriously harm India's pharmaceutical and textile exports to the U.S. In a recent keynote speech, Trump's chief trade adviser Peter Navarro singled out India for having "notoriously high" tariffs.
While Trump and his economic advisers have yet to present any concrete details around the idea of a "reciprocal tax," the idea should not be dismissed. According to news reports, the Trump administration's draft negotiating objectives for revamping the North American Free Trade Agreement with Mexico and Canada include securing "reciprocal" treatment of American exports. Furthermore, U.S. Commerce Secretary Wilbur Ross has indicated that the U.S. will seek to level the playing field on the tax treatment of imported goods. In this context, a similar bilateral trade renegotiation with other countries, especially China and Germany, must not be ruled out.
The U.S. Congress is mulling a separate proposal that would implement a blunt 20% import tax on foreign products. But the legislature's proposal has already attracted significant opposition from various retail associations and industry groups in the U.S. The "Americans for Affordable Products" coalition, which comprises more than 200 companies, including multinational retailers such as Nike and Walmart, has opposed any "border-adjusted tax," arguing that an across-the-board import tax would lead to significant price increases for average American consumers.
The controversial plan has also attracted questions over whether it is consistent with World Trade Organization rules. The intensity of opposition to the legislature's proposal may well produce a significantly watered-down version that would tax imports either at a much-reduced rate, or not at all.
It is in this context that the idea of "reciprocity" starts to look more realistic. If the "border-adjustment" part of the proposed tax plan fails in the U.S. Congress, Trump will likely push forward the idea of "reciprocity" and "fair trade" through bilateral deal-making on tariffs. In March, Trump took the first step in this direction by ordering the Commerce Department to study the effects of "non-reciprocal" trade between the U.S. and its trading partners.
Export-driven countries are staring at a fresh round of bilateral negotiations on taxes and tariffs with the U.S., which represents almost 30% of the world's consumer market, in order to remain competitive in global supply chains. Trump's "tax wall" promises to disrupt existing global production networks by forcing changes in how countries tax goods moving across borders.
Shrey Verma is an analyst at brokerage Height Securities in Washington.