Brace for a tax tsunami

Atax tsunami is set to wallop the global economy this week as the U.S. proceeds with its most extensive tax package since 1986. U.S. tax reform will have an immense impact on the global economy, not just in terms of investment but also corporate bond flows and the distribution of government tax revenues. As America’s largest trading partner, Canada’s economy is about to get heavily sideswiped.

Late last Friday, a congressional conference committee released its final report outlining the version of the U.S. Tax Cuts and Jobs Act that compromises between the Senate’s plan and the House of Representatives’ proposals. Both houses will likely pass the compromise this week. President Donald Trump is expected to sign it, given the importance of this tax reform to his overall economic agenda. The rest of the world is going to feel the impact. As of Jan. 1, 2018, the U.S. is set to move from having one of the highest tax burdens on corporate investment all the way down to the middle of pack.

The U.S. bill contains a large number of provisions that will affect the global economy, but the most important ones are the reduction in the corporate income-tax rate, the ability to expense investments in machinery and equipment (rather than amortize them), new limitations on the deduction of interest expense, and the adoption of new international tax rules that will be more similar to OECD countries.

Under the new version of the bill, the U.S. federal corporate income-tax rate will fall dramatically from 35 to 21 per cent beginning Jan. 1, 2018. Taking into account state income taxes (as shown in the first accompanying table), the new U.S. corporate income-tax rate will be 26 per cent, not much higher than the world average of 24.7 per

The lower corporate income-tax rate, and allowing expensing rather than amortization of machinery and equipment will boost productivity as American business retool operations with digitization, artificial intelligence, some important limitations on the deductibility of interest expense for corporations: specifically, any interest expenses in excess of 30 per cent of adjusted profits will not be deductible. That will see multinationals moving their debt out of the U.S. and onto their books in foreign jurisdictions. Canada will bear some of this cost with falling corporate tax revenues.

The new dividend exemption regime saves multinationals from paying U.S. corporate tax on foreign profits brought back to the U.S. Some US$2.5 trillion in profits belonging to American firms currently sits parked in foreign subsidiaries. That can be brought home to boost investment and equity values. So we’ll see significant dividend flows out of foreign countries to the U.S. just as corporate debt is flowing the other way, from the U.S. to other countries. Overall, the reform will likely support a stronger U.S. dollar.

The improving U.S. economy will be further charged by personal tax cuts and a somewhat wider trade deficit. It all suggests the U.S. will see higher interest rates down the road. All of this is going to put pressure on a depreciating Canadian dollar.

Canada’s competitive position is about to get rocked, making it harder for Canadian governments to push costs onto businesses through higher levies and regulations. Federal and provincial authorities will need to change course. If politicians sit on their hands, the private sector won’t: Canadians will see investment, jobs and profits flowing to the States.