Congressional Republicans have been touting a corporate tax reform plan that would exempt exports from taxation while preventing companies from deducting the cost of imports when calculating their taxes. The plan would also reduce the baseline corporate tax rate from 35% to 20%. After initially criticizing this proposal, President Trump has more recently shown tentative support for this so-called border tax, increasing the chances that it will be implemented.
Economists and Wall Street analysts have noted that department stores could be big losers if the U.S. implements a border tax. Nearly everything they sell is imported.
J.C. Penney (NYSE:JCP) has been cited as a company that is particularly vulnerable because of its weak profitability. However, paradoxically, its accumulated losses could actually be an advantage in this case vis-a-vis rivals like Kohl's (NYSE:KSS) and Macy's (NYSE:M).
What the border tax would do
The current border tax proposal is designed to encourage domestic production. It conveys a big tax benefit to companies that export goods and services, while penalizing importers.
Department stores like J.C. Penney, Kohl's, and Macy's all spend more than half of their revenue on buying inventory. While they do sell some products that are made in the U.S., the vast majority of their merchandise is imported. Thus, a significant amount of their costs would be hit by the border tax in one way or another.
For example, suppose J.C. Penney currently spends $5 billion a year -- roughly 40% of its revenue -- on imported inventory, with half being directly sourced by the company (for its own private brands), and the rest being supplied by vendors. J.C. Penney wouldn't be able to treat the $2.5 billion it spent on direct imports as an expense, making its profit appear to be $2.5 billion higher for tax purposes. At a 20% rate, this would put it on the hook for $500 million in taxes.
Meanwhile, its vendors would face a similar increase in their tax bills. They would presumably try to pass most of these costs through to J.C. Penney.
Given that J.C. Penney is barely profitable, it can't afford to bear any extra costs. However, if it tries to pass these cost increases on to customers, J.C. Penney's working-class and middle-class clientele would probably just buy fewer items.
Would a border tax have no impact at all?
Critics of the border tax proposal have said that any measure that taxes imports will drive up consumer prices. However, proponents of the border tax have argued that taxing imports while effectively subsidizing exports wouldn't impact consumer prices.
The rationale is that the change in tax policy would drive a big increase in the dollar's value, relative to other currencies. A strong dollar would allow importers to spend less money buying goods abroad. In theory, that savings could fully offset the tax due on imports, leading to zero net effect on consumer prices.
However, it could take years for exchange rates to fully adjust. Additionally, since so many commodities are traded in dollars, a strong dollar could spark inflation in emerging markets, driving up local-currency prices. Finally, department stores pay many overseas suppliers in dollars, so they wouldn't see any savings until they renegotiated those contracts.
J.C. Penney's trump card
In the long run, retailers will have to pass any cost or tax increases through to their customers. But in the short run, companies like Kohl's and Macy's might face more pressure to raise their prices than J.C. Penney.
Kohl's and Macy's have both experienced weak sales trends recently, which has translated to falling earnings. Nevertheless, they still pay hundreds of millions of dollars in income tax each year. By contrast, J.C. Penney pays no income tax, because it has racked up billions of dollars in losses over the past five years or so.
As a result, if a border tax were implemented, Macy's and Kohl's would have to immediately raise their prices -- or reduce discounts -- to protect their cash flow. The increase in their costs, either through higher tax bills or higher payments to suppliers, would likely exceed $1 billion annually.
J.C. Penney would face a similar increase in costs from vendors. But for private brand items that it sources directly from overseas, J.C. Penney wouldn't face a tax increase -- for now.
Returning to our earlier example, if J.C. Penney spent $2.5 billion in a year on direct imports, this amount would be treated as "profit" for tax purposes. However, J.C. Penney has $2.6 billion in loss carryforwards, reflecting its accumulated losses from the past few years. These tax credits would fully offset the tax bill from J.C. Penney's $2.5 billion in imports.
In effect, this means J.C. Penney would be able to phase in any price increases over the course of a year without negatively affecting its profit or cash flow. Kohl's and Macy's wouldn't have the same luxury.
A border tax would undoubtedly pose some long-term risk to J.C. Penney since the company would eventually have to pass through any cost increases to its price-sensitive customers. But in the short run, it could present an opportunity for J.C. Penney to use its tax shield to steal market share from Kohl's and Macy's.