What would the US border tax adjustment mean for energy?
A mooted border tax would likely strengthen the dollar and may buoy some oil producers. But it could raise US pump prices, be bearish for world crude markets and disruptive to geopolitics, and spark tit-for-tat trade spats
From opening new areas for drilling to accelerated pipeline permitting to scrapping regulations, there is no lack of speculation about what Donald Trump's energy agenda will mean for oil and gas. But the most consequential policy change on the horizon is not an energy one at all—it's rather a major overhaul of the US corporate tax code.
Among the most controversial parts of the tax-reform package put forward by the House Republicans is the so-called
border tax adjustment (BTA). This would effectively act as a charge on the US trade deficit by taxing imports and subsidising exports. Under the proposal, the corporate tax rate would be lowered from 35% to 20%, and the US would replace the current system that taxes profits anywhere in the world when brought back to the US with a "destination-based cash-flow tax" (DBCFT) that would tax corporations based on where their products are used. To implement this system, the cash-flow tax would be paired with a BTA that would exclude both import costs and export revenues from a company's tax obligation.
For example, a US refiner that imports all its crude feedstock for $50 per barrel and sells refined products at home for $100/b (unrealistic, but simplified) will pay the 20% tax on the full $100 (that is, $20), not on the $50 "profit" (that is, $10) that would be the case without border adjustment. On the other hand, a US refiner buying all its crude from US producers for $50 and selling all its products abroad for $100 would have a loss of $50, pay no tax at all and might even get a refund (compared with a $10 tax without the border adjustment).
The principle behind the DBCFT is already familiar throughout the world with the use of value-added taxes (VATs), although there are important differences. Rather than applying the corporate tax where goods and services are produced, or where the company is headquartered, as the current corporate income tax does, the DBCFT imposes the tax in the jurisdiction where the goods are sold. To tax goods where they are sold, however, imports must be subject to the tax and exports exempt from the tax—hence the BTA.
The impacts of a BTA on the oil patch are complex, especially given the recent increases in US production and shifts in the country's energy trade. Net petroleum imports have declined from 60% of US consumption a decade ago to just 25% last year. Nonetheless, the US remains a massive net importer of petroleum. These net figures also mask a large and growing dependence on petroleum trade. While the US imports 7.1m barrels per day of crude oil on net, the gross figure is 7.6m b/d, because about 0.5m b/d is exported at the same time. Given the configuration of American refineries, the US imports much heavy crude and increasingly exports light tight oil. In February, crude exports rose sharply, peaking at 1.2m b/d, as refineries went offline for maintenance and supplies tightened in Asia following the Opec cuts. Trade in refined petroleum products is even more pronounced. Over the past decade, the US has gone from the world's largest importer of refined products to its largest exporter. And the US this year joined the ranks of net natural gas exporters. Within a few years it will be one of the world's largest gas exporters.
At first glance, it would seem from the example above that US exporters win and importers lose. But the effects are far more complex. The adverse effects on the oil and gas sector could be much broader, as explained in a forthcoming in-depth study by myself and Akos Losz from the
Columbia University Center on Global Energy Policy. Dollar surge
While the impacts are varied, a key point to start with is that a BTA would likely have a depressive effect on world oil markets through the appreciation of the US dollar. Economists generally agree that by reducing demand for imported goods and boosting demand for exports, a BTA will cause the dollar to appreciate. That is because the increase in foreign demand for US products will increase foreign demand for US dollars, while the reduction in demand for less-competitive imports will reduce the supply of dollars to foreign holders.
Yet there is much disagreement about the extent and timing of the dollar adjustment. While many economists that specialise in tax issues think the currency adjustment will happen immediately and completely, many others—especially ones who focus more on exchange rate markets—believe it will take time and happen only partially at best.
If the US dollar increases due to a US-specific shock like a tax-policy change, then global markets should—theoretically—adjust to keep the global price of dollar-denominated oil in other currencies constant. So that would suggest that the dollar price of oil should fall by one-to-one to offset the rise in the dollar. That is because a US-specific shock should not have implications for the equilibrium price of oil relative to other goods and services in the rest of the world. If the dollar has appreciated, the only way in which oil (priced in domestic currency) can maintain its relative price with other goods and services is for the oil price to fall. While a shock to the dollar value would typically suggest other dynamics in and implications for the global economy and oil market, a domestic tax change in the US is a good proxy for an exogenous, US-specific shock that minimises these other impacts.
A BTA would likely have a depressive effect on world oil markets through the appreciation of the US dollar
To be sure, this is a textbook description. In reality, exchange and commodity markets may not work in such a perfect way. To the extent world oil prices do not fall to fully offset the rise in the US dollar, then, since oil is a dollar-denominated commodity, oil will become more expensive in local currencies, leading to higher pump prices, which would reduce demand, also putting downward pressure on prices.
Yet while a BTA would depress world oil prices through dollar appreciation, it would likely push up oil prices in the US, creating a wedge between the two. To understand why, consider how a domestic oil producer would respond to a BTA in a stylised example (ignoring transportation cost differentials) that assumes a 20% corporate tax rate and a $50/b oil price. The domestic producer has two options. It can sell a barrel of oil to a domestic buyer (like a refiner), in which case it will pay 20% tax on the $50 it receives. Or it can export the barrel and pay no tax on the $50 it receives. For the domestic producer to be indifferent between selling the oil domestically and selling the oil to a foreign buyer—for it to receive the same $50 for the barrel—the domestic producer would need to receive $62.50/b to sell oil domestically, or 25% more than the prevailing world oil price.
The extent to which the US oil price rises and world oil price falls depends on the degree to which the dollar appreciates. If WTI and Brent were both $50/b before BTA adoption, and the dollar appreciation were full and immediate to offset the BTA, the world oil price would likely fall to $40, leaving the US oil price unchanged. If the dollar did not appreciate at all, WTI would rise to $62.50 and Brent would remain at $50 (ignoring, for now, other dynamic effects like the US supply response to higher WTI). In reality, the most likely outcome is somewhere in between, with partial dollar adjustment. So WTI would be higher, Brent would be lower, and both may be gradually dragged down during the period of dollar appreciation.
The impact on oil prices will also be affected by the impact of a rise in domestic oil prices on US supply—which, importantly, is far different today than it was just a decade ago because of the shale revolution. In the past, a policy that pushed up domestic oil prices would have largely resulted in rents to producers. Today, a bump in the price of oil, of say $10/b, may mean higher US production of anywhere from 0.4m to 0.8m b/d. That extra supply will partially offset the higher pump prices potentially faced by US consumers as a result of a higher WTI price. And it would likely further depress world oil prices beyond the impact of dollar appreciation.
A stronger dollar may also help prop up global output by reducing production costs in local currencies around the world, further pressuring world prices. Recent trends in Russian production, for example, illustrate how weakening local currencies can more than counter headwinds from global oversupply and low oil prices. Producers in many other countries, such as Colombia, Canada, Norway, Venezuela and the UK, also pay for most upstream costs in local currency.
The extent of any world oil-price decline may be offset if Opec were to cut output yet further to prop up prices. In practice, it seems unlikely the group would respond in this way. Even absent a BTA, US shale oil production is poised to surge this year as prices recover, which may challenge compliance with the existing Opec agreement if producers feel like their market share is just being replaced by supply from the US and other producers like Canada and Brazil. Both the Saudi and Russian energy ministers pledged their commitment to the deal at CERAWeek in March, but there is surely a limit to how much burden they will bear if inventories are not drawing down quickly enough and further cuts are required in response to even stronger US shale growth. Saudi oil minister Khalid al-Falih has been clear that the kingdom will not shoulder the burden alone if compliance by other Opec and non-Opec members begins to falter.
Lower oil prices and a stronger dollar will have geopolitical consequences. As the recent price collapse made all too clear, from
Venezuela and Nigeria to Iraq and Saudi Arabia, low prices can upend existing geopolitical relationships, foster instability in key regions, and present new geopolitical risks. A stronger dollar means that foreign holders of dollar-denominated debt could see their debt obligations rise, and weaker relative currencies might slow growth in emerging markets. A stronger US dollar would also strain economies that peg their currency to the dollar—notably Saudi Arabia, already feeling the pain of low prices as it implements an ambitious economic reform agenda. (If the dollar were to appreciate without depressing oil prices, of course, the Saudis would stand to benefit from a positive terms-of-trade shock, as their oil revenue in dollars would be worth more relative to other currencies.) A fall in demand and prices may also push down the local currencies of oil exporters with floating currencies, for example the ruble in Russia.
The impacts on corporate oil producers would vary. In some ways, they would benefit. For example, US producers, especially independents, would benefit from being able to fetch higher prices for their crude. They may also benefit from a lower corporate income tax rate, depending on their tax liability. And producers outside the US would be helped by lower supply-chain costs to the extent these are priced in a depreciated local currency.
Refiners may be harmed by having to pay more for their crude inputs to turn into gasoline, diesel and other products
On the other hand, the combination of more US supply and a stronger dollar would also mean producers with portfolios outside the US may be hurt by lower world oil prices. In the US, the cost of tradable oilfield services may also increase, because of both stronger activity and higher import costs. The degree of service-cost impacts will be determined by the extent to which the dollar appreciates, to which services are priced in dollars, and to which dollar-priced services adjust to offset dollar appreciation. And the benefits of a lower corporate income tax may be muted to the extent producers have carryover net operating losses following several years of low prices, or to which independents may pay little cash income tax as they re-invest most of their cash flows in new production.
Refiners may be harmed by having to pay more for their crude inputs to turn into gasoline, diesel and other products—either because the domestic crude price rises or because they effectively pay a tax on imported crude. Refiners will see already-narrow margins squeezed to the extent they are unable to pass those higher input costs onto consumers. And refiners without the ability to export product will be harmed more than those that can.
On the other hand, the lower corporate tax rate and the full expensing of capital investments would be highly favorable for US refiners, which tend to pay relatively high cash taxes. Moreover, they should be able to pass most of the costs of higher input costs on to consumers, as has been the case during other periods of temporary blowouts in the WTI-Brent spread.
Higher pump prices
As refiners pass on higher WTI prices, consumers would see the price at the pump rise. As Phil Verleger explained recently, based on the historical relationship between oil prices and retail gasoline prices, that means the price at the pump would rise around $0.30 per gallon if the world oil price were $50/b. So for consumers, the BTA might have an effect similar to raising the gasoline tax, but rather than the revenue going to the government it would accrue to oil producers.
For the American economy as a whole, a policy that raises pump prices would seem to be a negative since the US is such a large consumer and importer of oil. Based on historical evidence, a $10/b increase in oil prices would be expected to slow the rate of US GDP growth by around 0.2 percentage points relative to the baseline, as higher spending on petroleum leaves consumers with less disposable income to spend in other parts of the economy and raises costs for firms. A $0.30 price increase at the pump would reduce the median family's disposable income by $300 to $400 a year.
Yet the negative macroeconomic impact of higher gasoline prices may now be muted for two reasons. First, to the extent the US dollar adjustment is quick and full, world oil prices may fall—in a stylised case, as noted above, by a one-to-one ratio that would leave US oil prices unchanged. Second, even if US oil prices rise, the greater share of oil in the economy because of the shale revolution has upended established ways of thinking about the macroeconomic benefits of lower oil prices. Indeed, a recent paper for
Brookings by two leading economists found that the boost to consumer spending from the 2014-15 oil-price collapse was almost exactly offset by the reduction in oil-related investment, which has risen as a share of the economy in the past five years. Economists at Goldman Sachs found the oil-price collapse was actually a net negative for the US economy.
While there are distributional concerns with higher oil prices, from the standpoint of GDP alone, the shale revolution may mean that oil prices can be too low as well as too high.
It is far from clear whether the BTA will become law. White House Republicans, notably Speaker Paul Ryan and Ways and Means committee chairman Kevin Brady, are strongly supportive, the Senate seems more mixed, and it is unclear what the Trump Administration's position will be. The business community is divided, as well, with large import-dependent retailers like Wal-Mart and other sectors (including independent refiners) opposed. On the other hand, the BTA might raise significant tax revenue in the 10-year budget window (although could worsen the long-run deficit if the trade imbalance narrows or reverses), and there are few other options in play to help offset the cost of lowering the corporate income tax rate.
It is also unclear whether, even if it becomes law, the BTA would be found illegal under
World Trade Organization (WTO) rules. Proponents of the BTA argue that WTO rules allow border adjustments in the case of VAT, a form of tax widely used around the world. WTO rules, however, only permit border adjustments on indirect taxes (for example, on sales or value added), but not on direct taxes (such as those levied on income or profits). Moreover, an important difference between VATs and the proposed border-adjusted cash-flow tax is that wages are included in the former, but excluded from the latter. Without other corrective measures, many trade lawyers argue that the BTA would thus discriminate against imports under WTO rules. Many economists, however, argue that if the WTO considers a BTA based on economic logic, there is no difference economically between a BTA and a VAT with a wage subsidy and a border adjustment, which is allowed under WTO rules.
Regardless, if the BTA is sold politically in the US as a protectionist boost for the country's competitiveness, others could decide to retaliate unilaterally even before it reached the point of a WTO ruling. The possibility of a tit-for-tat trade war developing following a BTA is another risk for industry to consider, especially given the liberalisation of US rules for oil and gas exports and its significant energy trade.
In short, if a BTA is adopted, the effects on the oil and gas sector, and global economy and geopolitics more broadly, would be far-reaching. World oil prices are likely to decline and US prices to rise, but the extent of each will depend on how quickly and completely the dollar adjusts, how sharply the US can ramp up oil output in response to higher prices, and how other producing countries respond to higher US output and a stronger dollar. Who wins and who loses among energy firms will vary based on many company-specific factors like their global production portfolio, upstream versus downstream activities, tax liability, share of upstream cost structure in local currencies, ability to export or need to import, and more. Geopolitically, producing countries may be harmed by a price decline and may see further fiscal strains from a stronger US dollar. In the US, consumers would likely see pump prices rise, acting as a drag on the macroeconomy that would be offset, at least in part, by increased economic activity in the oil patch as WTI rises. All these energy-sector-specific pros and cons, of course, must be viewed in the context of the much broader economic effects of a dramatic shift to a new system of corporate taxation.
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