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Briefing highlights

  • Some not-fake facts on trade
  • The NAFTA issues
  • The border adjustment tax threat
  • The GST debate
  • What corporate tax cut could mean

Here’s some real news for Donald Trump as he officially targets the North American free-trade agreement as early as this week: Observers warn the U.S. trade “tirade” is both off-base and dangerous.

And not just dangerous for Canada and Mexico, but for the United States, as well.

“The tirade by U.S. politicians against the North American free-trade agreement can be puzzling to those who actually analyze data before recommending policy changes,” said National Bank of Canada senior economist Krishen Rangasamy.

This comes as Mr. Trump plans to meet soon with Prime Minister Justin Trudeau and Mexican President Enrique Pena Nieto to launch the renegotiation of NAFTA, as The Globe and Mail’s Laura Stone and Daniel Leblanc report.

And, as The Globe and Mail’s Bill Curry writes, Canada’s ambassador to the U.S., David McNaugton, says Ottawa is now considering new trade deals with the U.S. alone so as not to become “collateral damage.”

To be fair, Mr. Trump’s favourite targets have been Mexico and China, with scant criticism of Canada. But you can’t renegotiate or, as Mr. Trump has threatened, tear up NAFTA without sideswiping America’s northern friend and neighbour since, like, the War of 1812 ended.

Here’s a look at the trade battlegrounds in North America.

First, the straight facts

“Canada and Mexico account for only a small portion of the U.S. trade deficit, contrasting sharply with China, which accounts for roughly 40 per cent of the deficit,” Mr. Rangasamy said.

“Hitting Canada and Mexico with trade barriers such as tariffs or a border adjustment tax will arguably do little to shrink the U.S. trade deficit while potentially dealing a crippling blow to all NAFTA partners, including the U.S. where several key industries have integrated supply chains across North America,” Mr. Rangasamy added.

Not only that, but the U.S. runs only a tiny goods trade deficit with Canada. And when services are included, America actually comes out on top.

“Canada-U.S. trade is close to balanced, particularly when we consider that the U.S. has no alternative domestic source for the oil and gas supplied by Canada,” said Paul Ashworth, the North America economist at Capital Economics.

NAFTA

The targets:

“As far as Canada is concerned, the U.S. is only interested in discussing country-of-origin rules that determine what goods count as duty-free and watering down the independent dispute-settlement procedures to give U.S. courts more authority,” said Mr. Ashworth.

“It was the inclusion of an independent investor-state settlement mechanism that nearly derailed the CETA deal with the euro zone.”

Potential consequences:

There are many, with ramifications for everything from supply chains to currencies.

“Effectively the U.S. wants to raise the North American and U.S. content in parts, most notably in the auto sector,” BMO Nesbitt Burns chief economist Douglas Porter said of the rules-of-origin issue.

“But, the auto market is extremely competitive, and presumably auto makers are sourcing parts at the lowest cost – a move to increase those costs could/would dent their competitiveness, possibly costing domestic producers more market share.”

As for currencies, economists have already called for a further decline in the Canadian dollar as trade tensions mount.

“With NAFTA first on the renegotiation block, ‘very shortly’ following Trump’s inauguration, CAD and MXN will be the focus of pricing in even greater risk premium,” said Daniel Hui of JPMorgan Chase, referring to the loonie and the peso by their symbols.

“MXN is clearly of particular focus given the repeated mentions by Trump, but MXN has also long been the most sensitive and quick to price in risks.”

Mr. Trump’s campaign could also backfire where his own currency is concerned.

“Any such protectionist measures that tilt the playing field more to the U.S. advantage could be met, rather quickly, by increased upward pressure on the U.S. dollar, essentially negating the impact,” Mr. Porter said.

Consider, too, that trade is a two-way street.

“While it is all good and well for the incoming administration to try to affect imports, their measures can have a major impact on U.S. exports as well,” Mr. Porter said.

“Carrying on the currency theme, how do you think the appetite for U.S. products will be in Mexico in the coming year, amid a massive increase in peso prices for such goods and services?” he added.

“Not good – it’s safe to say that we may well be looking at a double-digit decline in Mexican imports from the U.S. in 2017, based simply on the economic factors at play. And that’s even before considering the potential for any retaliatory trade measures from Mexico and/or the ill will many ordinary Mexicans will possibly feel about buying American products.”

Value-added or consumption taxes

The targets:

Observers also expect the Americans to push for a change to consumption taxes, the 5-per-cent GST in Canada and, at 16 per cent, a much higher equivalent in Mexico.

This is because Canadians and Mexicans pay those on imports from the U.S., while Americans pay no such federal levy.

“Essentially all of America’s trading partners (including Canada) impose value-added and other taxes on domestic consumption (i.e., destination-based taxation),” said BMO deputy chief economist Michael Gregory and senior economist Sal Guatieri.

“These taxes are levied on imports because they are consumed domestically, but not on exports because they are consumed abroad,” they added in a report.

“Apart from some select excise taxes, the U.S. government does not impose any taxes on domestic consumption (though many states have sales taxes). Instead, it relies mostly on taxation of income.”

That puts American exports at a “competitive disadvantage” compared to imports.

Potential consequences:

The U.S. isn’t likely to level the playing field by bringing in a similar levy, which wouldn’t fly politically.

“While less of a target of Trump, Canada would unlikely be able to be exempt from this, as a matter of principle,” said JPMorgan’s Mr. Hui.

“Although Canada is clearly not the primary target of a NAFTA renegotiation, we have long argued that CAD is nonetheless highly vulnerable, simply because of the overwhelming share of the U.S. in Canada’s exports (77 per cent), the intensity of supply-chain distribution cross-border, for which even a modest upset in cross-border trade (for example, the removal of the GST border adjustment) could cause substantial disruption on overall activity and drag significantly on the currency,” he added.

Border adjustment tax

The target:

It’s not what it sounds like in that it’s not a simple levy slapped on imports. And, notably, it’s not a Trump plan, but rather part of a broader proposal by the House Republicans. Indeed, Mr. Trump has said it’s too complex.

“A centrepiece of the proposal is to scrap the current method of taxing global net income and replace it with a destination-based cash flow tax,” said BMO’s Mr. Gregory and Mr. Guatieri.

“Revenue generated by domestic sales would be taxable, but revenue generated by foreign sales would not,” they added.

“Expenses incurred from domestic sources would be deductible, but expenses incurred from foreign sources would not. For U.S.-based firms, exporting would become more profitable while importing would become more expensive.”

There’s a huge oil issue here, too, given America’s dependence on Canada.

“The tax falls into the pro-America, protectionist playbook but the implications are not entirely practical given the mismatch between the light, sweet quality of domestic crude production and the desire of key domestic refining regions to run a heavier barrel,” said Helima Croft, Royal Bank of Canada’s head of commodity strategy in New York, and her colleagues Michael Tran and Christopher Louney.

“The tax does not translate into increased demand for U.S. crudes, but simply makes oil more expensive in the U.S. given the ongoing reliance on crude imports,” they added in a report.

“The proposal also runs counter to Trump’s otherwise rhetorical support for Keystone XL, which would move Canadian heavy barrels down to U.S. Gulf refiners.”

Many observers don’t believe this will come to pass. It would have to get through both the House and Senate and then Mr. Trump. It would also have to meet World Trade Organization rules.

And “if the U.S. pulled out of the WTO, it could be the start of a nasty global trade war,” said the BMO economists.

Potential consequences:

Watch out if it actually does see the light of the day as many observers warn it could be devastating.

“The U.S.’s major trading partners, Mexico and Canada, would end up with weaker currencies, lower purchasing power, and greater business uncertainty about exports and supply chains,” said BMO’s Mr. Gregory and Mr. Guatieri.

“And, that’s just in the ‘benign’ case of full exchange rate adjustment. If their currencies did not fully adjust to a BAT, exports would get hit harder and their economies would weaken even more.”

Many Canadian businesses would be threatened, including those in transportation equipment, chemicals, textiles, machinery, computers and primary metals, they said.

And then there’s the oil patch, which is still struggling to recover from the price shock and whose troubles always ripple across Canada.

“Given that Canada sends about 3 million barrels of oil per day to the U.S., its industry could get slammed,” the BMO economists said.

“The Canadian price of oil would fall, while the U.S. price would rise,” they added.

“Some increase in domestic production could restrain the U.S. price of crude for a while, but not if higher-cost reserves are required. The uncertainty about the tax’s impact would delay investment plans of Canadian energy producers. Still, the U.S. remains highly dependent on Canadian crude, and American consumers would likely balk at paying higher gasoline prices.”

Corporate taxes

The targets:

These are separate from the NAFTA dispute, but the House Republican proposal to cut corporate taxes to 20 per cent from 35 per cent would be felt around the world, nonetheless.

America’s top corporate tax rate is among the steepest in the world, the BMO economists noted, though, on its own, “simply cutting the tax rate would magnify the budget deficit, a big no-no for most Republicans.”

Potential consequences:

Given the integration with Canada, this could be a biggie.

“Even if the border adjustment proposal gets dropped, the U.S. corporate tax rate is likely to be cut sharply from the current 35-per-cent headline rate to 20 per cent,” said Mr. Ashworth of Capital Economics.

“That alone would provide multinational firms with a big reason to switch investment from Canada to the U.S., particularly if the U.S allows for investment expenses to be completely written off in the first year.”

These are early days for all of these issues, though Mr. Trump is expected to move quickly and aggressively.

“We are quietly confident/hopeful that the key players on the new Trump team are fully aware of these potential unintended consequences, and that – as [Wilbur] Ross subtly alluded to [last] week – much of the trade rhetoric is a negotiating position,” said BMO’s Mr. Porter.

“From a Canadian perspective, this is clearly the most important unknown at this stage.”

Editor’s note. An earlier version of this article incorrectly referred to the prime minister of Canada as Pierre Trudeau. Of course, it is now his son Justin Trudeau who is PM.