President Trump, during his election campaign and since his inauguration, has pushed the need to increase US manufacturing to create jobs. Some prior articles (“LCD Manufacturing in the USA? Don’t Hold Your Breath”, DSCM 01.23.2017, “Expect to See More “Assembled in the USA” Products, DSCM 01.23.2017, “LCD Manufacturing in the USA – Logistics Impact”, DSCM 01.30.2016) have discussed some of the aspects of possible Trump policies on the display industry; in this article we’ll discuss one likely idea for a US import barrier and how it might play out in the display industry.
During the campaign, Trump railed against both Mexico and China as unfair trading partners, and called repeatedly for up to a 35% tariff on goods from Mexico and up to a 45% tariff on goods from China. Since the inauguration, though, one idea floated as a mechanism to pay for a border wall with Mexico is a “border adjustment”, as one part of a comprehensive re-write of the US tax system.
The border adjustment idea stems not from Trump but from the Republican leadership in the US House of Representatives, specifically House Speaker Paul Ryan. The proposal would work as follows:
To illustrate the impact of a VAT and a border adjustment, let’s take as a theoretical example a 65” LCD TV. This type of large-size TV would be the most likely end-product of a proposed Foxconn LCD manufacturing plant in the US. Such TVs are sold in the US for a wide range of prices, from as low as $498 (special prices this weekend, for Super Bowl promotions) to several thousand dollars, but for this example we consider a US retail price of $1000.
Although this example is LCD TV, the numbers and concepts will be quite similar for most end-products of the display industry. An analysis of iPhone production and sales would be similar, as would a notebook computer or a desktop monitor.
Further, for the purposes of this illustration, we parse the value chain for this TV into four pieces: (display) components makers, display panel makers, TV set makers, and retailers. We lump “components makers” into a single group for simplicity, although in reality this would be dozens of companies supplying glass, liquid crystal, LEDs, polarizers, etc. Although not a precise picture, these four pieces of the value chain each have roughly ¼ of the value added of the TV set, about $250 each. Finally, we make the assumption that at each stage, the maker incurs various costs of $225 and reaps an economic profit of $25 which is subject to income tax. Although these are gross simplifications, they are not very far removed from the actual economics of the LCD TV value chain today.
Figure 1 below shows a diagram of this value chain for an LCD TV made in China using a China panel and China components, exported to the US and sold to a consumer by a US retailer. Note that in the manufacturers are “Chinese” because of their location, not their ownership. Component makers could include Corning, 3M, Merck, Nitto Denko and other non-Chinese multinationals; the panel maker could be Samsung or LG, and the TV Set Maker could be Sony or another international brand. For the purposes of tariff and taxation, though, these are considered Chinese companies because of their location.
Figure 1: China Value Chain for US Consumer
In the diagram, the goods flow is represented by the yellow arrows and the payment flow by the light green arrows. The other costs are shown in blue, and income taxes in red. The net of the flow in minus the flow out is the after tax income for each stage of the value chain. The China manufacturers earn a profit of $25, pay the China corporate tax of 25%, and get an after tax income of $19, while the US retailer pays a 35% tax for a net income of $16.
As a point of comparison, it is helpful to see how this picture is different for sales in the China domestic market, where a VAT is applied. This is shown in Figure 2.
Figure 2: China Value Chain for Chinese Consumer
At each stage of the value chain, the China VAT of 17% is applied, so in comparison to the case where products are built for export (and VAT does not apply or is refunded) the prices get progressively higher. Some readers may be surprised that TVs that are made and sold in China are sold for higher prices than comparable TVs in the USA, but that is precisely the case, largely because of the VAT paid. The US, which alone among major economies does not have a VAT, consistently has the lowest prices in the world for consumer goods like TVs, and not coincidentally has consistently run the world’s largest trade deficit for more than a generation.
In order to make some comparisons with a hypothetical border adjustment scenario, it’s helpful to envision the manufacturing steps as a single vertically-integrated company making the TV set. In China, the panel maker China Star (CSOT) combined with the TV maker TCL comes close to this example, but we can visualize it as per Figure 3:
Figure 3: China Value Chain for US Consumer (Compact version)
Next we envision this picture if we implement the border adjustment proposal described above. Without changing anything else, this becomes an unfortunate picture for the retailer. For this reason, Wal-Mart and other retailers have been leading the criticism against the border adjustment approach.
Figure 4: China Value Chain for US Consumer, with Border Adjustment
Why is the retailer suddenly paying so much income tax? Because the retailer is now unable to deduct the cost of the imported TV. As a result, for tax purposes the retailer’s profit becomes $1000 - $225 = $775, on which they pay 20% income tax or $155. Their economic picture, though, is a severe loss: $1000 - $750 - $225 - $155 = -$130.
It should be obvious that retailers would not proceed with this business, they would raise prices on goods imported. In principle, they would want to raise prices to recover their after-tax profit position of $16 per TV. The result of that adjustment can be seen in Figure 5
Figure 5: China Value Chain for US Consumer, with Border Adjustment Scenario 1
As many critics of the border adjustment have pointed out, this scenario results in higher prices for US consumers, and may result in higher inflation. However, this higher inflation would only occur if the products continue to be imported. Consider the situation if the products were sourced locally, and if (it’s a big if, but stay with me for the time being) the cost structure for a US manufacturer was similar to its Chinese counterpart, as shown in Figure 6.
Figure 6: US Value Chain for US Consumer, with Border Adjustment Scenario 2
Scenario 2 would not be a realistic picture for TVs in the US in 2017, but if Foxconn or someone else invested in US capacity for LCD panels, it might be a feasible picture in 2020 or 2021. Scenario 2 is also helpful to consider for an industry that relies only partially on imports. In industries with a substantial portion of US production, there may be little to no pricing impact of a border adjustment scheme.
In our LCD scenario, though, a single US manufacturer competing with imports would be tempted to raise prices, and might be capable of raising prices up to near the price level of the imported product. That leads us to Scenario 3, where a US manufacturer is pricing to compete with imports, and reaping huge profits, as shown in Figure 7:
Figure 7: US Value Chain for US Consumer, with Border Adjustment Scenario 3
Such is a dream scenario for a US manufacturer; like most dreams it is unrealistic, but it forms a boundary condition for a possible US business. With such a large possible profit pool, a US LCD maker could sustain higher costs than its China counterpart (thus increasing the $675 cost portion) and still be strongly profitable. However, in a highly competitive global industry like LCD, it is likely that competitors would continue to push for business in the US market. Further, many economists claim that the likely result of a border adjustment would be appreciation of the US dollar against other currencies. In our example, a weaker Chinese yuan would mean lower costs in the China value chain, allowing the Chinese manufacturers to sell at lower prices. If in such a scenario the yuan depreciated by about 20% against the dollar, the China value chain would again be capable of delivering a $1000 TV set to US consumers, as shown in Figure 8
Figure 8: China Value Chain for US Consumer, with Border Adjustment Scenario 4
The table above summarizes these scenarios for the main financial flows.
Compare scenario 4 with the current state of affairs. For the US consumer, there is no difference, they buy their TV for $1000. Likewise, for the US retailer, although the transactions are quite different the result is the same: they have operational costs of $225, revenue of $1000, and a net profit after tax of $16. The main difference is a shift in value from the Chinese manufacturer to the US government in the form of a depreciated currency and the border adjustment.
Although each of Scenarios 1-4 are unrealistic (each for a different reason), they illustrate the boundary conditions of the industry under this proposed tax and import change: think of these scenarios as a rectangle, with the likely reality lying somewhere inside. It’s quite clear from Scenario 3 that there would be a powerful incentive to increase US manufacturing, which after all is the main purpose behind the proposal, but it’s inconceivable that this would occur without some corresponding reaction from importers.
These are early days for the Trump administration, and the US Congress’ work to overhaul the tax system has hardly begun. There will be powerful interests arrayed against the idea of a border adjustment, but likewise there will be strong proponents. The display industry may be profoundly changed by the results.