by Carl Chrappa and Shawn Halladay September/October 2018
What do tariffs and tax reform mean for the equipment finance industry? Carl C. Chrappa and Shawn D. Halladay investigate the ramifications of recently enacted or threatened tariffs and explore the silver lining of tax reform that will encourage customers to lease.
Tariffs and taxes have been dominating U.S. economic news this year. What do these developments mean for the equipment leasing and finance industry? Here’s what we know.
Following economic news in assessing impacts of changing tariffs and taxes on the industry is vital. But it would be a mistake to make economic assumptions and business decisions based only on the headlines, regardless of one’s political leanings. Trusted sources, business fundamentals and sound economic data are far better indicators.
Tariffs and trade wars are fueling uncertainty in the market. In June, Ralph Petta, president of the Equipment Leasing and Finance Association, rightly described tariff friction as a wild card in mostly favorable economic conditions for the industry.
Some leasing customers may be delaying capital investment plans as they continue to assess tax and tariff changes. Michael Romanowski, president of Farm Credit Leasing Services, a respondent to the ELFA’s Monthly Confidence Index for the Equipment Finance Industry released in July, noted this development.
As with all challenging situations, tariff and tax changes also create opportunities for the industry, including the potential to sell more leases by analyzing the customer’s tax position and pointing out the negative ramifications of buying, instead of leasing, equipment.
We’ve seen a lot of uncertainty this year related to instituting or raising existing tariffs on selected items of many of our trade partners. President Trump campaigned on ending trade imbalances, stating, “trade deficits hurt the economy very badly.” Furthermore, he went on to blame “horrible deals” of the past for allowing too many cheap foreign imports into the U.S. at the expense of our factories and jobs.
China has been the main focus point because of suggestions that it employs unfair practices like currency manipulation, wage suppression and government subsidies to book its exports while blocking U.S. imports. Some politicians and economists disagree and state that, in spite of this, the singular role of the U.S. economy is providing liquidity to the global economy and driving demand around the world, which makes the U.S. trade deficit central to global economic stability. On the other hand, others argue that competitiveness from countries such as China stems from state involvement in the economy, giving its exports an unfair edge and violating global trade rules. In addition, many blame China’s alleged massive and sustained currency manipulation from 2000 to 2010 for widening the trade deficit to historic levels. This trend seems to hold today as the yuan has dropped about 10% versus the U.S. dollar since the beginning of April. This will offset part of the tariff increases on Chinese goods.
What is at stake for the U.S.? Economic growth. For example, an increase in exports in Q2/18 GDP added 1.6 percentage points to GDP. That illustrates the impact trade can have on the U.S. economy.
Looking back, one might ask, how did all these apparently unfair trade deals happen? To answer that, we need to go back to 1948 and the end of World War II. Most of Europe was in ruins, cities and factories were destroyed and economies were pummeled. To help, the U.S. enacted the Marshall Plan and lent billions of dollars to affected countries to rebuild themselves. Since the U.S. economy was by far the global economic giant at the time, it entered into generous trade agreements. But after the countries rebuilt and began competing with the U.S., the original, generous trade agreements remained unchanged — until now. The U.S. now seeks to level the playing field with its global trade partners via the proposed trade revisions and tariffs.
To examine the magnitude of the problem, last year China imported a paltry $130.4 billion of U.S. goods versus exporting $505.6 billion to the U.S. That amounts to a massive $375 billion U.S. trade deficit. For comparison purposes, the U.S. exported $282 billion to Canada and $243 billion to Mexico.
How do tariffs work? After the U.S. levied a tariff of 25% on Chinese steel and 10% on aluminum, China matched the tariffs plus added massive tariffs of between 62% and 70% on ham and other pork products and 100% on luxury cars. Even Germany, with which the U.S. has a trade imbalance of $63 billion, places a 20% tariff on U.S. auto imports while the U.S. places a 2% tariff on German autos. German auto exports also receive value-added tax (VAT) refunds from the government. In Japan, the U.S. trade deficit is about $69 billion, and the list goes on and on. (1)
Figure 1 illustrates the current state of total trade and tariffs enacted and threatened.
Some of the negative reactions to America’s attempts to level the trade playing field appear to be political in nature. Reports suggesting near economic collapse are overblown and particularly suspect. Legitimate news organizations are reporting the potential for adverse effects on companies, including layoffs and price increases, but these are anecdotal or projections based on their research or sources. Currently, all major U.S. trade partners (including China) are negotiating to arrive at fair trade deals. Since the U.S. has very large trade deficits with many countries, most of the damage in a trade war will most likely be to countries reliant on large trade surpluses with the U.S. to fuel their economies. Thus, experts widely believe many of the differences can be negotiated away. But China has a more aggressive track and recently said if the U.S. raises tariffs on another $200 billion of its exports, it will do the same for U.S. imports to China. The total would exceed all Chinese imports from the U.S. by approximately $120 billion, which is a problem.
At worst, earnings could decline in some companies. Those predicting the decline of the U.S. economy seem to forget that companies are not static when determining sales prices of their products, rather they are elastic, and many may choose to take on some price increases themselves, passing on a portion to consumers.
Finally, regarding steel, U.S. hot-rolled coil currently sells for $1,000/ton and Chinese steel sells for $560/ton (Ex-works), so the 25% tariff would add $140 or bring the total to $700/ton, which is still cheaper than U.S. steel. Add 10% to account for the recent drop in value of the yuan to the U.S. dollar and the real total should be $770/ton (not $700). The final analysis demonstrates the main negative effect caused by tariffs is uncertainty. This could account for the reluctance of some companies to close on equipment purchases or cancel them until the matter is resolved.
Added to the economic uncertainty surrounding expanded U.S. tariffs has been hesitation regarding equipment acquisition decisions attributable to the recent tax reforms, as companies struggle to identify the long-term implications of these changes on their tax position.
The Tax Cuts and Jobs Act of 2017 introduced major changes that affect equipment acquisitions and strategies. Some, like expansion of the §179 benefits and the reduced tax rate, are straightforward to apply. Others, such as net interest deductibility and 100% expensing of equipment, require substantial analysis to evaluate their impact on tax planning and equipment acquisition strategies. This is particularly true given the changes to the alternative minimum tax (AMT) and net operating loss (NOL) rules.
Now let’s add the fallout from higher tariffs into the mix. Many customers have accumulated deferred tax asset balances over the past several years from bonus depreciation and other factors. If higher tariffs did, indeed, prove detrimental to the economy, corporate taxpayers would have less taxable income 1) with which to absorb existing NOLs or 2) that will aggravate existing NOL positions.
This is good news for the leasing industry, as it creates an opportunity to sell more leases. A well-informed salesperson can really prove his or her value by analyzing the customer’s tax position and pointing out the negative ramifications of buying, instead of leasing, equipment. The bottom line is, in the current environment, knowledge of the footnotes and the answers to some probing questions can go a long way towards meeting those volume targets.
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