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Monday, February 27, 2017

Implications of Proposed US Tax Changes and Protectionist Policies on Real Estate Industry

By Amy Erixon, Toronto

In April 2016 I wrote a blog entitled “Implications of Rising Protectionism on the Real Estate Industry”.  This post is a continuation of that discussion.  Sweeping changes are being proposed to US tax, immigration and trade policies with a stated goal of invigorating the US job market.  It is hard to say what programs and features will actually see the light of day when all is said and done, but we know for certain, there will be winners and losers, and that experiments have consequences.  

The most dramatic aspects of the current plan include a significant shift in tax burden from income to consumption taxes via border tariffs; a 100% investment deduction up front on plant and building investments; and third the limiting of interest deductions (other than home mortgages) to the amount of interest income.   All of these measures have considerable implications for US property markets whose equilibrium pricing has been shifted much higher thanks to central bank subsidized interest rates and the huge influx of foreign capital which reached $87.3 billion in 2015, up from less that $5 billion six years earlier.   KPMG notes in their June 2016 report on the House Republican proposed tax reform that "In addition to WTO compliance concerns...a move from an income tax to a consumption tax effectively could void the current network of US treaties."  This would obviously raise liquidity concerns.  The investment deduction change could dramatically affect a tenant's inclination to own vs. rent, and will likely spawn a flurry of financial products to transfer the tax savings benefits between parties.  We should not forget about the last time this was tried.  Repeal of accelerated depreciation rules in 1986 triggered a 7 year real estate crash, (and caused the savings and loan crisis) as financially engineered property investments, whose primary goal was to provide tax shelter, imploded.   

 HOW TARIFFS WORK
The claim of tax neutrality hinges on the expectation that revenues lost would be replenished by border tariffs.  For those of us who could use a refresher on tariffs:  Tariffs are taxes on imported goods and services, imposed by governments at the border, traditionally for two reasons: 1) to protest violations of standing trade agreements, 2) to temporarily protect domestic industries unable or unwilling to compete with foreign competition.   Tariffs restrict trade, and reduce overall economic activity by increasing price to consumers.   This chart illustrates how it works: units sold is on the “Y” axis and price is shown on the “x” axis.  Consumer behavior is shown in red, decreasing as prices rise.   Light green and light blue areas show redistribution effects of the tariff.  In this example, where consumer demand is tied to price, total economic activity is reduced by $50 million, domestic producers gain $50 million of sales, foreign producers lose $175 million, and the consumers pay $300 million in additional taxes to the government.   

The asymmetry of results is one reason why tariffs are universally unpopular and considered a tool of last resort.   For a more complete treatise on tariffs, follow this link to an article written by faculty at the University of Washington: https://faculty.washington.edu/danby/bls324/trade/tariff.html.  

Taxes are a domestic affair, and the congress will decide who will pay more and who will pay less, and in the process create winners and losers, but trade and deportations are another matter (and much more in the hands of the President).   In the past when mass deportation has been tried, the adverse effects have shown up most strongly in housing construction and agriculture, both of which industries are also highly reliant on interest deductions.   Businesses reliant on foreign workers (or an integrated supply chain) are forced to pivot into other pursuits where automation can replace human labor, or goods may be substituted until the time new factories and/or supply chains can be built - for example growing nuts vs fruits, or selling software instead of smart phones.  Most US businesses are affected by trade and tariffs will cause considerable dislocation both for these businesses and for their customers.  In addition to depressing economic activity and hurting consumers, trade wars, whether via tariffs or deportation are not unilateral.  They have a tendency to escalate into counterproductive parry and counter parry as relations between countries quickly deteriorate, and domestic security is undermined. 


The US tax code is unnecessarily complex and is widely considered to be unfair, reforms are needed.  And rethinking trade has gained considerable popularity in the most recent year, but consequences are far greater and less predictable.   Let’s hope that there is deep study and reflection of unintended consequences prior to implementation of some of these proposals and an adequate phase-in period is provided to allow property investors, tenant companies, retailers and distributors time needed to re-tool their operations.  

Amy Erixon is and Avison Young Principal and Managing Director Investments.  Amy is based in the Toronto headquarters office. 

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