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The Trump Presidency – Policy Implications for Canada

What are the Potential Implications on Canada’s tax Regime, NAFTA and Bilateral Trade Relations?

With more than 5,500 miles of shared borders, the US and Canada have long been strategic partners concerning trade, national security and the general promotion of democratic ideals. While we expect continued co-operation between the two nations on these issues, the unique nature of President-elect Donald Trump’s candidacy necessitates an assessment of his presidency’s potential commercial and economic implications for businesses operating in Canada.       

Our focus here is on two key issues:

1.       The competitiveness implications that new US tax rates could have for Canada’s tax regime.   

2.       NAFTA and bilateral trade relations.  

 

Canada’s Tax Regime

Canada’s current corporate tax rate has often been characterised as being generally competitive, ranking highly in terms of attractiveness when compared to other members of the Organisation for Economic Co-operation and Development (OECD). At 15%, Canada’s national corporate tax rate places it third out of the 35 OECD member states, while the US ranks last, at 35%.

One of the cornerstones of Trump’s campaign was to make American businesses more internationally competitive by dropping the US corporate tax rate to 15% - a move that at first glance would put Canadian corporate tax rates on a par with their US counterparts. However, the self-governing nature of Canada’s provinces requires corporations to pay an additional rate on top of the national rate. While tax rates vary by province, businesses are effectively paying a rate near 26% - still lower than the current US rate but effectively moving Canada from 3rd to 23rd in the overall OECD ranking. Another factor here is that US states operate with a similar level of autonomy, and also charge additional corporate taxes on top of the national rate. While state tax rates vary, as an aggregate the additional sub-central government corporate tax rates total around 6.0-6.7%. A summation of both rates reveals that while US corporations are currently at a comparative disadvantage to their Canadian counterparts, a new lower national tax rate in the US would tilt the cost advantage towards US businesses.

Historically, incumbent US presidents are given leeway regarding Congressional approval of tax plans. Given Republican control of both houses in Congress and the desire of House Republicans to enact deep cuts to corporate tax rates, we think it highly likely that Trump’s initiative will be implemented. In addition, rough estimates of the likely total US multi-national overseas profits abroad amount to nearly USD2.1 trillion, and although that figure is spread across many nations, comprehensive US tax reform regarding the repatriation of US multi-nationals’ profits may lead to the excising of corporate cash across the border, creating a drop-off in business investment (a category that has recorded annual declines in Canada since Q4 2014).

Another possibility is that new, lower US tax rates could force the Trudeau government to offer competing tax breaks to ensure the international competitiveness of Canadian businesses, creating a potential windfall for such firms. Canada is currently in much better fiscal shape than the US: Canada’s Q2 2016 outstanding government debt was 87.4% of GDP, compared to 101.0% in the US, and Canada also has a better current government balance position. The Liberal Party, which holds a large majority in the House of Commons, has some flexibility on tax reform while delivering on the current programmes outlined in Finance Minister Morneau’s federal budget.         

However, further questions now arise over Trudeau’s proposed ‘green policies’ – specifically the per-ton carbon tax that will unilaterally begin for all provinces in 2018: this will effectively be a blanket tax encompassing all provinces in Canada that do not already have a carbon scheme. Moreover, carbon-tax programs with subtle differences are already in place in British Columbia and Quebec and schemes are set to start in Alberta and Ontario in January 2017.

Given Trump’s overall support for the American coal industry and his outright disbelief regarding climate change, a matching US carbon tax appears very unlikely. Trudeau’s ‘green policies’ may effectively be detrimental to Canada’s fossil fuel industries, making businesses less competitive globally. Perhaps more importantly, these carbon taxes come at a time when Canada’s strategically important oil and gas sector is recovering from a period of low global oil prices and a disruptive natural disaster that occurred in May 2016. In addition, a carbon tax could negatively weigh on consumer spending and put pressure on already highly leveraged Canadian households, where debt in Q2 2016 was 159.9% of disposable income, against 101.1% in the US.  

 

NAFTA and bilateral trade relations

Officially coming into force on 1 January 1994, NAFTA created a first-of-its-kind multilateral free-trade agreement between major developed and developing nations. The US, Canada and Mexico agreed to liberalise trade by removing trade barriers on the goods and services of participating nations. Trump, in the action plan for the first 100 days of his presidency, has vowed to renegotiate NAFTA, or to trigger Article 2205 - effectively removing the US from the agreement six months later (requiring no Congressional approval).   

The US and Canada had long-established trade links prior to NAFTA, jointly promoting the concept of deeper integration as far back as 1911, when US President Taft signed a free-trade agreement with Canadian Prime Minister Laurier (although the agreement subsequently broke down). Additional attempts at bilateral trade agreements between the nations took place in 1965 (through the US-Canada Automotive Products Agreement, which liberalised barriers for the automobile industry) and again, more comprehensively, in 1989 (via the US-Canada Free Trade Agreement).

Decades of trade between the two nations and the implementation of NAFTA has led to increased dependence, broader market access and deeper supply chain integration between Canada and the US. Canada’s share of total trade (exports and imports) with the US rose considerably after the implementations of both USCFTA and NAFTA. The average share of total trade rose to 75.3% in the ten years after the implementation of NAFTA (although the total share was always high, at an average of 69.9% in the ten years before NAFTA), and greater integration has led to deeper trade ties and interdependence. Recent data suggests that this share has fallen, with increasing proportions of total trade attributed to other nations, especially countries with which Canada has established bilateral and multilateral trade deals. However, we emphasise that the US remains Canada’s most important trading partner.  

Moreover, deeper trade ties have promoted a proliferation of US direct investment in Canadian companies. The share of US foreign direct investment (FDI) in Canada increased substantially following the implementation of NAFTA; in addition, the amount of subsequent year-to-year flows of US FDI in Canada grew at a much quicker pace when compared to other countries.

There are a number of scenarios for the future of NAFTA. In one scenario, the US could effectively depart from NAFTA outright, leaving just Mexico and Canada as parties to the agreement (Canada has recorded a similar shift in total trade shares and FDI flows with Mexico since NAFTA went into force). The US’s exit from NAFTA would likely mean a reversion to the old 1989 USCFTA discussed above, but many of the ground-breaking aspects included in NAFTA were not part of the USCFTA (including intellectual property rights protection, specific cultural exemptions on broadcasting, film and publishing, and trade dispute-settlement mechanisms).

A more likely scenario is a renegotiation of NAFTA. In this case, the Trudeau government would need to assess the impact of any new trade barriers that were established between Canadian and US businesses. Canada has long benefitted from access to the vast US consumer market, and has built a transport network of highways and railways that is deeply integrated into the larger North American network - including a well-integrated supply chain network that spans the US/Canadian border. If Canadian businesses do face new tariff or non-tariff barriers regarding the US market, the opportunity to pivot to other markets is possible, but will have to be weighed against the likely increased intermodal transportation costs (given Canada’s geographic location).

A reversion to pre-NAFTA trade levels would probably not be immediate, as firms would need time to identify alternative sources for existing supply chains. Nonetheless, a reversion to historical trade levels between the two countries would likely mean that US direct investment in Canada would also back-pedal (FDI expands the amount of capital available, and is often accompanied by the supply of specialised expertise for recipients).     

Commercial Implications

· Decades of liberalised trade barriers have created a deeply integrated and highly price-competitive North American automotive industry. A reversion to protectionism would be likely to make Canada’s auto industry (and indeed North America’s auto industry more broadly, as well as related industries) less competitive internationally.

· The different stances on environmental policies adopted by Trump and Trudeau will likely put pressure on Canada’s carbon-producing industries, including crude oil, natural gas and coal extraction, refinement, and oil-field and ancillary services. Reduced environmental regulation in the US, combined with Canada’s national carbon tax, will probably make Canada’s carbon industries less competitive than the US’s.

· The likelihood of the completion of Phase IV of the proposed expansion of the Keystone Pipeline System has increased substantially. Phase IV would reduce the distance (and increase pipeline capacity) between Canadian hydrocarbon businesses and US refiners.

· As of October 2016, businesses within Alberta and Ontario had the highest export exposure to the US. Businesses in these provinces are likely to be the most negatively impacted if new trade restrictions are placed on Canadian goods and services.

· In terms of value transportation and equipment (22.9%), oil and gas extraction (19.6%), chemical manufacturing (7.8%) and primary metal manufacturing (6.4%) were the top merchandise trade exports respectively from Canada to the US in 2015. These industries may be the most disrupted if new trade restrictions are placed on Canadian goods and services.      

Recommendations

· If President Trump triggers Article 2205, look to make contingency plans by exploring alternative relationships in countries where free-trade agreements remain in force (including South Korea, Israel, Chile, Peru, Colombia and Honduras).

· Note that US involvement in the Trans-Pacific Partnership is expected to end under Trump’s presidency, as he has promised to follow a highly protectionist trade policy that excludes the US from multilateral trade deals.

· Given the US and Canada’s dependence on one another for trade, we expect heightened currency volatility: consider using hedging techniques by purchasing forward contracts or currency swaps.

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