A More Stable Trade Regime

Carl Milsted, Jr on May 12 21:27:25 View QTML

On April 2^nd 2005, "Liberation Day", Donald Trump declared trade war on most of the rest of the world. The financial markets bounced hard; Maalox consumption tripled across America's country clubs. The Wall St. Journal harumphed; Glenn Beck had a hissy fit; old school Republicans across the land contemplated gender transitioning and joining the Lincoln Project. (And maybe some liberals got upset as well. Hard to tell, given how upset they have been in general these days.)

All this governance by executive order and personal deal making should be disturbing even to Trump cheerleaders. Precedents are being set. Trump fans should contemplate what will happen when a Democrat gets in office. And shouldn't tax policy be set by Congress? And finally, setting tariffs on other countries based purely on their trade surplus with the US is woke logic applied to diplomacy.

On the other hand it is true that many other countries tax and restrict imports from the United States. For example, value added taxes are taxes on imports. Look up the VAT rates of Europe. It's also true that Donald Trump is not unique in his protectionism. Remember H. Ross Perot and Dick Gephardt? Remember the World Trade Organization protesters? Two of these came mainly from the political Left and the other was the darling of CNN.

Protectionism is so popular with politicians around the world that Free Trade requires supranational organizations such as the World Trade Organization and the European Union to attempt to make everyone play fair. Those who favor democracy should take note.

This brings us to the question at hand: Why is protectionism so popular? Are politicians deranged lunatics? Or are economics blinded by obsolete theories while politicians are better at seeing the obvious?

And the answer is: Yes.

Anyone who wants the benefits of Free Trade without unelected world governments overriding local democracy should pay careful attention to what follows. I have a solution which should satisfy both the populist and the Free Trade libertarians. It's time to update the econ books. But doing so will require a somewhat lengthy derivation. Get some coffee and/or cigarettes and get comfortable.

The World as Black Box

For our first simple economic model, let's treat the rest of the world as a black box, and look at the effect of international trade on US federal revenues. Given how the US federal government is teetering on the edge of bankruptcy, federal tax revenue is a rather important issue!

Let's look at a consumer product -- say, a washing machine -- and compare federal tax revenues from imports vs. domestic production under Free Trade, aka zero tariffs. For the imported washing machine, Samsung USA gets to deduct the price charged by Samsung Korea, along with the cost of shipping. The only revenue that the IRS gets to tax is the difference between these costs and the wholesale price Samsung charges Lowes and other retailers.

Liberals take note: Samsung has a great deal of control over the price Samsung Korea charges Samsung USA. Samsung can thus realize its profits in the country with the lowest corporate income tax rates. Free Trade means a race to the bottom for corporate income taxes.

Compare this with a washing machine made in the USA using US parts suppliers. (You might need a time machine to find such a machine today.) For the domestic machine the entire wholesale price is taxable revenue. Exactly how that revenue gets taxed is rather complicated. Some of it is corporate profits of the washing machine manufacturer. Some of it is corporate profits of the suppliers. The rest is wages of workers and management of said businesses.

We'll try to get a handle on what the resulting tax revenues would be later. The key takeaway here is that the federal government receives considerably less tax revenue when the washing machine is manufactured abroad than when manufactured here. When we treat the rest of the world as a black box, Free Trade constitutes Subsidized Outsourcing.

OK, ye free market economists in the audience, explain to me why imports should be subsidized. Once we factor in the income and payroll taxes, we need tariffs for international trade to be revenue neutral -- at least when we are looking at the world as a black box.

Revenue Tariffs?? Huh??

At this point the economists in the audience, both armchair and pro, are dusting off their obsolete tomes and are preparing for some serious high falutin' rebuttals.

Once upon a time, the US federal government was financed primarily from import duties -- aka tariffs. However, back then the federal government was incredibly small by modern standards, and given the popularity of Social Security and the welfare state, it's never going to shrink back.

As those dusty obsolete economics books correctly point out, tariffs by themselves are an incredibly inefficient way to collect tax revenue. Tariffs can be dodged by making it here when otherwise it would be more efficient to make it there. Most of the revenue ends up in the hands of domestic producers, vs. the federal government. And opportunities for Comparative Advantage are lost, which makes economists sad.

Indeed, during the American Civil War, the Union levied an unconstitutional income tax in order to fund its side of the war. Tariffs were insufficient, especially considering that most of the tariffs had been collected in the then rebellious states.

Donald Trump's take of replacing the Internal Revenue Service is thus double plus silly. But hey, he's a silly guy who rides in a garbage truck. What do you expect?

But today, we have a permanent federal income tax. We also have additional labor taxes in the form of Social Security and Medicare taxes. And we have a welfare state. These factors make the classic economics texts obsolete!

Today, when a company chooses to insource to avoid tariffs, the company gets hit with income taxes and labor taxes. Today, tariffs lead to federal government revenue both directly and indirectly.

Trump's ten percent tariff baseline as an additional revenue source is not silly. Indeed, I will make the case later that ten percent is way too low if we want to be revenue neutral with respect to the choice of whether to make it here or there.

And we most definitely need additional revenue. Treasury department spending nearly doubled between FY 2019 and FY 2024. That is, interest on the national debt is exploding. Debt service now costs more than national defense. And there is no way to offset this cost with spending cuts without depriving old people of their Social Security checks and/or depriving both old and poor people of medical care. The money has already been spent!

Revenue tariffs are an essential component to avoiding national bankruptcy. We cannot tax our multinational corporations heavily without some serious tariffs. Without tariffs, multinationals can move their profits to tax havens with a bit of accounting magic.

Exactly how high those tariffs should be in order to be revenue neutral is a matter for a later section. Let us open that black box a bit and think globally first.

A Dangerous Feedback Loop

We have a paradox. If we think locally, zero tariffs constitutes Subsidized Outsourcing. If we think globally, however, local revenue neutral tariff policies lead to double taxation of international trade. This makes economists sad. Double taxation of world trade means lost opportunities for Comparative Advantage, lost opportunities for gigantic economies of scale.

But I submit that the Subsidized Outsourcing problem is the worse problem today. It is destroying the societies of the First World nations. Our relentless pursuit of Comparative Advantage has led to mass importation of foreign labor for the industries we are still good at and utter contempt by the elite for those who worked in industries where the US no longer has a competitive advantage. Silicon Valley is now 70% foreign born. It is basically a foreign country on US soil. Meanwhile, we have massive welfare ghettos and a rusting Rust Belt. While official unemployment rates are low, male workforce participation has plummetted since 1950. We have too many men doing too much drugs and too much prison time.

We are flirting with fascism because our country is dying. And we are not alone. Look at Western Europe.

The problem stems from a dangerous positive feedback loop. When a country begins running a trade deficit, it loses tax revenue. Two options are available under Free Trade:

1. Increase domestic taxes.
2. Increase the budget deficit.

The first option makes the country less competitive for obvious reasons, which leads to yet higher trade deficits. But the second option also leads to higher trade deficits! Budget deficits raise the cost of capital. Countries running a trade surplus have an incentive to buy the financial instruments of the budget deficit country instead of the products.

The brute instincts of politicians are thus wiser than the theory infused pronouncements of most modern economists.

But still, stabilizing economies by ending Subsidized Outsourcing through tariffs alone does result in double taxation of international trade. Economists do have reason to be sad at my first solution. I'll give some alternatives later, but first let's look at how much double taxation are we talking about.

Time to Run some Numbers

So how high would tariffs need to be in order to be revenue neutral with respect to outsourcing decisions?

As a first hack, we can look at a long running proposal to replace the federal income and labor taxes with a national sales tax, aka the Fair Tax. A national sales tax would tax foreign and domestic merchandise identically. And if all countries replaced their income and labor taxes with a national sales tax (or Value Added Tax), we would have world Free Trade without the Subsidized Outsourcing problem! We'd have happy economists dancing and blowing bubbles.

Alas, the Fair Tax has some serious problems. First, it is regressive as all get out. It is much easier to defer spending if you have a high income. If we replace Social Security (and maybe even Medicare) taxes with a national sales tax (or other consumption tax such as tariffs), the net result is progressive, since the Social Security tax is flat on the bottom but chopped off at the top. But replacing the income tax is quite another matter. We can simulate the Standard Deduction with the Prebate, but the rich get too big a windfall.

The other problem with the Fair Tax is that it's impossible to collect without creating an even worse police state. The income tax is a "voluntary" tax. It works with just a few audits and an acceptable level of government terrorism. People "voluntarily" report their incomes because they know that other people and businesses are giving the IRS most of the necessary data. The employer reports employee income in order to get the deduction for himself. The big business reports supplier revenues in order to get deductions from corporate income tax.

A sales tax has one point of collection/reporting, and everyone involved has great incentive to cheat. It would require no-knock audits, undercover agents, and/or the elimination of physical cash. Kind of Beastly if you ask me.

State sales taxes work because they are low (and they do have no-knock audit provisions). A 30% national sales tax on top of state sales taxes are a completely different ball game.

Thirty percent! In 2016, Libertarian Presidential candidate Gary Johnson was calling for a 30% national sales tax. All that cheap Chinese merchandise at Walmart? 30% tax! Donald Trump's 10% tariff baseline looks pretty wimpy by comparison.

However, if the Fair Tax follows the conventions of typical sales taxes, it would only apply to final products, not intermediate goods, like raw steel or parts going into a new washing machine. I would need to reread The Fair Tax Book in order to be certain. According to Mark Skousen, intermediate goods are roughly half of economic activity. If we include them, that 30% drops to 15% -- which seems a bit low, as federal spending is more than 15% of the economy.

Also, The Fair Tax Book was published back in 2005, before the Boomers began retiring and federal deficits broke a trillion dollars per year.

Let's try again. Let's use federal spending as a percentage of GDP as our basis for computing proper tariffs -- assuming a target of a balanced budget. According to Wikipedia, federal spending is 23% of US GDP and GDP does NOT include intermediate products. So if we are to tax all economic transaction an average of 23%, that means we need baseline tariff rates of...30%.

Huh?!

A Difference of Conventions.

Fans of the Fair Tax have probably been grumbling at my 30% figure. The Fair Tax people like to use 23%. They are being fair and cheating at the same time. They are being fair by using the conventions used for income taxes on labor. They are cheating because sales taxes and tariffs generally use a different convention.

For income taxes on labor we use percentage of money paid out. For sales taxes and tariffs, we use percentage of value received -- after tax is paid.

Let's illustrate using a 23% flat income tax with no deductions. A worker who earns $130,000 pays approximately $30,000 in income taxes.

Now consider buying a $100,000 item directly from China with a 30% tariff. The tax comes out to $30,000, for a total price of $130,000.

Social Security and Medicare taxes use yet a third convention! Employers pay half of each. This screws everything up, since the total wage $W_T$ differs from the nominal wage $W_N$ .

The employer portion of Social Security is 6.2% and the employer portion of Medicare is 1.45%. Since the employee portions of FICA taxes also total 7.65%, the marginal tax on an employee in the 10% income tax bracket is:

which is really close to my target average tax rate of 23%.

Of course, 10% marginal income tax is not the same as 10% average. There be many deductions, and there are tax free benefits like health insurance and 401(k) plans. Low income earners pay no income tax -- as ought be. (The income tax was originally intended to be a surcharge for the very rich. Consumption taxes like tariffs were for the masses.)

But the marginal gain to the federal government for workers getting a low wage job can be far higher than 23% of what the employer is paying! When a worker who goes from Medicaid or an Obamacare subsidized health plan to employer provided plan the federal government is gaining something close to 100% of what the employer is paying out in tax free benefits! Ditto for other welfare clawbacks such as free school lunch, subsidized housing, etc.

Once we factor in the cost of the welfare state, that 30% rate starts to look low.

There Will be Windfalls

Those dusty old economics classics predict that tariffs would give windfalls to producers at the expense of consumers. To some degree they remain correct.

Consider the case of a struggling maker of deluxe flush valves, a family business since 1926. Profit margins are zero, but the company muddles along more out of tradition and loyalty to the remaining workers. Foreign competition has been brutal. 30% across the board tariffs are imposed and the Chinese competition refuses to budge on price. Ceteris Paribus that 30% increase is pure profit margin for the Worthington Howell Flush Valve company. Worthington Howell IV could pocket the profits and buy back that ivory back scratcher he had to sell to pay off gambling debts. While the government gets a piece of that profit in the form of income tax, it is only a piece. Meanwhile the 30% tariff charged to the Chinese is pure tax money.

The American company is getting a windfall. Somewhere, a libertarian economist is neener dancing...awkwardly.

But that neener dancing economist should be embarrassed. He missed part of the puzzle. While the Worthington Howell Flush Valve company was making no profits before the tariff, it did have revenues -- which went to employees, suppliers, etc. which did pay taxes. The government gains less additional tax money per flush valve from the American company because it was already getting money from the American company, whereas it was getting nothing from the Chinese company under Free Trade.

If Worthington Howell IV decides to expand operations due to the higher price, net government revenue per additional American flush valve will be about the same as per Chinese valve, for reasons already explained. If the American company is content with a lower profit margin in return for higher volume, then the price per flush valve will eventually fall to somewhere between the Free Trade price and the immediate price spike from imposing the new tariff.

Tariffs on Intermediate Goods

Thus far I have focused on final products. Things get a bit more complicated when we consider the goods needed to make the final goods.

Consider an American manufacturer who relies on a Chinese part, and there is no US made equivalent. I have been hearing some tales of great woe from my Libertarian friends of American businesses in this predicament.

If the tariff rate is 30% across the board, the solution is to simply pass along the additional cost to the customers. Any competitor would be in the same circumstance. Things get tricker when tariffs vary from country to country. Trump recently imposed a 145% minimum tariff rate on Chinese imports. A competitor in a country with a much lower tariff rate could buy the Chinese part without the penalty rate and then sell the finished product in the US. If said part is a major portion of the cost of the final product the US manufacturer does indeed lose.

And if something like the 30% across the board tariff becomes the norm across the world, we get a serious cost problem for intermediate goods made from intermediate goods from yet other countries. Each border crossing imposes a double tax. This might be a real problem.

But for now let's go back to the world as black box model and look more closely at intermediate goods. In fact, let's start with a refresher on intermediate goods made domestically. Recall that I wrote you can look at the entire revenue stream of a final goods producer to roughly determine the tax collected. (At least, you can for consumer goods, including goods consumed by the government. I'll leave it to those more expert in tax law to handle capital goods.) But if you do this for intermediate goods producers, you get a double count. Yes, intermediate goods producers and their employees generally pay taxes, but their revenues constitute tax deductions further downstream.

It all balances out when we keep things domestic, but things get off balance when we go international.

Consider a domestic consumer goods producer which purchases intermediate goods from abroad under Free Trade. We have the tax deduction as usual, but no longer have the taxable intermediate goods producer. We have a leak! We can no longer take the total revenue of the consumer goods producer as a tax basis. The brute instincts of politicians to levy tariffs and other trade restrictions is an instinct to restore balance.

Now consider a domestic exporter of intermediate goods. The exporter gets revenues, but there are no corresponding tax deductions. The government gets a windfall! The brute instincts of politicians to subsidize exporters is also an instinct to restore balance.

Contemplate these instincts for balance a bit, and we can come up with a solution for the Subsidized Outsourcing problem which also should pacify free trade economists.

At Last, The Solution!

We have solution to Subsidized Outsourcing which involves no tariffs, save for direct consumer purchases from abroad. And that solution is to make the Black Box even blacker. If it doesn't happen here, the IRS doesn't see it.

That is, eliminate the tax deduction for the cost of imports. For Samsung USA, the wholesale price of their washing machines is pure profit, save for the costs of US employees, US shipping, and marketing costs.

And also treat the revenues of exporters as something that happened abroad. No government tax windfall for exports.

The arrangement creates negative feedback. Countries running a trade surplus lose tax revenue compared to the current convention. Countries running a trade deficit get more tax revenue. This makes the surplus countries less competitive and the deficit countries more competitive, naturally bringing things into balance.

The arrangement also single taxes international trade just as Free Trade does. But instead of eliminating taxes on imports, we eliminate the tax on exports. (This is similar to replacing income taxes with consumption taxes, by the way, except we have the double-entry accounting and potential progressivity of the income tax.)

And it's very much in the spirit of MAGA and other forms of nationalism. Each country minds its own business. We get nationalists and economists dancing and blowing bubbles!

Tags: world trade tariffs