The Free Market Case for Revenue Tariffs

Carl Milsted, Jr on May 7 16:37:47

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Originally published August 1, 2018

“Free Trade” isn’t.

For those who haven’t noticed: We live in a hugely expensive welfare state. Domestically produced goods are taxed from multiple angles. We have corporate income taxes at the state and federal level for corporate profits, and then tax the profits again when the owners sell shares or collect dividends. Wages are taxed via Medicare taxes, Social Security taxes, the federal income tax, and state income taxes.

Imports without tariffs aren’t free trade; they are subsidized trade.

Once upon a time our leaders knew this, and enacted low tariffs anyway. Much of the world was digging out from the rubble of World War II, and we feared a Communist takeover of the Free World if we didn’t lend a hand. Our low tariffs were an intentional subsidy to preserve democratic capitalism.

Today, the biggest beneficiary of this policy is nominally Communist China.

The People know there is something wrong, that our heartland is being economically gutted. They have been trying to get the Establishment’s attention for decades. Eventually they go so fed up that they elected a blatantly dishonest, foul-mouthed adulterer who has all the charm and manners of a pro wrestling heel to be our President.

It didn’t begin with Trump or the recently resurgent Racist Right. This has been fermenting for a while from both ends of the political spectrum. Remember H. Ross Perot? He might have become President if he hadn’t dropped out of the race for a bit, and then picked a running mate who was laughably unprepared. Remember the WTO protests? Those were Leftists.

The Establishments — both D and R — are losing out to those ignorant of textbook economics. Because the basic textbooks are dangerously wrong.

The Simple Textbook Case Against Tariffs

With the right premises the textbook argument against tariffs is logically impeccable.

Let us consider a simple case: an automobile tariff. Let’s consider a parallel universe where Toyota’s are still imported from Japan, Volkswagons from Germany, etc. Slap a 25% tariff on foreign made automobiles and what happens?

GM stockholders get a windfall. Consumer advocates complain about expensive unreliable gas guzzlers. Conservatives complain about uppity labor unions. Economists lament the resulting inefficiency: those extra workers building Oldsmobiles could be working on higher value goods such as solar panels, video games, or viral websites featuring cute kitten pictures.

Meanwhile, the government gets little revenue from the tax. The tax is easy to dodge: just buy from the Big Three.

In this scenario the tariff is indeed a net bad. It costs consumers while doing little for the Treasury. Score one for the Establishment.

But this scenario is artificial!

Here in the real world domestically produced goods are taxed too. The Big Three pay federal corporate income taxes — now only 21%. The factories in Michigan are subject to 6% state corporate income tax. Shareholders pay income tax on dividends — somewhere between 10% and 37%, which is a total profit tax between 29% and 50%. The workers pay between 10% and 37% marginal income tax rates, depending on their pay rates and deductions. For non executives, the entirety of their wages are subject to payroll and Medicare taxes (15.3% of nominal wages). Michigan auto workers pay a flat 4.25% state income tax on their wages.

That 25% tariff is starting to look a bit low by comparison.

(Astute readers will note that corporations don’t actually pay the full corporate income tax. In part this is because of overly generous depreciation schedules. The other reason is that today multinational corporations can move their profits to tax havens through accounting trickery. If tariffs are set at least as high as the corporate income tax rate, this cheat goes away. Liberals take note!)

A Different simple Scenario

Some readers might be troubled by my comparing tariffs to income and payroll taxes. After all, corporate income taxes are paid by corporations, payroll taxes by a combination of employers and employees, etc.

This is where reading the economic textbooks pays off. An income tax is a tax on the transactions that produce the income. A tariff is a tax on the transaction between purchaser and foreign producer. Exactly who takes the tax hit depends on “elasticity.” (Look it up.)

The picture would be clearer if we used consumption taxes instead of income taxes. Suppose we replaced the income and payroll taxes with a 30% across-the-board national sales tax, as the Fair Tax people advocate. (They cheat by advertising a 23% number. If you have a 30% sales tax, the tax is 23% of the total cost.) That 30% tax would fall on domestically produced consumer goods and Chinese imports equally.

A Fair Tax coupled with complete elimination of tariffs is the same as a 30% across-the-board tariff rate on consumer goods. In 2016, the Libertarian candidate was more protectionist than Donald Trump! (Gary Johnson endorsed the Fair Tax.)

I have a question for Free Traders: would the Fair Tax be unfair mercantilism? If we had such a tax should imports be exempt?

On Producer Externalities

One could answer: “Yes, domestic goods should be taxed more since producers consume government services.” Also, domestic factories are ugly, often smelly, require government infrastructure and protection, and require government regulators to protect us from dangerous chemicals. When we move production to China, we move away the pollution to somewhere out of sight and smelling range.

But domestic production produces positive local externalities as well. That Oldsmobile factory can turn welfare recipients into productive citizens. It can make manual laborers into middle class Americans who can afford to pay for their own health insurance.

I’d rather pay for an overpriced Oldsmobile than pay taxes for welfare and Medicare for All.

Comparative Advantage Nonsense

The advocates of Free Trade point out that when we replace domestic goods with imports we free up labor for higher value items. Just look how well that worked in Allentown, Youngstown, Detroit, Kannapolis…

Sometimes Creative Destruction isn’t all that creative.

Here’s a wakeup call to academia: not everyone is college material. Not everyone is suited to be a symbol manipulator. For millennia, the bulk of humankind has been hunters, fighters, and farmers. Symbol manipulation was for shamans and weirdos. We are short on hunting grounds, the farms have been merged, and job opportunities in the military are limited.

By subsidized outsourcing of manual production, we are freeing up locals to be gang members and spaced out druggies — along with the police and prison guards who take care of them.

I’d rather pay for an overpriced Oldsmobile than for an archipelago of prisons and security forces to protect me from the unemployable who aren’t in prison yet.

The Double Taxation Problem

Note that I am not calling for full on mercantilism, protection of special industries, or anti dumping laws. I am calling for flat, across-the-board, tariffs that are comparable to our domestic taxes. This is a neutral position, if we treat foreign nations as black boxes.

(And as someone who prefers to limit meddling in foreign lands, I think treating foreign economic policies as black boxes is a Good Idea.)

Astute economists will note a problem with my proposal: if nations use a mix of income taxes and comparable tariffs, international trade goods get double taxed. That Japanese Toyota gets taxed by Japanese taxes before it comes here to be taxed with my proposed tariff.

And so the wonks keep calling for a more optimal system: zero tariffs by everyone.

These days, I disagree with the wonks. Two reasons:

1. Free Trade Agreements are Unstable

Suppose two countries (A and B) agree to zero out import duties and only tax domestic labor and profits. This is fair and momentarily efficient.

Then Country A starts running a trade surplus with B for some reason (it matters not what). Country A gets a tax windfall. If a conservative government is running Country A, then producers in Country A get a tax cut — which encourages businesses to move their profit generating activities from Country B to Country A.

Meanwhile Country B loses tax revenue. They can either do without some government services, or raise taxes. The latter could drive away producers reducing the tax base further. (So could the former if the government services are actually useful for producers.)

We have an unpleasant positive feedback effect.

The impulse to cheat becomes enormous. Country B could resort to non tariff barriers. They could increase net revenues in the short run by subsidizing some of the remaining producers (while undermining the rule of law). Or they could switch from income to consumption taxes, and have tariffs under a different name.

To stop such cheating you need an international body with clout: neutral bureaucrats with the power to review a very wide range of domestic tax and regulatory policies. You need to disable democracy.

None of this is hypothetical. It has all happened in the European Union.

I’d rather suffer a bit of economic inefficiency than turn over government to globe trotting bureaucrats.

2. Redundancy is Robust

When the Big Three got fat and sloppy, consumers were rescued by quality auto imports from Japan. International trade was very useful.

But those high quality, high gas mileage, Japanese autos existed in part because Japan had a mercantilist economy which fostered the local auto industry. Had the Big Three been allowed in before the Japanese perfected their own brands, history might have been less pleasant.

Perfect Competition is only efficient in the short run. Perfect Competition creates a Winner-Take-All dynamic that leads towards monopoly and oligopoly.

Imperfect Competition preserves economic diversity. Having economic speed bumps around the nations of the world creates a home court advantage in each nation, nurturing businesses that aren’t currently world class. This makes the world more diverse and interesting. And as long as the speed bumps aren’t too high, we get to sample the diversity in the form of premium luxury brands, exotica, and extreme niche products.

(And where Comparative Advantage is truly compelling, the speed bumps are just another source of tax revenue.)

Tariffs vs. the Fair Tax

If everyone switched from income to consumption taxes, we could have stable trade without international bodies, and the speed bumps would be minimal.

But we would also have a tax system that is regressive. The rich can better afford to save. Wealthy families could accumulate wealth over generations without paying tax.This could be a problem.

Perhaps a combination of wealth and consumption taxes could work.

But I have one other objection: an across-the-board consumption tax would be fair. I don’t want to be completely fair. I actually want to subsidize imports from the truly needy nations of the world.

Sub Saharan Africa is currently experiencing the demographic explosion that just about every other region has experienced when making the transition to the modern world. If they don’t complete their Industrial Revolution at a breakneck speed, humanitarian and environmental catastrophes will happen soon.

I want to actively subsidize trade with these developing nations. So my preference is flat tariffs for all, save for imports from the poorest nations.