Is a Flat Tariff the Answer to America’s Trade Mess?
Economics / Economic Theory Sep 25, 2010 - 06:28 AM GMTBy: Ian_Fletcher
The House Ways and Means Committee has finally approved a bill that would attempt to crack down on Chinese currency manipulation, a key cause of America’s trade deficit, by threatening China with retaliatory tariffs. Leaving aside the bogeyman of a trade war—which China is unlikely to start as the nation running the trade surplus and thus the nation having something to lose—this raises the obvious question of whether tariffs are a plausible long-term solution to America’s trade problems. What would happen, that is, if America reverted to its historical norm (from Independence to after WWII) of being a tariff-protected economy?
The obvious question here is what kind of tariff are we talking about? As I have documented in other articles and in the book Free Trade Doesn’t Work, there are any number of valid criticisms of the economics of free trade. There is not one thing wrong with it, but at least half a dozen things, and they get complicated very fast. As a result, the nightmare that haunts criticisms of free trade in this country is this: what if these criticisms imply that America needs a complicated technocratic tariff policy? This seems to be suggested by the complexity of the defects in free trade and by the fact that the nations which have most successfully repudiated free trade actually have complicated technocratic tariff policies. That would spell trouble, as the political difficulties of achieving such a solution in America are no secret. The dangers of a special-interest takeover are not imaginary. Even if America has in the past done a lot more successful picking of winners than laissez faire ideologues are prepared to admit, it’s so hard to convince people of this fact that we might as well take the pessimistic assumption that this is not feasible as our baseline, and if it later turns out to be feasible, treat it as gravy.
Billionaire investor Warren Buffett says that one of his criteria for investing in a company is that it must have a business that even a fool can run, because sooner or later a fool will. A similar philosophy should guide our construction of a tariff policy. We need a broad-based policy that can survive imperfect implementation and political meddling, a certain amount of which will be inevitable. We do not need an intricate, brittle, difficult policy that will only create work for bureaucrats, lawyers, and lobbyists. Among other things, any policy too complex for the public to understand will be beyond the reach of democratic accountability, the only ultimate guarantee that a tariff policy will remain aimed at the public good.
One of the great puzzles of American economic history is how the U.S. once succeeded so well under tariff regimes that were not particularly sophisticated. This is where the idea of a so-called “natural strategic tariff” comes in. This idea says that there may be some simple rule for imposing a tariff which will produce the complex policy we need. The simple rule will produce a complex policy by interacting with the existing complexity of the economy. All the complexity will be on the “economy” side, not the “policy” side, so all specific decisions about which industries get protection, how much, and when will be made by the market. No intricate theory, difficult technocratic expertise, or corruptible political decision-making will be required.
There are obviously any number of possible natural strategic tariffs. The one we will look at here (probably the best) is actually the simplest:
A flat tax on all imported goods and services.
Prima facie, this is strategically meaningless because it protects, and thus promotes, domestic production in all industries equally. And if a tariff is going to win the U.S. better jobs, it will do so by winning us strong positions in the sorts of industries (largely but not exclusively high technology) that have the per-man-hour productivity to pay high wages today and have a future in terms of spawning the industries of tomorrow. While a flat tariff would help reduce the deficit, which is extremely important in its own right, it would provide the same incentive for domestic production of computer and potato chips alike, so it would not push our economy towards any industry in particular.
Or would it? The natural strategic tariff is a bet that it would. The key reason is this:
Industries differ in their sensitivity and response to import competition.
Although this is a complex issue, the fundamental dynamic is clear from the obvious fact that a flat tariff would almost certainly trigger the relocation back to the U.S. of some industries but not others. For example, a flat 30 percent tariff (to pluck a number out of thin air) would not cause the relocation of the apparel industry back to the U.S. from abroad. The difference between domestic and foreign labor costs is simply too large for a 30 percent premium to tip the balance in America’s favor in an industry based on semi-skilled labor. But a 30 percent tariff quite likely would cause the relocation of high-tech manufacturing like semiconductors. This is the key, as these industries are precisely the ones we should want to relocate. Therefore a flat tariff would, in fact, be strategic.
The exact level at which to set the tariff remains an open question. Thirty percent is suggested here because it is in the historic range of U.S. tariffs and is close to the net disadvantage America’s trade currently faces due to America’s lack of a VAT. The right level will not be something trivial, like two percent, or prohibitive, like 150 percent. But there is absolutely no reason it shouldn’t be 25 or 35 percent, and this flexibility will provide wiggle room for the compromises needed to get the tariff through Congress.
Granted, a natural strategic tariff would be an imperfect policy. But it would be infinitely better than the “free” (on America’s part but not on the part of our trading partners) trade we have now, and relatively politics-proof. Above all, it is a policy people are unlikely to support for the wrong reasons (i.e., producer special interests) because it does not single out any specific industries for protection. It thus maximizes the incentive for voters and Congress to evaluate protectionism in terms of whether it would benefit the country as a whole—which is precisely the question they should be asking. It would also create the right balance of special-interest pressures: some interests would favor a higher tariff, others a lower one. This is a prerequisite for fruitful debate, as it means both views will find institutional homes and political patrons.
The tariff’s uniformity across industries would avoid the problems that occur when upstream but not downstream industries get tariff protection. For example, if steel-consuming industries do not get a tariff when steel gets one, they will become disadvantaged relative to their foreign competitors by the higher cost of American-made steel. And why should steelworkers be protected from foreign competition at the price of forcing everyone else to pay more for goods containing steel? The only reasonable solution is that steelworkers should pay a tariff-protected price for the goods they buy, too. This logic ultimately means that all goods should be subject to the same tariff.
The natural strategic tariff is more ideologically palatable than most other tariff solutions. Above all, it respects the free market by leaving all specific decisions about which industries a tariff will favor up to the marketplace. It will thus be considerably easier for ideological devotees of free markets to swallow than some scheme in which tariffs are set by a federal agency, leading to that nightmare of free-marketeers: government picking winners.
One obvious objection is simply that a tariff is a tax increase. So it is. But it does not have to be a net tax increase if the revenue it generates is used to fund cuts in other taxes. In order to obtain a “clean” policy debate, in which the tariff is debated purely on its merits as a trade policy, unmuddied by differing opinions about the total level of taxation, any tariff proposal should be packaged with compensating cuts in other taxes.
Another objection to a tariff is that if American industry is granted tariff protection, it will just slumber behind it. Many industries indeed long to shut out foreign competition, reach a lazy detente with domestic rivals, and coast along with high profitability and low innovation. But a flat tariff resists this danger because it does not hand out a blank check of protection: it gives a certain percentage and no more. Any industry that cannot get its costs within striking distance of its foreign competitors will not be saved by it. This discipline, although unpleasant for the losers, is the price we must pay for having a tariff that actually works, rather than one which eliminates the discipline of foreign competition entirely and protects all industries, whether or not their protection is useful to the economy as a whole. And the logical remedy for competitive sloth is stiffened antitrust enforcement.
Another objection to a tariff is that our trading partners would just shrug it off by increasing subsidies to their exporters. This would force us into an endless game of matching these moves on a country-by-country, industry-by-industry, and even product-by-product basis. However, such subsidies by our trading partners would be restrained by the fact that they would be very expensive in the face of an American tariff. Right now, these subsidies are relatively affordable only because they don’t have to climb an American tariff wall. But if they did, their cost would increase dramatically. Currency manipulation is probably the only subsidy that is affordable over prolonged periods of time (and even then problematic in the end), as it involves buying foreign assets and debt, thus accumulating wealth rather than just expenditures. But other subsidies amount to a give-away from the exporting to the importing nation. While this doesn’t prevent them absolutely, it does tend to set a limit. This is all we need, especially as we have no hope of eliminating or countervailing all foreign subsidies no matter what we do, tariff or no tariff.
One final point: a natural strategic tariff would need to include a rebate on reexported goods in order to avoid handicapping American exporters. There would, of course, be any number of other administrative complexities, but this is true of any tax proposal in a complex economy.
Whether a flat tariff is ultimately the best trade policy for America is an open question, but it is worth considering the possibility simply because it sets a baseline, “the least we can do,” for a solution. And nothing about it precludes adopting a more complicated approach later. Even if we do not adopt such a policy, knowing that we plausibly could will give us crucial leverage in threatening our trading partners. It is thus an idea that even would-be free traders, who merely want to get America’s trading partners to stop interfering with genuinely free trade, should take seriously as a Rooseveltian “big stick” to hold in reserve as our diplomats talk softly to Hu Jintao.
Ian Fletcher is the author of the new book Free Trade Doesn’t Work: What Should Replace It and Why (USBIC, $24.95) He is an Adjunct Fellow at the San Francisco office of the U.S. Business and Industry Council, a Washington think tank founded in 1933. He was previously an economist in private practice, mostly serving hedge funds and private equity firms. He may be contacted at ian.fletcher@usbic.net.
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