“While protectionism may intuitively seem to benefit the American economy, it contradicts decades of modern economic insight, and it will ultimately make working class Americans worse off.”
By David Riccione
On campus and around the city, there’s no short supply of political activism in revolt against the new president’s plethora of new policies. Whether it be discontent regarding Trump’s seemingly nonsensical moratorium on immigration from 7 predominately Muslim countries, or continued dissatisfaction from the flagrantly reactionary social and cultural positions he took during his campaign, much attention has been given to Trump’s social policies. I agree these issues have merit, but there are also colossal concerns regarding upcoming Trump economic policies that will have material effects globally, that also deserve our attention. I hope this article serves as inspiration for activism regarding Trumpanomics as well.
As a student of economics, I’ve always been skeptical of arguments that lack empirical or quantitative corroboration, so I’ve decided to focus this article on the hard, theoretical, analysis of one of Trump’s most contentious policy proposals: the installment of protectionist economic policies, particularly the 20% border tax on Mexican imports called the Destination Based Cash Flow Tax (DBCFT), or Border Adjustment Tax. This policy will undoubtedly have measurable impacts on American consumers, and will substantively make the average American (not just Mexican) worse off.
What is the DBCFT?
We are all familiar with Trump’s early campaign promise to build a border wall along the Mexican-US border, and even more so with Trump’s promise to make Mexico pay for it. After not securing the funding directly from the Mexican Government (surprised?), the Trump administration decided that they could extract the funding by applying this Border Adjustment Tax – a 20% tax on all products produced outside of the US, in this case Mexico, and sold to US consumers.
The plan, on the surface, seems elegant, and many House Republicans see it as a replacement for what is a broken corporate tax code. The idea is this: the current US corporate tax level is cripplingly high (35% – the highest in the developed world), but the code is riddled with easily exploitable loopholes. US corporations often capitalize on these loopholes by realizing their profits in nations with lower corporate taxes – Ireland, Switzerland, etc. – essentially robbing the U.S. Government of tax revenue. Feel free to Google Tax Inversion for more details. So the Trump administration’s solution is to lower the corporate tax to 20%, and then make up the revenue difference by taxing foreign produced goods consumed domestically (via DBCFT).
It’s simple; the government stops trying to track down how profits are realized, and instead decides that it doesn’t care: if you sell goods in the US but produce them abroad, we’ll tax your product 20% regardless of where you domicile your profits – alternatively if you produce in the US and sell abroad, you aren’t taxed on those sales. Companies can trick the government vis-a-vis where their profits should be recorded, but they can’t trick the government as to where they are actually selling their products.
The Trump administration also argues that it will help promote a healthier balance of trade with foreign trade partners, as it discourages consumers from buying the more expensive foreign produced products. This seems like an appealing solution, superficially, and it in many ways resembles Europe’s Value Added Tax. However, anyone with even the most basic understanding of international economics understands that protectionist trade policy, and more particularly the DBCFT, is and will be generally detrimental for both, the host and global economy.
Who Actually Pays for the Wall?
The idea of free trade is intuitive. Countries should specialize in producing products that they can make at the lowest marginal cost (or lowest opportunity cost, according to Ricardo). Thus if every country specializes in producing those goods and services at the lowest global unit cost, they are able to trade for the goods and services they need and everyone pays the lowest price for the most goods and services that could be available with a finite amount of global resources. This logic has guided international economic policy for decades, and it is the reason why average global tariffs have fallen consistently since the early 20th century Today, the total value of all global imports is equal to nearly 30% of global GDP, almost 2.5 times the 1960 level, according to the World Bank. However, Trump’s nationalistic Border Adjustment Tax, although certainly a great way to gain populist emotionally driven support, contradicts this modern economic law.
If countries selfishly look inward to give some of their industries a tax advantage (by taxing foreign produced products at the border), they encourage the growth of domestic industries with more efficient counterparts abroad. This is bad for domestic consumers, bad for the environment, and bad for the entire global community.
Think of this practical example: the United States is great at developing software and hardware. Apple engineers its iPhones in the United States because we can produce that service at a lower cost than most other places in the world. However, Apple manufactures its iPhones in China, because China can manufacture the physical phone at close to the minimum global unit cost. This is near global economic efficiency, i.e. nearly zero waste as everything is produced as cheaply as possible.
But what happens when you introduce a tariff? Suddenly it’s 20% more expensive for Apple to produce its product in China, so they may decide to move their manufacturing facilities to the US (they probably still won’t). Accordingly, Trump tweets about making new jobs, but under the surface the world is now worse off. Apple creates the phones in the US at a higher unit cost than it would’ve in China, expending more global resources, and the extra cost is passed onto the consumer in higher prices. Apple could decide to continue production in China, nonetheless, consumers would still need to pay the higher price that Apple would charge in order to recover the losses created by the DBCFT.
So what is the moral of the story? Tariff models like that imposed by the Border Adjustment Tax actually make average American’s considerably worse off, as the tax imposes higher prices on consumers. Ironically, this would effectively transfer the burden of a corporate tax onto American citizens. Even more ironic, is that when applied to the Mexico example – it wouldn’t be Mexico effectively paying for the wall, but the average US consumer, as companies who produce their goods in Mexico but sell in the US will simply pass the burden of the tax onto US consumers making them pay more (if they decide to move to the US instead, consumers still pay because they must pay higher prices from less efficiently produced products).
Even this analysis is reductive, because higher prices won’t just hurt consumers, but the entire economy. Higher prices usually lead to inflation, which has broad economic costs.
Those Worse Off
What’s most troubling about tariffs like the DBCFT is that those most considerable damaged will be the poor. Lower class American’s consume a large quantity of imported goods as they are more price sensitive to the esoteric, locally produced, economies of the wealthier. They also spend a considerably larger part of their income on necessities. Accordingly, a tariff would mean they would be hardest hit by more expensive products.
Indeed, most studies explicate that Trump’s comprehensive tariff plan will impose $2,200 of extra cost onto the average American household consuming a fixed bundle of goods per annum, equivalent to 4% of after tax income. However, for the poor, Trump’s comprehensive tariff plan would consume up to 18% of their per annum after-tax income, almost 5 times the national average (see CNN citation for more details).
But this is just one side of the story. What happens to the global community when countries begin to abandon free trade? Undoubtedly free trade and globalism have lifted billions of humans out of chronic poverty via economic growth. Since 2001 global poverty has fallen by 15%. Furthermore, global inequality has fallen considerably in the last 40 years due to rapid growth of developing export based economies across the globe – most estimates show that global inequality has fallen as much as 8% since 1980 (note this is inter-country inequality, not intra-country inequality, which has risen).
Tariff models like those introduced by the Trump administration would reverse these trends, as countries looking to industrialize would no longer have easy access to American markets to grow their production. The implication is of course that the global poorest of the poor would be doomed to their static scarcity, while the poorest of the poor in America will sink even further into scarcity.
The evidence of much of the theory I’ve presented thus far is well explicated by work done by Dominick Salvatore, PhD in Economics at Fordham University, in which he measured the cost of protecting few select American industries with tariffs.
For example, for the market for Frozen Orange Juice, a 30% levy on all imports was imposed. On average, this costed American consumers $281 million from price hiking (the difference between the global price, and the American price, multiplied by the number of units bought in America). Indeed, Trump would argue that there was a benefit from this tariff in the form of new jobs created from domestic producers who could now compete because of the advantage of the tariff. However, Salvatore shows that this benefit amounted only to $101 million. From such, it’s easy to see that the tariff created a net loss for American society, which amounted to $57,000 per job in Frozen Orange Juice Production.
The logic here is actually as comical as it is disturbing, because American’s would have been better off paying every person employed to create Frozen Orange Juice up to $56,999 to do nothing, rather than to work under the conditions of the tariff. Although the study was conducted in 1990, the model elucidated by Salvatore applies universally.
Accordingly, the principle here regarding the DBCFT is analogous. Although we will create more American jobs, the benefit of those jobs will be far outweighed by the cost that every American will have to pay in the form of higher prices. Americans would actually be better off paying those potentially employed by tariff protected industries to do nothing, rather than to work (up to the cost/job).
Well, as we discussed, clearly American firms who could not produce products at a marginal cost below the global equilibrium price, can now enter the market if the new domestic tariff price rises above their marginal cost. Accordingly, domestic corporations will net win.
Furthermore, special interest groups, particularly organized labor, in industries that exist domestically only by the harbor of the DBCFT will win. American steel is an excellent example of such, but US manufacturing generally applies. United States consumers were forced to pay up to $650 per ton of steel going into 2016, whereas if there were completely frictionless international trade for steel, consumers could’ve paid as low as $450 per ton.
It should be clear that a select few, firms and their labor, are benefiting at the expense of the majority. Trump’s new tariff plan would continue this trend, but instead of affecting only a few niche industries that have lobbied well, it will be much broader in its touch.
The Bottom Line, and Alternative Solutions
As has been vigorously enumerated, clearly trade barriers like tariffs are not the solution. If applied to Mexico specifically, Americans will be indirectly paying for the wall. If applied to all nations, average American consumers could face cripplingly high prices and spiralling inflation.
This isn’t to reject the fact that there are indeed losers to free trade. That is to say, there are unequivocally Americans who are worse off from the hyper specialization of national economies. American industrial workers laid off as factories migrated to their most efficient homes (East and Southeast Asia), are an example of losers. Note that this is still to the net benefit of Americans and the globe, as our own economy develops industries in our own specialties like white collar service sector industries, as emerging economies have a source for economic growth, and as everyone pays less.
However, the minority of people worse off need attention. This attention could be in the form of increased Structural Unemployment Aid, in which American taxpayers transfer some of the benefits they receive from free trade to those who now suffer. Job training, education, and temporary cash relief are also tools that could be employed to assist displaced workers find new skills relevant to the specialized domestic economy.
In order to deal with the poor US corporate tax code, fixing the code itself instead of completely replacing it with a tariff based system would be far more favorable. Reducing loopholes and closing exceptions would yield higher government revenue, and it may even allow the government to reduce the nominal tax rate.
These solution are far from exhaustive, but they are considerably more rational than a blanket tariff policy. The new president would do well by considering them.
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This is an insightful and articulate description of the dangers of insular protectionist policy. While seductive on the surface they often spread more diffuse pain around then the gains they make for a few. In addition to your points, I would mention that increasingly insular and nationalistic nations are more likely to engage in conflict too. History has shown that globalization has contributed to not just increased economic prosperity but also to a decrease in global war. The hyper nationalism, xenophobia and protectionism of the early 20th Century brought us two world wars and a depression. International interdependence has more than just economic advantages too. Thanks David for this thoughtful article.
Excellent article. Well thought out and based on objective facts and data. very impressive