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Nothing to Lose but Your (Supply) Chains

Posted on Sep. 3, 2019

Whether or not they are justified as a negotiating tool, tariffs throw a wrench into the workings of the global economy. A trade war, in which nations fire broadsides of tariffs at each other, is an economic storm with an outcome that's difficult to forecast. Until recently, international cooperation has kept tariffs in check, so we can’t rely on experience as a guide. Given our lack of familiarity with these matters, it's worth taking a few moments to drill down below the (Ricardian) textbook mantra about the superiority of free trade relative to protectionism and ask what a trade war means for people and businesses.

Free trade promotes competition. It allows producers to achieve greater economies of scale. It promotes the exchange of ideas and know-how. It allows consumers to enjoy a wider variety of products at lower costs. Reflecting the concerns of the public and politicians, the media’s coverage of the U.S.-China trade war has given primary attention to the effect of tariffs on consumer prices. 

On this count, it seems fair to say that so far America’s consumers haven't been overwhelmed. The U.S. inflation rate remains at the worryingly low level of 2 percent. This shouldn't be too surprising. Yes, the U.S. appetite for Chinese-manufactured goods is enormous, but it's still a relatively small part of the macroeconomy. Each year U.S. consumers spend about $14 trillion on goods and services. U.S. imports of goods from China amount to about $560 billion. During the two-year period between fiscal 2017 and fiscal 2019 (ending September 30), U.S. revenue from all customs duties increased from $35 billion to an estimated $72 billion.

Assuming that all of this $37 billion increase was attributable to new tariffs on imported Chinese goods, that would in the aggregate be only about a 0.03 percent (3 cents per $100) increase in the cost of goods and services. This assumes that all the burden of the tariffs is passed along to consumers, which is more likely to be true in the long term. Meanwhile, that relatively small burden on aggregate consumption will be offset by Chinese producers lowering prices, by U.S. business purchasers (most notably, retailers) lowering their prices, and by a decline in value of the renminbi vis-à-vis the dollar.

That has been our experience so far. But what about the immediate future? It's easy to get lost in the endless stream of inch-deep press reports, but the big news is this: U.S. tariffs on Chinese goods — as well as commensurate retaliatory tariffs by the Chinese government — will rise sharply before the end of this year. Last month the Trump administration announced that the existing 25 percent tariff rate on approximately $250 billion worth of Chinese imports will increase to 30 percent. Further, tariffs will be levied on approximately $300 billion of other Chinese imports (not yet subject to tariff) at a 15 percent rate. Calculations from the Peterson Institute for International Economics (in the adjacent figure) show that 97 percent of U.S. imports of goods from China are scheduled to be subject to an average tariff rate of 24 percent. That’s double the 2019 level.

Despite the burden the abrupt rise will place on particular items, a major increase in price level isn't in the cards. At most, consumers can expect a one-time 0.6 percent increase in the average price they pay for goods and services as a result of tariffs on Chinese goods. The pain caused by tariffs won't be so much at checkout counters as in the disruption to the planning, production, and processes that ultimately get products into the stores.

Right now uncertainty about the direction of trade policy looms like a dark cloud over plans for capital spending. The effect of uncertainty on business investment is hard to measure, but in this environment it cannot be ignored. In addition to the U.S.-China trade war, business has been befuddled into inaction by Brexit, the worldwide rise of economic populism, and — near and dear to the hearts of our readers — uncertainty about implementation of, and the likely impermanence of, the Tax Cuts and Jobs Act. The latest figures from the Commerce Department on business investment are startlingly low, especially in light of the 2017 tax cuts. Adjusted for inflation, for the year between the second quarter of 2018 and the second quarter of 2019, equipment investment is up only 2.7 percent, and investment in nonresidential structures is down 4.6 percent.    

Eventually, businesses must get over their jitters about where and in what to invest because they must maintain and expand capacity. Over the long term, a greater problem than uncertainty about future policy is the realization of future bad policy. When businesses get around to investing, some of that investment will sacrifice productivity to avoid tariffs. Capital won't be allocated to its most efficient uses. That brings us to the subject of supply chains. In what some call the “supply-chain economy” it matters not so much what you sell as the way you provide it.

In March Adam Posen, president of the Peterson Institute for International Economics, gave a lecture on the macroeconomic impact of trade wars. He stressed the inability of most economic models to capture the productivity losses from tariffs that break highly integrated multinational supply chains generating valuable network effects. That deficiency of economic models is largely attributable to lack of data (from the last 70 years) incorporating economic experience with major trade disruptions. Posen stressed that trade wars are not market-driven, but are political shocks motivated by economic nationalism. And he stressed that in the long run the major effect of trade wars will concern the breakdown of networks and economic relationships that will result in a reduction of productivity and income.

What does that mean for tax planning that is usually referred to as "tax-efficient supply chain management"? On the one hand, tax-efficient structures, which centralize risk and decision-making in regional low-tax headquarters and draw profits from related limited-risk distributors and contract manufacturers, could be sufficiently flexible to adapt to any business relocation needed to minimize tariffs or reduce tariff risk. In that case, maybe Google has just announced that it's moving cellphone manufacturing from China to Vietnam in part because of tariffs. It doesn't seem that the substitution of one related-party contract manufacturer in Country X for another in Country Y requires a rethinking of worldwide tax minimization strategy.

But that's probably just wishful thinking. The details may take years to manifest, but it's hard to believe that a trade war between the world’s two biggest economies — not to mention the new trade barriers soon to be erected between the United Kingdom and the European Union — won't upset the best-laid tax planning. Fine-tuned tax minimization strategies may have to take a back seat to tariff minimization. Stuart Webber and other authors have pointed out that the rise of tax-efficient supply chain management was made possible by a decline in trade barriers. Will rising tariffs and other protectionist measures reverse that historical trend? Carrie Brandon Elliot has described the interplay of transfer pricing (for income tax purposes) and customs valuation. It has always been the case that multinational tax managers have needed to be cognizant of tariff issues. Now the stakes have risen.

All this will take a lot of figuring out. Tax professionals and supply chain managers already have their hands full dealing with rapid and complex changes in their respective areas of expertise. Combining trade and tariff planning is a staggering challenge. But the challenge is the unavoidable reality multinational businesses face. Within multinational corporations, supply chain managers and tax professionals need to collaborate and form their own supply chain of services . . . to support supply chains.

Escalating Trade War: U.S. Tariffs on Imports From China
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