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Tariffs, Free Trade, and Open Economies

David: Welcome to the podcast. I am David Stewart, editor in chief of Worldwide Tax Daily. This week: You say tariff; I say tax. We're stretching a bit beyond our comfort zone this week to talk about tariffs and free trade — issues that have become the subject of heated discussions in recent years with proponents and detractors from across the political spectrum.

My guest this week is the author of the book, Open: The Progressive Case for Free Trade, Immigration, and Global Capital. Joining me now by phone is Kimberly Clausing, she's the Thormund A. Miller and Walter Mintz Professor of Economics at Reed College. Kim, welcome to the podcast.

Kim: Thank you. Thank you for having me.

David: I guess we should start out from the basics. How should we think about tariffs? Are they just a species of tax, or are they fundamentally different?

Kim: Yeah, so a tariff is an interesting tax because it's really a combination of two things. It's a consumption tax; it falls just on imports. And because it's falling just on imports, there's an element to the tariffs that's also subsidizing domestic production. So you could view a tariff as a combination policy that's part domestic production subsidy and part consumption tax. As it turns out, the consumers end up paying more than the producers get in terms of the subsidy, and some of that difference is government revenue, and some of it is distortion — or sort of lost beyond what is recouped, in terms of revenue and benefits to domestic producers.

David: So you say that it's collected on import, and it's a consumption tax. Now, does that mean that it's ultimately individuals bearing the burden of this tax?

Kim: Yes, definitely consumers are bearing the burden of this tax, and in the news we've often heard the president and others argue that foreigners are bearing the tax. And that's possible if the foreigner has a lot of market power that they would bear some of the tax, but for your typical product, say steel, there's a, you know, there’s a world price of steel, let's call it $100. If the United States put a 30 percent tariff on that bar of steel, then the manufacturer abroad can decide, OK, well, I could sell to the U.S., in which case I'm gonna have to pay this $30 tariff in addition to the regular cost of doing business, or I could sell to Canada or Germany — some other place that doesn't have this tariff. And so they're not gonna wanna sell to the U.S. at all unless they can raise their price. So what they'll do is just raise the price for the tariff-inclusive price. And in a way that's part of the point of the tariff, that higher price helps domestic producers because now they can get $30 more for their bars of steel. So when someone goes to buy steel it's gonna be 30 percent more expensive whether you're buying the domestic one or the foreign one. And so the ultimate person who's paying for this is whoever's consuming the product. Now you might say with steel, well that's actually being consumed by firms, but, of course, steel is a cost in production and a lot of things that consumers consume, like cars and appliances and houses that have steel in their construction. So those costs ultimately get passed on to consumers. A second thing to think about here, too, is that even though consumers are bearing this burden, we're also simultaneously shifting resources toward those sectors that benefit from this tariff and away from other sectors. So in this case, the steel sector gets bigger, but the sectors that use steel get smaller. And so you're gonna have shocks that harm, for instance, the auto sector and the appliance sector because their inputs are more expensive than their competitors’ inputs that are producing those products in other countries. So that hurts, you know, some firms while helping other firms. But it also causes some shocks to labor, right? Cuz if you're working in the auto plant, or the appliance plant, and your plant is getting smaller because it can't compete with your foreign competitors cuz your inputs are more expensive, that's a real cost to sort of adjustment for the economy as well.

David: So until recently, the general direction globally has been for reducing tariffs. Now why did policies move in that direction? And did that lead to positive outcomes?

Kim: So I think if we go back to sort of the end of World War II, which I realize is a long time ago, but in sort of the pre-World War II period, a lot of countries had raised tariffs to both help finance the war and under the idea that this was for demand for their own industries. But of course, if everyone does that, it's sort of a beggar thy neighbor policy because one country's tariffs are hurting another country's producers and vice versa. And so after the war when things were settling down, one of the very first things that the international community did when they sorta gathered together, and it turns out in Bretton Woods, New Hampshire, is they sort of made a new set of institutions for thinking about, you know, a more liberal world economy, and so this included the World Bank, which financed reconstruction from the war originally, and the IMF, which helped with the international financial system. But also the idea was to start what they called at the time an international trade organization but ended up being the GATT, the General Agreement on Tariffs and Trade. And what that did was basically sort of provide a forum for countries to cooperate in lowering their tariffs with the recognition that that sort of helped everybody if they could agree to have lower tariffs, and there were then subsequent rounds of multilateral negotiations that brought more and more countries into the fold until by the 1990s we had over 100 countries who were lowering tariffs. Some of this is through the organization itself, but a lot of the countries that choose to join these efforts are making a deliberate decision that they want the benefits of access to, you know, other markets on favorable terms. And so they found it in their interest to sort of join this world trading community to help reduce their disadvantages associated with having the tariffs when other countries didn't. So that, I think, was part of the aim was to sort of realize that maybe everybody does better if we have low tariffs worldwide than having these higher ones. Another, I think, impetus for lower tariffs in general in history [is] that the tariffs are a regressive tax if you look at who actually ends up paying tariffs. There was a nice study for the U.S. that shows that the bottom fifth of the population actually pays three times as much, relative to their income, in tariff burden than the top fifth of the population. In part because they're consuming a higher share of their income, and it's a consumption tax. But also because, if you look at the consumption bundles of the poor, they tend to be more import-intensive than the consumption bundles of the rich. So I think a lot of countries looked at that and decided it wasn't really a great way to be raising the money for the state and, in fact, if you go back in U.S. history, to the early parts of the 20th century, one of the big factors that led people to push for the income tax — and so you got that constitutional amendment that allowed that — was the sense that tariffs weren't sort of a fair way to raise revenue in the era of the gilded age and the robber barons and all that. So to do something that was more fair, to the income tax [they] went for it.

David: During the last presidential election in the U.S., both major party candidates came out strongly against the Trans-Pacific Partnership (TPP), a sweeping agreement to reduce the trade barriers, including tariffs. How did free trade end up losing support?

Kim: Yes, that was a very interesting election. I think in 2016 you saw candidates both on the far left of the spectrum, that Bernie Sanders, but also on the far right with Donald Trump, really holding up trade agreements as a chief culprit in explaining the declining fortunes of the middle class. So [the North American Free Trade Agreement] for instance, was a villain in this story, and was blamed for all sorts of things that were happening in the U.S. economy. And many economists, you know, would hardly disagree with that cuz if you look at NAFTA, it actually didn't really do that much to U.S. trade policy; we lowered tariffs a tiny bit. It didn't really have a big effect. But then people took that and applied that same logic to the TPP and sort of argued that these agreements are tilted in favor of business, and not in favor of workers. But nobody really stopped to really look at the TPP and understand what it was trying to do and what its aims were. You know, interestingly when Trump was elected, one of the very first things he did is he withdrew from this agreement but then he insisted on sort of renegotiating NAFTA. And when NAFTA got renegotiated, it actually took a lot of the parts of the TPP that had been in place already from that negotiation, and then applied them to the new [United States-Mexico-Canada Agreement], which is basically a lot like the original NAFTA with a dash of TPP on top. So there's this sort of a very deep misunderstanding of what these agreements do. Trade is often made a scapegoat for sort of thinking about broader problems in our society that really are big. You know, the increasing income inequality and the wage stagnation issues are really important. But this was a way to sort of blame foreigners for those issues without necessarily going straight to the problem. And one way we can see that sort of blame taking hold is if you look at public opinion on these trade agreements. If you go back to 2000, and that's, you know, about six years after NAFTA went into effect and about half of both Democrats and Republicans thought NAFTA was good, about half of them. And if you fast-forward to 2017 and you ask the same question: Republicans, only 22 percent of them think NAFTA is good, and Democrats it's gone up to 67 percent. So you might say, well, why is it that the Democrats now like NAFTA [LAUGH] a lot more than they used to and the Republicans dislike NAFTA more than they used to? And I think what we're seeing here is that if voters are voting on these things not because of their narrow views of their self-interests but because of what they've been told, what stories they're listening to, what their sense of a better world looks like. And then when you look at opinions on trade policy, how people feel about trade has a lot to do with how nationalistic their overall outlook is. I think that shows up in the polling data.

David: All right — and to follow on with the stories that we're told — so proponents of tariffs often invoke them as a means of protecting industries in decline, such as manufacturing. Now, are they effective at protecting those industries?

Kim: The production subsidy part of the tariff that we talked about earlier is effective in channeling resources toward those industries. So if you think about, for instance, the steel tariffs, that will enable steel prices to be higher, which will help U.S. steel producers make more steel. And so that is definitely a component of it. But the problem with the tariff is it's kind of a clumsy tool to get at what you're trying to do. So let's say you really care about steel workers, and, you know, why not? Let's take some time to care about the steel workers. Now, if you do a tariff, you're simultaneously helping their industry, but you're also hurting any user of steel, so you're hurting consumers of steel, which are often other companies that also employ U.S. workers, right? So you're sort of taking from one group of companies to help another. Imagine if instead of doing the tariff, you did a simple production subsidy. You said, OK, I care about steel, so let's subsidize steel producers. Now you no longer have this cost that's happening to the steel users. In fact, steel will probably get cheaper after the production subsidy and not more expensive. So you're basically going closer to your goal, which is helping the steel industry. And better yet, if you really care about the steel workers rather than just steel industry, including their shareholders and the people who own the machines and all that, then really what you should be subsidizing is the steel workers, right? So you could even imagine a tax credit for steel employment, right? And that would be even more direct. Cuz if that's what you really care about are the workers making steel and the closer you can get to this goal, the more effective you can be. So subsidizing the steel workers goes straight to them. Subsidizing the steel industry, you may also be helping shareholders you don't particularly care about or the owners of the capital and that industry. But a tariff is the least direct of all those policies because in addition to maybe helping your steel workers, you're harming workers and other sectors and you're harming the consumers of steel. And so that is a much more clumsy way to get at your ultimate goal.

David: So the U.S. trade deficit is often invoked during discussions of tariffs. How much can be read into the trade deficit, and what effects does it really have on the U.S. economy?

Kim: Yeah, so the trade deficit part of this conversation is I think one of the most persistently misunderstood features of the reporting on economic statistics and outcomes. A lot of business journalists and others will sort of report the trade deficit as if it's some sort of marker in the struggle for global success. You know, so if one country has a surplus and the other has a deficit, the surplus country is winning and the deficit country is losing. But interestingly if you stop and think about it, the trade deficit actually has absolutely nothing to do with how successful companies are or how successful their products are, how successful their workers are. What the trade deficit is really an outcome of is countries’ saving behavior. So as an example, take the United States. In the United States we tend to save less than we invest. So that means if you add up all the savings of companies and individuals, that amount is less than what we're spending on this sort of uses abating, like investment. And our public sector, our government also taxes less than it spends. So it collects less in tax revenue than it's spending. So if you think about the U.S. economy as a whole, every year we're consuming more than we earn both because private people aren't saving enough to meet all of their investment needs, but also because the government isn't collecting enough in taxes for their spending needs. So this means that the country as a whole borrows. It typically borrows about 3 percent of GDP from other countries. Whenever you're one of those borrowing countries — and the United States frequently is, Mexico frequently is, the U.K. often is — that means you are simultaneously gonna be running a trade deficit because the only way that you can consume more than you make [LAUGH] is if on net you're importing more than you export. That's how you do the extra consumption relative to what you're making. So countries like the United States and Mexico that tend to run big deficits with the rest of the world are doing it because they're consuming more than they're making. Whereas countries like China and Germany, they're doing the opposite. If you look at those countries as a whole, they're actually consuming a little less than they make each year, so if they make, you know, a hundred dollars worth of stuff and they consume 97, then they'll end up with, you know, a 3 percent trade surplus. And so this is just a mathematical fact throughout all times and across all countries. The countries that are running the deficits, they are spending more than they earn, and the countries that are running the surpluses are spending less than they earn, in terms of their production. And that's what’s really driving those deficits and surpluses. So when we think about this in the economics profession, we think it's really what we call a sort of a macroeconomic thing, in the sense that it's really determined by the same things that determine the government budget balance. How much people wanna save, how much companies want to invest. And even if we had, you know, the most competitive firms in the world, which arguably we do in the United States, we're still gonna run a trade deficit in a year that we're spending more than we earn. And that's why we run these trade deficits year after year. And so nothing that the Trump administration is gonna do on the trade policy front is gonna change that. And arguably, what they did with the tax cuts actually makes the trade deficit worse, because it increases that discrepancy between what we're collecting in taxes and what we're spending. And so we're gonna have to borrow even more from the world, and so our deficit's gonna get even worse, rather than better.

David: You have a new book coming out. The book is called Open: The Progressive Case for Free Trade, Immigration, and Global Capital. Can you tell me about your book?

Kim: Yes, absolutely. I'd be delighted too. So I started writing this book actually in the wake of that 2016 election. Cuz one thing I notice is that some candidates seem quite content to blame folks outside the United States for problems that were very real, but they really weren't necessarily the fault of foreigners. So NAFTA and immigrants I don't think are really at the root of our economic problems. And so what I set out to do with this book is sort of respond to that sort of blaming tendency by candidates in that election by sort of asking three questions. One is, what's happened that's created so much economic discontent in the United States? And so there I point [to] this income equality and this wage stagnation problem that we’ve had for 35 years. And one of the questions that I asked about that is, well, how much can we blame those trends on the global economy? And I conclude, well, you know, there's some evidence that aspects of globalization has contributed to that problem but that problem is really a lot bigger than global markets. It's about things like technological change, it's about market power, it's about the evolution of social norms, it's about declining unionization, it's about changes in economic policy. And so if we take that storm that's coming at workers from many directions, and we blame it all on the foreigners, we're probably not gonna really get to the root of the problem. The second thing I do in that book is I sort of look at each type of globalization — at trade, at capital mobility, at international business, and at immigration. And I ask, well, what are the good parts of those types of globalization, but also what are the, some of the cautions we might have about them? How might we modernize economic policy to make sure that we're getting the best of these global market forces without disadvantaging workers? And I have some specific suggestions about that. But I basically conclude that immigration and trade and global capital mobility are good things. And that it would be wrongheaded to restrict them because we'll actually end up hurting some of the workers that we're trying to help. So one example is, of course, the steel tariffs. You help the steel workers, but you hurt the auto workers, so it's not clear you've really helped workers. And furthermore, if that's your policy response to what's happening to workers, you're sort of missing a lot of opportunities to really go straight to the workers' problems. So if instead of doing steel tariffs, you expand the earned income tax credit. Then those workers are gonna see, at the bottom parts of the income distribution, lower taxes, and, in fact, negative taxes is what the earned income tax credit creates. And so that would help workers directly, whereas these restrictive trade and immigration policies may actually make workers worse off. I mean, immigrants do a lot of job creation. They have a lot of skills that we definitely need in this economy, and so immigrant bashing is unhelpful as well. And the final part of the book talks about, well, how do we help workers? And there's sort of three policy chapters, and I talk about ways to support workers and communities directly, ways to reform the tax code to better encourage shared inclusive growth. And ways to generate what I call a better partnership with the business community. But to address things like market power and the lack of transparency and social norms by sort of relooking at that partnership. So that's what the book does.

David: What do you see as the best way to address these concerns of those who view free trade and globalization as a negative force?

Kim: Yeah, so I think there are a lot of ways to modernize how we do trade and globalization. I think we can have better trade agreements. There are some aspects of the trade agreements that people legitimately don't like that we could rethink. I don't think there needs to be the investor state dispute settlement provisions, for instance, which give companies I think too much power relative to government. And I think we can be more cautious about throwing in all this intellectual property protection into these agreements. But we can do things to these agreements that can help sort of buttress the bargaining power of labor by, you know, insuring some core labor standards. Which doesn't mean minimum wages for poor countries at rich-country levels; that's not the kinda thing I would suggest. But ensuring basic labor rights across different countries, and making sure that countries aren't weakening their labor standards to compete in the world economy. And so there are things you can do to modernize trade agreements. There's things that you can do to better tax economic activity when it's crossing borders. I think we have major tax avoidance problems with those individuals and companies where they are able to move income offshore and avoid paying adequate tax contributions with that income once it's offshore. And I think we can revamp the tax system to better address these global flows. And on immigration, I think actually what we probably legitimately need is more rather than less immigration, which is the argument that I make in the book. But most important, I think, is to not look at modernizing globalization as really the key part of responding to workers' needs. I think the key to responding to wage stagnation, economic inequality, is to go straight to those problems with the policy solutions that I mentioned. Clamping down on trade and immigration is actually gonna harm those workers that you're trying to help. But you can do things to help the workers by supporting them better through the tax system and in other ways. And those policies are really gonna help. Whereas a lot of this international protectionism and nationalism is both a distraction and ultimately harmful.

David: How do you see the role of tax policy in shaping the outcomes of globalization?

Kim: I think taxes are really key here. And I think for your listeners, they'll be happy to hear that their investment in understanding taxes isn't a waste. If you look kind of across the economics discipline at the nontax parts, often when things get tough, the economists will sort of point to taxes as the way to sort of solve the tough parts. So for example, trade creates both winners and losers, but you can use the tax system to help the winners compensate the losers. Then everybody can be better off. Technological change creates a lot of losers. When robots displace labor in many industries, that reduces the demand for labor and lowers wages. And you can use the tax system to make sure that those who are profiting from the implementation of robots are also paying more, and that we're compensating the workers. One of the really interesting things over the last 35 years is despite the fact that we've had pretty stagnant wages, GDP per capita, or the average amount of GDP per person in the United States, has increased about 60 percent in real terms over those 35 years. So that implies that in theory everybody [LAUGH] has 60 percent more income than they did 35 years ago. What we tend to see instead is those at the top having a lot more income and those at the bottom having almost no income growth over that time period. So one thing we can use the tax system for is to make sure that when we have economic growth, that it's shared more equitably, and that's a strong enough tool to do that. By expanding their earned income tax credit, by taxing incomes at the top, but in a way that is serious and that doesn't allow them to escape tax burdens at all. So I don't think we need [a] 70 percent tax rate, but I do think if we're gonna tax those incomes at 37 percent or whatever we decide the top rate should be, we need to make sure we're collecting that tax. And that goes for both companies and individuals. And that means treating different types of income more similarly. Like right now, if you're a hedge fund manager, you can have a much lower tax rate than your secretary does because you're earning a lot of your tax as capital income. I think that we need to tax capital income much more like labor income, especially because capital income is often sort of excess profits. It's not the normal return to capital; it's sort of profit above and beyond that. And so we can tax capital income better for both individuals but also for companies by looking at addressing some of the multinational company tax avoidance that we've seen so far. So I think if I were in charge of tax reform and worried about the future of the world economy, I would do three things. I would make sure that the winners are compensating the losers so that growth really affects all Americans. I would make sure to tighten up the treatment of different forms of income so that whatever we ask from the rich, we're asking it irrespective of what form they're earning the income. Then I would also add a carbon tax to the mix too. There are ways to do a carbon tax without harming the poor. For instance, you can use the carbon tax revenue to lower taxes elsewhere in the system, or you can simply rebate it back to the poor. But the carbon tax is just an extremely powerful way to incentivize every actor in the economy to take climate change more seriously. Because it basically makes using carbon more expensive, and companies and individuals are known for being very price sensitive. So you get people to economize on their carbon. But you also simultaneously encourage innovation because now when the carbon-intensive energy is more expensive that makes things like wind and solar and other alternative energy sources relatively attractive. So it's a very effective tool at dealing with climate change but also raises a lot of revenue, and so I think it would be a useful part of a reformed tax system.

David: Well, Kim, this has been fascinating, and I think we might have to have you back when we do a future episode that does a deeper dive on the carbon tax. Because that's an area that we definitely have to explore here. Where can listeners find you online?

Kim: Online you can find my web page, which is at Reed College. So you could just Google my name and Reed. You'll be able to see the webpage there. I'm also on Twitter as KClausing, and so that's another place to locate me online.

David: Excellent. Thank you for being here.

Kim: Thanks.

David: And now, coming attractions. Each week we preview commentary that will be appearing in the next issue of the Tax Notes magazines. We're joined by executive editor for commentary, Jasper Smith. Jasper, what will you have for us?

Jasper: In Tax Notes, Michael Knoll considers whether the [Tax Cuts and Jobs Act] provides incentives for high-income businesses to convert passthrough entities to C corps. And Ted Stotzer discusses foreign trademark acquisition, focusing on how base erosion and antiabuse tax and the [foreign-derived intangible income] deduction apply.

In State Tax Notes, Darien Shanske and David Gamage argue that states should incorporate [global intangible low-taxed income] into their corporate income tax base. And Robert Fisher and Robert Wassmer discuss state and local government employment trends.

 

And in Tax Notes International, Jefferson VanderWolk examines the arm's-length standard in light of today's evolving tax environment. And Paulus Merks and Olivier Elsenburg discuss the Netherlands' effort to overhaul its policy on international tax rulings.

David: You can read all that and a lot more in the March 4 editions of Tax Notes, State Tax Notes, and Tax Notes International. That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email at us podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.

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