“To me the most beautiful word in the dictionary is ‘tariff,’” former US president Donald Trump told an audience at the Economic Club of Chicago last week. Judging from the thunderous applause that followed, many in the business community believe that Trump’s plan for comprehensive tariffs will help their bottom lines.
At the same time, Trump and his allies insist that tariffs will aid American workers.
However, tariffs cannot raise worker incomes and business profits simultaneously, because they undermine the US economy’s efficiency, imposing costs on consumers and producers that compress total national income.
A more likely outcome is that workers and business owners alike will suffer real economic pain.
Those who favor tariffs regard international trade as a main cause of US manufacturing job losses and wage stagnation for workers lacking college degrees. According to this view, cheap imports from low-wage countries like China have eliminated US jobs producing similar goods; at the same time, US businesses have moved production abroad in search of cheaper labor.
The truth is more complicated, with new technology playing a more important role than trade.
Tariff proponents nevertheless argue that restricting imports can revive US manufacturing and boost demand for middle-skilled workers along with their wages.
Economic theory — namely, the famous Stolper-Samuelson theorem of international trade — suggests that protectionist tariffs can raise real wages in a country like the US, which imports goods embodying cheaper foreign labor. However, economic theory also shows that a tariff causes total national income and the return to capital — real business profits — to decline. The business leaders who applauded Trump in Chicago cannot achieve higher profits if workers are made better off while the total economic pie shrinks.
The outlook gets even worse when one realizes that Trump’s proposed comprehensive tariffs (like his tariffs in 2018 and 2019) would apply to a wide range of intermediate goods (mainly parts used in producing other more advanced products), raising their US prices. Intermediate goods make up well over half of all US merchandise imports, so tariffs on items like steel and aluminum are unavoidable if Trump’s goal is to revive manufacturing.
When tariffs apply to the intermediate imports used to produce other goods, the idealized assumptions of the Stolper-Samuelson analysis no longer hold. Such tariffs force real wages down.
Intuitively, an increase in the cost of intermediate goods reduces profitability in the import-competing sector, causing layoffs and wage declines. The total economic pie shrinks even more and workers are made worse off.
Evidence from Trump’s 2018-2019 trade war suggests that dependence on intermediate imports was a dominant factor causing manufacturing industries to cut employment, outweighing a smaller positive effect from the reduction of foreign competition. Foreign retaliation hit US exports and added significantly to the harm to employment.
The US Congressional Budget Office has estimated that the 2018-2019 tariffs reduced the size of the US economy by 0.3 percent by 2020.
Proponents of tariffs sometimes argue that there need not be a trade-off between the income of domestic labor and capital because a tariff might induce foreign producers to jump over the tariff wall by ramping up their US-based operations. For example, anticipating tariffs that the US imposed on residential washing machines in 2018, South Korean producers LG Electronics and Samsung started producing in the US.
Can tariff-jumping foreign direct investment (FDI) add to the economy’s capital and so increase the total size of the economic pie, allowing labor and business both to gain? A first approximation suggests that the answer is no, as shown in a classic 1960 analysis by Scottish economist G.D.A. MacDougall.
While GDP — the output produced within US borders — rises, the more relevant measure of the country’s earned income, gross national product (GNP), need not rise. The rise in GNP equals the rise in GDP minus the higher profits that the firm engaging in FDI remits to its stockholders back home, but if the firm’s remitted profits equal its contribution to US GDP, the direct impact on US GNP is zero.
That does not mean the FDI would yield no benefits for labor: real wages might rise, but these gains to labor would be offset by losses to business profits owing to stiffer domestic competition.
Again, workers can gain, but businesses lose. (The only possible gain in overall US GNP, entirely the result of business losses, comes from lower dividends paid abroad by foreign firms previously in the US — some of which might return home because of their US operations’ reduced profitability.)
On top of all of these harms, Trump’s proposed tariffs would undoubtedly trigger foreign retaliation and fuel a destructive trade war.
As harmful as the Smoot-Hawley tariff of 1930 was to the US, the international trade war it ignited was much worse. If the experience is repeated in today’s far more interconnected world, the costs will be higher still, and US workers and businesses alike surely will lose.
Maurice Obstfeld, a former chief economist of the IMF, is senior fellow at the Peterson Institute for International Economics and a professor of economics emeritus at the University of California, Berkeley.
Copyright: Project Syndicate
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