Commercial Policy, Employed to Curb Trade Imbalances: Revisiting Decades-Old Literature

Year: 
2017
Topic: 
Globalization - Trade
tags: 

The relationship between the trade balance and tariffs puzzled economists for many decades. Prompted by current events, I revisit some of the old literature. Recently, the US is attempting to curtail the US current account deficit by commercial means. What the old literature can say about the effectiveness of these policies?

For Trump, NAFTA is “an economic disaster” because the United States has increased its trade deficit with Mexico from a $1.6 billion surplus in 1993 (the year prior to NAFTA’s implementation) to $63.2 billion in 2016. In part, the US-Mexico trade balance reflected a weak peso after it was weakened by the uncertainty over the future of US-Mexico bilateral trade relations.  To reverse it, Trump’s solution is to abolish NAFTA. Interestingly, Mexico’s relative deficit with the United States is the lowest among the top 10 largest U.S. trade deficits, with an 11 percent ratio vis-à-vis China (61.1 percent), Ireland (63 percent), and Vietnam (68.6 percent). The US President’s reflex is to try via commercial policies to change trade imbalances.           

However, as we teach our students, trade imbalances are saving-investment imbalances.

The economic logic behind the US trade deficit is the emergence of big savers, all US trade partners, on the world stage. Figures 1 and 2 flash out the decline in the  US share of world output, and the striking fall  US contribution to the world saving. These developments   are indeed   the proximate driving forces behind US persistent trade deficits.

Border Taxes and Saving

Policy makers often justify export subsidies and import tariffs by their improving effects on the current account. On the other hand, in standard international trade theory we teach the Lerner’s (1936) Symmetry Theorem, according to which export taxes (rather than subsidies) and import tariffs have identical effects on resource allocation. Indeed, in his analysis Lerner explicitly abstracted from intertemporal aspects. The apparent puzzle is resolved once a distinction is made between temporary and permanent trade taxes in an explicitly intertemporal model. Razin and Svensson (1983) show that only a temporary import tariff improves the trade balance, and only a temporary export tax deteriorates it. However, fully persistent import tariffs or export taxes have an identical effect on the current account, as in Lerner Symmetry. Furthermore, to the first approximation border taxes neither improve, nor deteriorate the trade balance. The reason for the above results is that temporary trade taxes, in contrast to permanent trade taxes, result in changes in intertemporal relative prices, and hence induce substitution between present and future goods. Therefore, they do affect saving behavior. The current account, being the economy’s excess of saving over investment, is more unambiguously influenced by changes in intertemporal Price such as consumption-based real interest rate/ this price is primarily affected by temporary changes in relative prices changes within each period; not by the permanent changes of them [see Obstfeld (1982) and Svensson and Razin (1983)].

VAT and Border Adjustments

Paul Ryan, the speaker of the US Congress, has recently proposed to scrap the tax the corporate income and replace it with a modified value-added tax (VAT). The new tax, assessed at a rate of 20%, would apply to all domestic sales while exempting foreign ones. This “destination-based” system would reduce the incentive to move profits or operations abroad. [1] The plan includes a border adjustment: imports would be subject to the tax while firms would receive a credit for their exports. The border adjustment, common to a destination-based VAT do not however make it a border tax. Indeed, as Feldstein and Krugman (1993) and (Krugman (2016) explain, a VAT is not an export subsidy. Krugman (2016) puts is succinctly: “Think about two firms, one domestic and one foreign, selling into two markets, domestic and foreign. Ask how the VAT affects competition in each market. In the domestic market, imports pay the border adjustment; but domestic firms pay the VAT, so the playing field is still level. In the foreign market, domestic firms do not pay the VAT, but neither do foreign firms. Again, the playing field is still level. Therefore, a VAT is just a sales tax, with no competitive impact. (See also Slemrod (2005). [2]


1. See Frenkel, Razin, Sadka (1991) for the difference between destination-based VAT and origin-based VAT.

2. However, a destination based cash-flow corporate tax, proposed by Paul Ryan, is not quite the same as a VAT. With a VAT, a firm pays tax on the value of its sales, minus the cost of intermediate inputs – the goods it buys from other companies. With a corporate tax-VAT, firms similarly get to deduct the cost of intermediate inputs. However, they also get to deduct the cost of factors of production, mostly labor but also land; both non-traded. Therefore the cash flow corporate VAT, with border adjustments, affects directly the real exchange rate: the relative price of traded goods in terms of non-traded goods.
 

References:

Feldstein, Martin and Paul Krugman. (1990). ‘‘International Trade Effects of Value Added Taxation.’’ Assaf Razin and Joel Slemrod (eds.), Taxation in the Global Economy. Chicago and London: University of Chicago Press, pp. 263-278.

Frenkel, Jacob, Assaf Razin, and Efraim Sadka (1991), International Taxation: in an Integrated World, MIT Press.

Krugman, Paul (2017) “Border Tax Two-Step (Wonkish),* January 27, 2017, New York Times Blog.

Lerner, Abba., 1936, The symmetry between import and export taxes, Economica 3, 306-313; also reprinted in R.E. Caves and H.G. Johnson, (eds.), 1968, Readings in International Economics (Allen and Unwin, London) 197-203.

Obstfeld, Maurice, (1982), “”Aggregate Spending and the Terms of Trade: : Is There a Laursen-Metzler Effect?” Quarterly Journal of Economics, 97,251-270.

Razin, Assaf and Lars E.O. Soensson (1983) “Trade taxes and the current account” Economics Letters, 13 55-57.

Slemrod, Joel (2005) Does VAT Promotes Exports? www.taxhistory.org/www/freefiles.nsf/Files/SLEMROD-14.pdf/.../SLEMROD-14.pdf.

Svensson, Lars .E.O. and Assaf Razin, 1983, The terms of trade and the current account; The Harberger-Laursen-Metzler effect, Journal of Political Economy 91, 97- 125

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