Thursday, May 30, 2019

Finding a Justifiable Tariff Rate in a Floating Currency World

President Trump recently announced a tariff increase  from 10% to 25% on a basket of Chinese products with American officials charging "backtracking on commitments". This seems to be a political reason, not an economic reason, to raise tariff rates. That said, can we find an economically justified tariff rate for products in a floating exchange rate world? We will try to find a logical answer to that question over the course of this post.

The political backdrop

Trade between nations with different currencies is essential to solve resource unbalances on a world wide basis. If this trade is roughly financially equal, there is little long term concern. Political concern develops when the financial trade is unequal for long periods of time. The cumulative American trade history with China yields one such example.

When we see every modern industrial nation spending far more than possible with taxation alone, we can deduce that, world-wide,  we live  in a  subsidized economy. This subsidized macro-economic environment includes a subsidy enhanced export environment characterized by floating currency relationships. Having created imbalances that have gone on for many years at an increasing pace, the political climate has reached a point in time where finger-pointing has been replaced by real actions to change perceived imbalances, primarily job displacement. Tariffs are the tool of choice now being used by the American government.

National resource imbalances

Not only are there wide differences in resource bases between nations (some have oil, some have iron, some have labor, etc), there are wide differences of willingness to expend national resources to keep people working productively. A strong case can be made that export industries will be economically favored when a currency is weakened, putting people to work at the cost of an internal shift in the distribution of wealth. Of course, increased exports from one nation will likely result in increased competition with reduced prices and jobs in the importing nation.

A strong argument can be made that China (as a nation) has subsidized it's labor and absorbed the results of a currency mismatch, enabling China to export into America and maintain an unhealthy trade imbalance over a period of many years. In the process, America has exchanged paper money for goods. China has built a cash investment exceeding $1 trillion in the U.S. while the U.S. has enjoyed consumption of perishable goods (as seen from a longer perspective). The Chinese earned their money fair and square, but at the same time, this trade has come at the cost of American job loss.

Job losses means fewer people working to pay taxes. This is a real problem for a share-the-wealth, semi-socialist economy. When taxes fail to pay the cost of government, government borrows and increases benefits! The alternative to borrowing, increased taxes on domestically produced products, makes products more expensive, thus increasing the attractiveness of foreign production, such as those from China. A vicious circle develops and we are seeing the advanced results after some 40-50 years of expanding effect.

A philosophy of taxes

The link between taxes and products is inescapable. Taxes are levied so that real physical products and valuable productive time can be purchased by non-producers (whose services may or may  not be needed to keep the economy running).  Producers are taxed so that they will share the products they make by fruitful utilization of their time and materials.

Taxation on production begins at the very roots of production. Materials coming from the ground first pay property taxes (which can be considered as rental fees conferring conditional ownership). Labor used in extracting and building product pays employment taxes before sale of the product, and later, income taxes. These tax sequences do not occur when the finished product is imported. Granted, foreign producers also pay taxes on production using a foreign currency but none of these taxes come into the coffers of the importing nation. Not a problem when trade is balanced but a huge problem when a trade unbalance exists for many years.

The General Effect of Taxes by Type

We will not try to broadly examine the economics of taxation here but we need to do at least a swipe at the issue to even start finding a economically justified tariff rate. We will limit our examination to sales taxes and income taxes.

We can easily see that a tariff is a sales tax levied on a selected product that originated outside of local tax control. General sales taxes are a levy on goods of any source, locally paid when the product is purchased. Payment of a tariff is unlikely to result in avoidance of an additional general sales tax.

Income taxes are taxes on the income stream of citizens. They are commonly graduated and partially excused following a general pattern of improving income distribution and encouraging economic behavior.

Subsides are an inversion of taxes

Subsidies are an enhancement of income in some fashion, often hidden for political reasons. A good example of hidden subsidy is found in the expenses of the U.S. Government. Government spends far more than it has available from tax revenue, balancing it's annual budget with borrowed money. This borrowed component can only be viewed as a massive macroeconomic subsidy benefiting with full effect those getting payments directly from government. Citizens not getting direct payments from government benefit indirectly from a macro-economic money flow that is larger than could be sustained by tax revenues alone.

A favorite tactic of governments trying to improved exports is to under-tax the favored industry. A very subtle way of doing this is to reduce the purchasing power of the exporting currency, thus increasing the purchasing power of the targeted importing nation. This action favors exporters and their workers at the expense of the broader domestic economy.

Impossible to tax imports until they are under local control

Imports yield in no government tax income until they enter local control. As a consequence, we can say that imports as tax generators have not contributed to the local tax base via production taxes in all their local forms. Foreign workers do not pay income taxes, property taxes, sales taxes on raw materials, or any of the taxes on production that serve to sustain a local economy. The first local tax on imports is often a local sales tax.

Without full taxation on production, we can easily see that imports have the potential to completely destroy a narrowly based local economy.

An initial attempt to find a fair import tax rate.

In the United States, federal government tax revenue is roughly 19% of GDP. On an individual basis, the income tax rate graduates into the 35% range, but is near zero for a high percentage of the working population. Not usually considered an income tax, Federal Insurance Contributions Act (FICA) taxes are income based and functionally flat at about 15% (when employer and employee taxes are combined). Of course, workers building imports pay no share of this.

Based on Social Security taxes alone, we might agree that a 15% tariff on all imports would be reasonable. Finding few exceptions to paying FICA taxes, we would have no favored products.

FICA taxes are not part of the revenue stream resulting in a tax rate calculation of 19% of GDP. We should be able to add a lost tax component approaching 19% to the FICA justified tariff rate. We could modify this by adding the avoided taxes replaced by borrowing. The income tax rate component would approach 25% if we took this approach. [This is a VERY rough estimated tax rate component.]

We could combine the FICA component and income tax rate components to conclude that a tariff rate of 40% on all imports is not unreasonable.

Wow! The American economy would certainly feel the distributional effects of the implementation of that kind of tariff rate, but we would be making a economically justified rate choice!

The effect of foreign local taxes on exports.

It is logical for the reader to say "Whoa! Foreign workers making export products pay their own local taxes. Why should we double tax them?"

My answer is bound to be controversial. When two currencies are involved, with product made using one currency and sold to a second currency, we have no natural value adjustment mechanism to use. All values are relative, which explains why currencies have floating value relationships. A full application of the lost tax rate is the most severe economically justifiable rate possible.

A less severe tariff rate could be negotiated in an effort to find an average of the two country tax rate. The idea would be that each nation will charge tariffs on imports, with the goal to be an average rate representing the expected loss income to each entity. I would suggest that the relative amount of government funding imbalance should also be a factor. It seems to me that avoiding double taxation would be a very desirable economic enrichment necessity.

(c) Roger Sparks 2019