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Three Simple Principles of Trade Policy

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Three Simple Principles of Trade Policy Three Simple Principles ofTrade Policy Douglas A. Irwin The AEI Press Publisher for the American Enterprise Institute WAS HING TON, D. C. 1996 Distributed to the Trade by National Book Network, 15200 NBN Way, Blue Ridge Summit, PA 17214. To order call toll free 1-800-462-6420 or 1-717-794-3800. For all other inquiries please contact the AEI Press, 1150 Seventeenth Street, N.W., Washington, D.C. 20036 or call 1-800-862-5801. ISBN 0-8447-7079-5 3 5 7 9 10 8 6 4 2 ©1996 by the American Enterprise Institute for Public Policy Research, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatso­ everwithout permission in writing from the American Enterprise Institute exceptin the case ofbriefquotations embodied in news articles, critical articles, or reviews. The views expressed in the publications of the American Enterprise Institute are those of the authors and do not necessarily reflect the views of the staff, advisory panels, officers, or trustees ofAEI. THE AEI PRESS Publisher for the American Enterprise Institute 1150 17th Street, N.W., Washington, D.C. 20036 Printed in the United States ofAmerica Contents ACKNOWLEDGMENTS v INTRODUCTION 1. A TAX ON IMPORTS Is A TAX ON EXPORTS 2 2. BUSINESSES ARE CONSUMERS Too 10 3. TRADE IMBALANCES REFLECT CAPITAL FLOWS 18 CONCLUSION 27 NOTES 29 ABOUT THE AUTHOR 31 iii Acknowledgments This is a revised version of an informal talk I gave at the American Enterprise Institute inJanuary 1996. I thankAEI President Christopher DeMuth for inviting me to write up my remarks and make them available to a broader audi­ ence, as well as for his constructive advice on the text. I also wish to thank Claude Barfield,Jagdish Bhagwati, and Donald Davis for helpful comments. v Introduction t the conclusion of a class I teach on international commercial policy, I try to distill the essence of a ten­ Aweek course down to a few simple principles that stu­ dents might remember long after the final exam is over. In this essay I expand upon three of these principles. I have selected these principles with the aim of cor­ recting some common economic fallacies in the political debate over U.S. trade policy. The principles are a bit more subtle, and more pointed, than elementary first principles such as "voluntary exchange is generally beneficial"-a proposition that almost everyone accepts but that rarely settles a practical policy issue. Indeed these principles might seem to be mistaken, on first reading, to many read­ ers whose understanding of trade issues is derived mainly from newpaper accounts-and yet I believe they can be explained persuasively and illustrated with straightforward data and examples that demonstrate their practical rel­ evance. Most of all, the three principles are offered as ex­ amples of important and enduring knowledge about inter­ national trade, as opposed to the unstructured (or tendentiously structured) information about trade that comes our way every day. Each principle is the distillation of generations of serious thinking about the nature of trade among nations-thinking that has endured much longer than the ad hoc arguments and partial informa­ tion of political debate. This thinking can help us make sense ofthe information supplied by politicians and inter­ est groups. Major improvements in U.S. trade policy may be out of reach at the present time, but a greater under­ standing of the three principles offered herein would improve the trade policy debate. 1 IMPORT AND EXPORT TAXES 1. A Tax on Imports Is a Tax on Exports The first proposition is that a tax on imports is equivalent to a tax on exports. Any restraint on imports also acts, in effect, as a restraint on exports. The converse ofthis propo­ sition is also true: when a government undertakes policies to expand the volume of exports, it cannot help but to expand the volume of imports as well. The fundamental reason for this truth is that exports and imports are flip sides of the same coin. Exports are necessary to generate the earnings to pay for imports, or exports are the goods a country must give up in order to acquire imports. Exports and imports are inherently in­ terdependent, and any policy that reduces one will also reduce the other. At one level, the idea that import restraints will re­ duce exports is simple and straightforward: ifforeign coun­ tries are blocked in their ability to sell their goods in the United States, for example, they will be unable to earn the dollars they need to purchase U.S. goods. In policy discus­ sions about international trade, however, there is a ten­ dency to view a country's exports and imports as being separate, independent phenomena. In this view, govern­ ment policy can diminish imports without adversely affect­ ing exports, or vice versa. This view is erroneous because exports and imports do not wander too far from one an­ other. The two are inexorably linked even if the mecha­ nism by which they are linked is not immediately obvious. (Trade imbalances will be considered in proposition 3.) Before I present some simple data that illustrate this point, let me briefly discuss the intellectual history of this proposition. Economists will recognize it as the "Lerner symmetry theorem," named for the distinguished econo­ mist Abba Lerner, who wrote a short but brilliant paper on the subject as a graduate studentat the London School of Economics in the mid-1930s. I Lerner established the for­ mal truth of the proposition, but it had been a feature of 2 DOUGLAS A. IRWIN trade policy debates long before then. The principle was used extensively in the House of Commons in the early 1840s and before, when Parliament was considering whether to repeal the Corn Laws, legisla­ tion that limited British grain imports. Members in favor ofrepeal argued that the import tariffs restrained exports of manufactures, and that allowing greater imports of wheat would lead directly to greater exports of textiles. One Member of Parliament, James Deacon Hume, is re­ corded as saying that "he did not expect to hear it denied that every import must be paid for by an export. If so, every quarter of wheat imported put into employment some manufacturers to pay for that import."2 The symmetry between import and export taxes was recognized even in the seventeenth-eentury English mer­ cantilist literature. Popular understanding of mercantilist doctrine is that trade barriers were recommended in or­ der to achieve, among other things, a balance of trade surplus. By my reading of this literature, seventeenth-cen­ tury mercantilistwriters certainly wanted to achieve a trade surplus, but they were not at all sanguine about the efficicacy ofimport tariffs in achieving this objective. ~ Even these writers, who rejected free trade as a matter of prin­ ciple, recognized that exports and imports are fundamen­ tally interdependent. In discussing the tax burden on imports, the pamphleteer Henry Robinson cautioned as early as 1640 that "here is it worth remembrance that a great part of foreign commodities brought for England are taken in barter ofours, and we should not have vented ours in so great quantity without taking them." In 1680 William Petyt took this point to its logical conclusion: For the opening of a sufficient foreign vent and market for our home commodities, it is not only necessary to remove all unequal clogs on mere exportation, but also those on imported goods; 3 IMPORT AND EXPORT TAXES because ... the value of our English exporta­ tion must be in a manner confined to the value of the goods imported.... Whereas were the clogs on our imported goods taken off, we mightyearly vend of our own home commodities to the value of all foreign goods we should then import and re-export... whereby our exported home com­ modities would then amount to much more.4 Recognition of the interdependence of exports and im­ ports put mercantilists in a bind because import tariffs appeared to be the obvious instrument for improving the balance of trade by reducing imports without directly af­ fecting exports. Thus, the Lerner symmetry theorem has a long intellectual pedigree. Lerner's Symmetry: True and Nontrivial. What is particu­ larly marvelous about the Lerner symmetry theorem is that it is both true and nontrivial. (In this regard it is like an­ other fundamental principle of international trade: the theory of comparative advantage.) The equivalence of export and import taxes is not an obvious proposition, and it is often counterintuitive to most people. Imagine taking a poll of average Americans and asking the follow­ ing question: "Should the United States impose import tariffs on foreign textiles to prevent low-wage countries from harming thousands of American textile workers?" Some fraction, perhaps even a sizeable one, of the respon­ dents would surely answer affirmatively. Ifasked to explain their position, they would probably reply that import tar­ iffs would createjobs for Americans at the expense offor­ eign workers and thereby reduce domestic unemployment. Suppose you then asked those same people the fol­ lowing question: "Should the United States tax the expor­ tation of Boeing aircraft, wheat and corn, computers and computer software, and other domestically produced goods?" I suspect the answer would be a resounding and 4 DOUGLAS A. IRWIN unanimous "No!" After all, it would be explained, export taxes would destroy jobs and harm important industries. And yet the Lerner symmetry theorem says that the two policies are equivalent in their economic effects. This all goes to show that the issue of tax incidence is a tricky one. One may think that an import tariff is felt only in the import sector, but in the end this is not the case.
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