Container shipping has revolutionized foreign trade by greatly reducing costs of transportation by ship, rail, and truck.
Wikimedia Commons / Hafiz343

I have written several times  about why foreign trade is always a win-win proposition when the selling country has a comparative advantage of producing the traded good. Yet, the issue of foreign trade is becoming increasingly divisive, and the costs of unintended consequences of repressing foreign trade are becoming more apparent. In addition, the foreign trade issue might well cause proposals for corporate and middle class tax cuts to be scuttled through congressional quarrels over the federal government’s increasingly desperate financial condition. This is an excellent time to reconsider this divisive issue.

The Basic Argument Over Foreign Trade

The prime motivation  for opposing foreign trade is, of course, the loss of jobs no longer needed to produce the imported goods. As we see within our own not so United States, this can become an extremely potent political force in any democratic country with a persistent trade deficit. The problem with blaming foreign trade for the loss of domestic jobs is that most of the electorate cannot see the overall advantages of foreign trade, and even more important, they cannot see how government bars redeployment of capital assets released by trade to create new jobs.

Even if the exporting country charges import tariffs on goods we sell them and we charge no import tariffs on them, we still come out ahead in a trade where they have a comparative advantage. This is what Ricardo’s Law of Comparative Advantage teaches us. The exporting country has a comparative advantage over us if two conditions are true:

1. The exporter can sell the good to the importer for more than they can sell it to their domestic consumers.
2. The importer can buy the good from the foreign importer for less than he can buy it from any domestic producer.

If these conditions hold, then the exporting country has a comparative advantage over the importing country. Notice nothing has been said about the exporting country being able to produce the good for less than the importing country could. If that were true, the exporting country would also have an absolute advantage over the importing country, as well as a comparative advantage. To make the discussion a little more concrete, let us suppose the exporting country is China, and the importing country is the U.S. It may well be that China has higher costs in producing the good than the U.S., but because the Chinese do not value it very highly, China can sell the good to the U.S. for a higher price than to any Chinese consumer. Assuming the U.S. price is larger than the Chinese costs of production and higher than any price any Chinese would be willing to pay, yet smaller than the American buyer could get from any American supplier, both sides of the trade wins. In fact, both countries win as a whole.

It is easy to see how China wins in such a trade. Yet, mindful of the possibility for U.S. job losses through import substitution of the good making those jobs unnecessary, let us ask how the U.S. wins. Certainly, the importing American company wins, since they obtain the good at a smaller cost than if they bought it domestically. However, if the American company producing the good can not adjust by producing something else in lieu, they will lose those revenues. Certainly, the employees let go because their jobs are no longer necessary will lose, at least temporarily. How, then, can the U.S. as a whole be a winner?

The answer comes in two parts. The first part is the one you will see most often. The importing company can undercut the prices offered by other companies who obtain the good domestically, and drive down the price in the market place. Consumers will then have to spend a smaller fraction of their income on the imported good, leaving more to make other demands on the economy. This new, added demand then requires the creation of new American jobs to produce more to satisfy the increased demand. This will at least partially offset the lost jobs displaced by import substitution.

The second piece of the answer, the one less often heard, is at least as and conceivably even more important. Companies that used to produce the imported good no longer have to invest to produce it. Capital and capital goods that formerly were used to produce the imported good are suddenly free for other uses. Plant, equipment, and employees that are now free can be redirected to produce something else. If capital goods and employees can not be immediately used, they can be sold or laid off, respectively. This gives the companies new assets to produce something else that hopefully is a good for which the United States has a comparative advantage. Companies that can adjust survive and prosper; those that cannot are diminished or even go out of business, releasing additional capital resources for other uses in the economy. All hail Schumpeter’s Creative Destruction!  The new enterprises and production created in response to the release of assets by import substitution then should create a great many jobs, conceivably more than were lost to imports.

Yet, somehow it has not worked out that way over the past few decades. The United States has lost more jobs to imports than have been gained by new industry. Why has this happened? Why has the U.S. not adjusted?

An American Failure to Adjust to Foreign Trade

As is true of many problems with our economy,  American governments at all levels, but particularly the federal government, are the villains who have made the adjustment of American companies to foreign trade from extremely difficult to impossible. Any action by the government that makes the economic environment more hostile to corporations, making it more difficult for companies to make a profit, gives those companies less reason to invest their assets here in the United States. Instead, the government is motivating them to look abroad to find better, more profitable places to invest. Rather than investing capital savings from import substitution here, they look abroad to places like Canada, Great Britain, Ireland, and the Netherlands.

Many of these nations may have their own economic problems holding down growth, but they treat their companies with much lower corporate taxes. In 2014, the top U.S. marginal corporate tax rate was 39.1%. Only Chad and the United Arab Emirates had higher corporate taxes. At the same time the worldwide average of the top corporate tax rate was 22.6%, while Europe had the lowest average top corporate rates at 18.6%. The standard progressive answer to these observations is that many U.S. companies do not pay the maximum rates because of tax breaks. Yet these tax breaks are all targeted to motivate corporations to do things the government would like to see them do, such as the laudable goals of hiring veterans, the disabled, or the economically disadvantaged. Not all corporations can take advantage of many of these tax breaks. In addition, they greatly increase compliance costs to document how they meet tax break requirements, thereby making the effective tax break lower. In the end, tax breaks or incentives are in themselves economically damaging because they distort the behavior of companies to make economic decisions for noneconomic reasons.

In addition, the U.S. creates difficulties for multinational companies in bringing back their overseas profits to the United States. Unlike most developed countries in the world, the U.S. uses a world-wide tax system rather than the more usual territorial tax system. In a territorial system a government taxes a company only on income made within its territorial borders. In the world-wide system of the United States, the government taxes all income of a company, no matter where in the world the income is earned. However, the tax is collected on overseas income only when it is brought back to the United States. In the process, those companies are taxed twice for their overseas revenues: once by a foreign government and once by the U.S. As a result, U.S. multinational corporations have every motivation to invest their overseas profits overseas, or to park them in foreign banks to avoid U.S. taxes. This is especially true since the overseas profits would qualify for few (if any) of the U.S. targeted tax breaks. It has been estimated that U.S. corporations have stashed around $2.5 trillion in cash in foreign bank accounts, an amount equal to 13.3% of the current $18.8 trillion GDP. Needless to say, if that money could be enticed back into the United States and invested here, it would go a long way to create new jobs and help the U.S. to adjust to the effects of foreign trade.

Unfortunately, the U.S. federal government holds down American corporate investment in many other ways than just by bad tax policy. The government has created an immense number of regulations that effectively put American companies in a strait jacket, both reducing corporate opportunities and increasing compliance costs. This is not to say that some regulations are not needed and required. Nobody wants to live in an unhealthy environment. However, many of the regulations are nonsensical. The Heritage Foundation reports that in 2015, before the Obama Administration instituted their final round of new regulations, total regulatory costs reached an astounding $2 trillion, 11.1% of 2015’s GDP of $18.0 trillion GDP! No wonder American economic growth is so low!

I have written a great deal in the past about how the U.S. government has retarded economic growth through both taxes and economic regulations, too much to be repeated here. Instead, links to past essays on the subject are provided below.

• The Burden of Economic Regulations
• Beware BEPS!
• Economic Effects of Current Tax Policy
• The Debilitating Effects of ObamaCare
• Economic Effects of the Dodd-Frank Act
• The EPA. CO2, Mercury Emissions, and “Green” Energy
• Big Corporations Abandoning the U.S. at an Increasing Rate
• Failures of New Keynesian Economics
• Economic Damage Created by the Fed
• The Fecklessness of the U.S. Federal Reserve
• The Keynesian Excuse: Secular Stagnation
• What to Do About Keynesian Secular Stagnation
• The Thoughts that Haunt Me
• Economic Freedom in the United States
• The U.S. Federal Government Budget
• The US is Drowning In Debt
• Why Isn’t the U.S. Economy Booming?
• Labor Market Not Nearly As Good As Many Think
• Perspectives on Unemployment
• Dirigisme No Longer Works. What Replaces It?
• Obama Has Not Produced An Economic Recovery
• The Federal Government’s Projected Bankruptcy

One way to see how much the federal government is driving corporate capital abroad is to look at how much U.S. corporate foreign direct investment is made each year. This is shown up to the year 2013 in the plot below, taken from the Congressional Research Report U.S. Direct Investment Abroad: Trends and Current Issues by James K. Jackson.

As the plot tells us, U.S. corporate direct investment abroad has generally been increasing in time, with one major dip in 2005, with U.S. direct investment exceeding that of foreign companies in the U.S. after 2006.

Unintended Consequences of Curbing Foreign Trade

From the data provided in the previous section,  one would think the obvious solution to displaced jobs from foreign trade would be to remove government impediments to corporate investments. Then, new investment in the economy to increase productive capacity, plus cheaper prices from imported goods allowing consumers to spend more on other products of the economy, would create new jobs to soak up the displaced workers caused by import substitution. However, there is one more issue raised by the new Trump administration, and that is the fact that just as the global ecumene closed between the sixteenth and eighteenth centuries with the explorations of Europeans ([H8], Chapter 7, loc.5811), the world economy is currently knitting together as a whole. This is the process of “globalization” reviled by so many on both the Left and the Right. No important national economy in the world is now totally separate from all the others. As a result economic decisions by one government will effect not just its economy, but all others to one degree or other. This is especially true when either import or export tariffs are applied, or when currencies are manipulated.

These kinds of connections between the U.S. economy and foreign economies are what lead President Trump to object to some foreign trade, particularly with China and Mexico. One way in which these foreign trade interconnections are impacting the news today is with  “border adjustment” taxes. Some Republicans are advocating their use to defray the cost of a big decrease in corporate and middle class income taxes. These taxes would be added to imports and subtracted from exports; the proposed import rate is 20%. The corporate income from exports would not be counted as income for tax purposes. Therefore, this is a mercantilist measure that would add federal revenue if there were more imports than exports; it would never add a federal expenditure except as a so-called “tax expenditure” if exports were larger than imports. Because imports have consistently been larger than exports, this border adjustment tax would help counteract other tax decreases.

Under all conditions, any tax is destructive of economic activity; the country will get less of anything that is taxed. The question is: How can we arrange for a tax scheme that produces the least amount of destruction per dollar raised to support the government? In fact, Trump does indeed have a point (a very small one) that other governments (particularly China) are arranging their trade relations in a way that is not optimal for the United States. Nevertheless, if Trump were to ignore these non-optimal trade relations and concentrate on eliminating U.S. government impediments creating a hostile economic environment for American companies, he would then dispose of the conditions not allowing creation of new jobs to replace jobs lost from import substitution. Then the United States would indeed be better off with free-trade with foreign markets.

According to a realclearmarkets.com post, A Quick Guide to the ‘Border Adjustments’ Tax, all advanced countries except for the United States have border adjustment taxes. Since a border adjustment tax is a tax on consumption of foreign goods, those other countries are taxing their domestic consumption of American goods, while the U.S. does not tax its domestic consumption of their goods. If the U.S, does adapt border adjustment taxes to defray the costs of other tax cuts, at least it would give the U.S. a level playing field with those other countries. The border adjustment tax would raise the prices retailers selling imported goods would have to charge, almost certainly harming their sales. Exporters on the other hand would be helped. The combination of these two effects would encourage U.S. multinationals to produce more within the United States, and less abroad.

This is where real world problems begin to complicate life. Many Republicans, justifiably frightened by the prospect of an insolvent U.S. government, are balking at the large tax cuts necessary to restart economic growth. It is for this reason the Speaker of the House Paul Ryan has proposed border adjustment taxes to offset the tax cuts. Yet, this particular kind of offset smells too much to many Republicans like an import tariff, which is anathema to most free-trade loving Republicans. However, there seems to be no other viable way to defray tax cuts. If Republicans are not wary, the combination of the Republican fear of an insolvent government together with their fear of border taxes killing demand at retailers will destroy any chances for the needed tax cuts, dooming the economy to  lackluster growth as well as probably losing the Republicans’ present dominance of the federal government in the next elections.

It would help if any law enabling border adjustment taxes would institute them only against countries that levy them against us. This would make them into a bargaining chip to entice countries to drop their own border adjustment taxes, thereby creating an even playing field. No matter what happens, however, we need those tax cuts for both corporations and the middle class.

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