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Archive for the ‘Protectionism’ Category

Happy New Year!

We listed yesterday the good and bad policy developments of 2017, so now let’s speculate about potential victories and defeats in 2018.

Here are two things I hope will happen this year.

  • Welfare reform – If my friends and contacts on Capitol Hill are feeding my accurate information, we may see a bigger and better version of the 1996 welfare reform in 2018. The core concept would be to abolish the dozens of means-tested programs (i.e., redistribution programs targeted at low-income people) in Washington and replace them with a “block grant.” This could be good news for federal taxpayers if the annual block grant is designed to grow slowly. And it could be good news for poor people since state government would then have the ability and flexibility to design policies that help liberate recipients from government dependency.
  • Collapse of Venezuela – Given the disastrous deterioration of the Venezuelan economy, it’s difficult to envision how the Maduro dictatorship can survive the year. Yes, I know the regime is willing to use the military to suppress any uprising, but I suspect hungry and desperate people are more likely to take chances. My fingers are crossed that the corrupt government is overthrown and Venezuela becomes another Chile (hopefully without a transition period of military rule).

Here are two things I fear may happen in 2018.

  • Pulling out of NAFTA – America dodged a bullet in 2017. Given Trump’s protectionist instincts, I worried he would do something very dangerous on trade. But pain deferred is not the same thing as pain avoided. The President has made some very worrisome noises about NAFTA and it’s possible he may use executive authority to scrap a deal that has been good for the United States.
  • A bad version of Brexit – Given the statist mindset in Brussels and the continent’s awful demographics, voting to leave the European Union was the right decision for our British friends. Simply stated, it makes no sense to stay on a sinking ship, even if it sinking slowly. But the net benefits of Brexit depend on whether the United Kingdom seizes the moment and adopts pro-growth policies such as tax cuts and free-trade pacts. Sadly, those good reforms don’t appear likely and it appears instead that the feckless Tory leadership will choose to become a satellite member of the EU, which means living under the thumb of Brussels and paying for harmonization, bureaucratization, and centralization. The worst possible outcome in the short run, though at least the U.K. is better positioned to fully extricate itself in the future.

I’m adding a new feature to my hopes-and-fears column this year.

These are issues where I think it’s likely that something consequential may occur, but I can’t figure out whether I should be optimistic or pessimistic. I sort of did this last year, listing Obamacare reform and Italian fiscal crisis as both hopes and fears.

It turns out I was right to be afraid about what would happen with Obamacare and I was wrong (or too early) to think something would happen with Italy.

Here are three things that could be consequential in 2018, but I can’t figure out whether to be hopeful or fearful.

  • Infrastructure reform or boondoggle – I put an “infrastructure boondoggle” as one of my fears last year, but the President and Congress postponed dealing with the issue. But it will be addressed this year. I’m still afraid the result may be a traditional pile of pork-barrel spending, but it’s also possible that legislation could be a vehicle for market-based reform.
  • Normalization of monetary policy – I try to stay clear of monetary policy, but I also recognize that it’s a very important issue. Indeed, if I was to pick the greatest risk to the economy, it’s that easy-money policies (such as artificially low interest rates) have created a bubble. And bursting bubbles can be very messy, as we learned (or should have learned) in 2008. The Federal Reserve supposedly is in the process of “normalizing” monetary policy. I very much hope they can move in the right direction without rattling markets and/or bursting bubbles.
  • A China bubble – Speaking of macroeconomic risks, I’m very glad that China has partially liberalized and I’m ecstatic that reform has dramatically reduced severe poverty, but I also worry that the government plays far too large a role in the banking sector and interferes far too much in the allocation of capital. I’m guessing this eventually leads to some sort of hiccup (or worse) for the Chinese economy, and all I can do is cross my fingers and hope that the government responds with additional liberalization rather than the bad policies being advocated by the OECD and IMF.

By the way, I fully expect the Democrats to sweep the 2018 elections. And since the Party is now much farther to the left than it used to be, that could lead to very bad news in 2019 – particularly if Trump unleashes his inner Nixon.

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Using comparative bar charts, I’ve analyzed the economic policies of Presidents Barack Obama, George W. Bush, Bill Clinton, Ronald Reagan, and Richard Nixon.

My basic conclusion was that economic policy moved in the right direction under Reagan and Clinton and moved in the wrong direction under Obama, Bush, and Nixon. Though I always included the caveat that I was agnostic about whether the various presidents deserved credit/blame for the changes that happened during their tenure.

Now let’s go back in time and look at the unambiguously awful economic record of Herbert Hoover. I’ve written about Hoover’s statism on several occasions and thought there was no need for an overall assessment since there was near-unanimous agreement that he was a failure (even if some people don’t understand why).

But near-unanimous is not the same as unanimous. And I was horrified to read that David Frum actually thinks Herbert Hoover should be some sort of role model for today’s Republicans. Here are some excerpts from his Atlantic column, which looks at a new biography of Hoover.

Hoover commenced his political life as a progressive-leaning Republican. …progressives like Hoover…accepted some increased government regulation of industry…endorsed heavier taxation of inheritances. …it’s possible to imagine a Hoover presidency that signed into law some kind of Social Security system… Hoover’s old party could learn things from his impressive career of public service. …Hoover’s astounding accomplishments and generous impulses have been effaced by polemical narratives written to serve polemical political purposes. Such distortions are offenses against historical memory.

Before we look at his economic policies, I should acknowledge that Frum makes a compelling argument that Hoover was a fundamentally good person with some impressive achievements both before and after his time in the Oval Office.

But my presidential economic scorecards are very dispassionate. I’m only looking at the changes in economic policy that occurred while a president was in office.

And by that very neutral benchmark, Hoover was terrible. Nothing but bad policy.

I give extra weight to the protectionist Smoot-Hawley legislation, which surely must rank among the worst bills ever enacted. The tax hike in 1932 also gets some extra weight because of the radical increase in marginal tax rates (the top rate was increased from 25 percent to 63 percent!).

By the way, this assessment (like all my previous assessments) only includes policies that were adopted.

If I included policies that should have been adopted (sins of omission rather than sins of commission), Hoover would get severely dinged for his failure to prevent a severe contraction of the money supply by the Federal Reserve (those interested in such issues should watch this George Selgin video and read this George Selgin article for more information).

And if you want more information on Hoover’s record, I strongly recommend this article by my buddy from grad school, Steve Horwitz.

By the way, the Wikipedia entry on Herbert Hoover is very accurate in noting that he engaged in “large-scale interventions.”

As president from 1929 to 1933, his ambitious programs were overwhelmed by the Great Depression, which seemed to get worse every year despite the increasingly large-scale interventions he made in the economy.

But it is grossly inaccurate because it says that the economy got worse “despite” that intervention rather than “because of” that intervention.

There’s one other blurb that is worth sharing, just in case anyone thinks that I’m unfairly characterizing Hoover as a statist.

FDR aide Rexford Tugwell would claim in a 1974 interview that “practically the whole New Deal was extrapolated from programs that Hoover started.”

I’ll close by recycling a Center for Freedom and Prosperity video that reviews the anti-market policies of Herbert Hoover and Franklin Roosevelt.

P.S. I heartily encourage this cartoon for anyone who wants an easy way of understanding public policy and the Great Depression.

P.P.S. Looking at presidents from the 20th century, Ronald Reagan and Calvin Coolidge stand head and shoulders above all the others when looking at economic policy, though I’ve never tried to figure out which one is best. Similarly, I haven’t figured out who deserves the “prize” for being the worst president, but I have decided that Hoover, FDR, Wilson, and Nixon are the Four Horsemen of the Economic Apocalypse.

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What’s the worst government statistic, based on whether it distracts from sound thinking and encourages bad policy?

Well, I definitely think gross domestic income is a better measure than gross domestic product if we want insights on growth, so I’m not a big fan of GDP data.

I’m even less enthused about the Gini Coefficient because measures of inequality lead some people to mistakenly think of the economy as a fixed pie, or to falsely think that lots of income for a rich person somehow implies less income for the rest of us. And that then encourages some people to focus on redistribution (i.e., change how the pie is sliced) when it will be far better for the poor if policy makers focus on growth (i.e., expand the size of the pie).

But if you want to know the most unfortunate piece of economic data, I actually gave the answer to this question last year.

…the worst government statistic is the “trade deficit.”This is a very destructive piece of data because people instinctively assume a “deficit” is bad. Yet I have a trade deficit every year with my local grocery store. I’m always buying things from them and they never buy anything from me. Does that mean I’m a “loser”? Of course not. Voluntary exchange, by definition, means that both parties gain from any transaction. And this principle applies when voluntary exchange occurs across national borders.Moreover, people oftentimes don’t realize that the necessary and automatic flip side of a “trade deficit” is a “capital surplus.” In other words, when foreign companies acquire dollars by selling to American consumers, they frequently decide that investing in the American economy is the best use of that money. And the huge amount of investment from overseas is a sign of comparative prosperity and vitality, not a sign of weakness.

And we’re not talking chump change. Foreigners are “voting with their dollars” by making huge investments in the American economy.

According the Commerce Department data, the value of these investments is now well above $10 trillion. Yes, that trillion with a “t.”

That’s something we should celebrate. But you don’t have to believe me.

Let’s see what other have to say, starting with Professor Walter Williams.

There cannot be a trade deficit in a true economic sense. Let’s examine this. I buy more from my grocer than he buys from me. That means I have a trade deficit with my grocer. My grocer buys more from his wholesaler than his wholesaler buys from him. But there is really no trade imbalance, whether my grocer is down the street, in Canada or, God forbid, in China. Here is what happens: When I purchase $100 worth of groceries, my goods account (groceries) rises, but my capital account (money) falls by $100. For my grocer, it is the opposite. His goods account falls by $100, but his capital account rises by $100. Looking at only the goods account, we would see trade deficits, but if we included the capital accounts, we would see a trade balance. That is true whether we are talking about domestic trade or we are talking about foreign trade.

Of course, it’s not surprising that a scholar like Walter Williams is on the right side and puts forth sound arguments.

But it is a bit of a shock when an elected official does the same thing. So I was very impressed when I saw this column in the Washington Post from Senator James Lankford of Oklahoma.

…the administration has…emphasized its desire to reduce the trade deficit… This is a faulty assumption but one that has unfortunately found its way into mainstream political dialogue. Trade deficits are not always bad for U.S. workers and consumers.

Senator Lankford points out a very important reason why Americans buy more from Mexicans than vice-versa.

For starters, a powerful economy such as ours often runs a trade deficit because of the immense buying power of its people. Mexico’s average net per capita income is roughly $13,000, while the average U.S. household brings in more than $41,000 each year. Americans have a far greater capacity to buy goods than do consumers in Mexico. It should come as no surprise that we do exactly that.

But the Oklahoma lawmakers also echoes what others have said about capital flows.

Because we have the world’s largest economy and the strongest currency, more money comes into the United States than goes out. …this foreign cash…is a positive for our economy. When a Canadian company decides to invest in a U.S.-based company, it increases our trade deficit. Similarly, when the Mexican government buys U.S. Treasury bonds (as most of the world does), the likelihood of an American trade deficit increases. Investments such as these are indicative of a strong economy. It should be an encouraging sign that we are by far the world’s largest receiver of foreign direct investment. Our trade deficit means, in part, that U.S. companies are considered to be a better investment than companies in other countries. More investment in American businesses means more jobs and higher wages for American workers.

Michael Strain of the American Enterprise Institute adds to the discussion.

Foreigners purchase U.S. stocks, bonds and currency. Foreigners invest directly in the United States… Generally speaking, this is good. It is a vote of confidence in the United States economy and, in some sense, in our nation as a whole. …we should think of foreign investment as increasing wages and economic growth by making workers and firms more productive.

But if President Trump succeeds in limiting the ability of Americans to buy from foreign producers, he will also limit the ability of foreigners to invest in America’s economic future.

…when the president and his administration attack the trade deficit, they are attacking foreign investment in the United States. …when we import capital from abroad, we run a trade deficit. Trade deficits and capital flows from abroad go hand in hand. …If the president wants to significantly reduce the trade deficit, he also wants to significantly reduce inflows of foreign capital. Waging a war on the trade deficit is waging a war on foreign investment.

Here’s what Kevin Williamson wrote about this topic for National Review.

…investing in the United States…is a very attractive proposition, which is…the main reason why we have trade deficits. Trade deficits are partly a question of consumer preference…but they are not mainly a question of consumer preference. They are mainly a question of investor preference — and investors prefer the United States, which is why there is almost twice as much foreign direct investment in the United States as in China, even though China’s economy has grown at a much faster rate over the past 20 years. …When Walmart orders $1 million worth of flip-flops from a Chinese concern, those Chinese gentlemen receive 1 million delicious U.S. dollars, which they are very happy and grateful to have. But what can you do with U.S. dollars? You can buy stuff from U.S. companies or you can buy assets from sellers who take U.S. dollars, which ultimately means U.S.-based investments. …But it isn’t only the Chinese. The Japanese, the British, the Germans and the other Europeans, the Canadians, the Mexicans, and practically everybody else in the world with a little bit of coin to invest likes to buy American assets. And why wouldn’t they? The American economy is the most wondrous thing human beings have ever managed to do… Trade deficits don’t happen because the wily Japanese juke us on trade policy. They happen because intelligent people holding a fistful of dollars very often decide to forgo the consumption of American consumer goods in order to invest in American assets. In economics terms, what this means is that the trade deficit is a mirror image of the capital surplus.

By the way, there are two ways that foreigners invest in the American economy.

Most of their money is for “passive” or “indirect” investments, which is simply a way of saying that they buy lots of stocks and bonds.

Those investments are very important for our economy. As I wrote just a few days ago, investment is what leads to productivity growth, and that’s how we earn higher wages and get higher living standards.

But foreigners also engage in “direct” investments, such as BMW building a factory in South Carolina. Mark Perry of the American Enterprise Institute points out that this also is a recipe for lots of job creation.

Since I’ve shared a lot of information on why a capital surplus is good, I supposed I should share some information explaining why protectionism is bad.

We’ll start with a column from the Wall Street Journal that looks at the impact of protectionist policies in Brazil and Argentina.

For decades, South America’s two largest economies have tried to shield their workers from global trade, largely through high tariffs and regulations that promote domestic production over imports. The World Bank ranks Argentina and Brazil among the world’s most closed big economies. …These protectionist policies have…come at a huge cost to consumers, who now pay higher prices, and to taxpayers, who underwrite the subsidies. …air conditioners and other products are…sold for two to three times the market price of other countries. The cost to Argentina’s taxpayers of these jobs is steep: up to $72,000 per factory worker a year… But for ordinary Argentines, the products’ price tag can be hefty. An unlocked Samsung J7 smartphone sells for $240 in the U.S. but costs nearly $500 in Buenos Aires. …Brazil’s long history of protectionism bred complacency… Consider Brazil’s auto industry, until recently one of the world’s 10 largest. Shielded for decades by high tariffs, it has devolved into a peddler of rinky-dink hatchbacks… And for Brazilian consumers, cars are far pricier: A new Volkswagen Gol Comfortline lists in Brazil at $15,231—nearly twice as much as in Mexico, which has low tariffs and an efficient car industry.

George Will looks at the cost of similar (but thankfully mostly in the past) policies in the United States.

…there are more than 45 million Americans in poverty, “stretching every dollar they have.” The apparel industry employs 135,000 Americans. Can one really justify tariffs that increase the price of clothing for the 45 million in order to save some of the 135,000 low-wage jobs? …A three-year, 15 percent tariff enabled domestic producers to raise their prices, thereby raising the costs of many American manufacturers. By one estimate, each U.S. job “saved” cost $550,000 as the average bolt-nut-screw worker was earning $23,000 annually. …Ronald Reagan imposed “voluntary restraints” on Japanese automobile exports, thereby creating 44,100 U.S. jobs. But the cost to consumers was $8.5 billion in higher prices, or $193,000 per job created, six times the average annual pay of a U.S. autoworker. And there were job losses in sectors of the economy into which the $8.5 billion of consumer spending could not flow. …In 2012, Barack Obama boasted that “over a thousand Americans are working today because we stopped a surge in Chinese tires.” But this cost about $900,000 per job, paid by American purchasers of vehicles and tires. And the Peterson Institute for International Economics says that this money taken from consumers reduced their spending on other retail goods, bringing the net job loss from the job-saving tire tariffs to around 2,500.

Let’s close with some good news.

Here’s a poll showing that Americans are increasingly supportive of trade.

I don’t know why the numbers have improved so much since 2008, but I’m happy with the outcome.

And one of the big reasons I’m happy is that the global shift to more open trade has been very beneficial to the global economy.

Indeed, expanded openness to trade in the post-World War II era has helped offset the damage caused by a bigger fiscal burden.

And more trade has been very good for the poor, as Deirdre McCloskey explains in this video.

I’ll close by recycling my column that challenges protectionists with eight questions. I wrote that column also six years ago and I still haven’t received any good answers.

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I was recently interviewed on Fox Business Network about Trump’s policies and the economy, and the discussion jumped around from issues such as border-adjustable taxation to energy regulation.

Though the central theme of the discussion was whether Trump had good ideas for American jobs and business competitiveness.

Given my schizophrenic views on Trump, this meant I was both supportive and critical, and I hope certain people in the White House paid attention to my comment about there being no need for the “stick” of protectionism if Trump delivers on the “carrot” of tax cuts and deregulation.

For today, though, I want to elaborate on why protectionism is the wrong approach. I mentioned in the interview that the long-run outlook for manufacturing employment wasn’t very good, but that we shouldn’t blame trade. So I decided to find a chart that illustrated this point, which then gave me the idea of using a Q&A format to share several charts and tables that make very strong points about trade and protectionism.

Did you know…that manufacturing employment is falling because of productivity growth rather than trade?

The bad news (at least for certain workers) is that manufacturing employment has fallen. And it will continue to fall. But as illustrated by this chart from Professor Don Boudreaux, manufacturing output is at record highs. What’s really happening is that productivity improvements enable more to be produced while using fewer workers. And this is happening all over the world.

Did you know…that there’s a strong relationship between trade openness and national prosperity?

One of Professor Boudreaux’s students augmented one of his charts to show the link between pro-trade policies and per-capita economic output.

Did you know…that you can’t hurt importers without also hurting exporters?

Many of the major multinational firms engage in considerable cross-border trade, meaning that they are both major importers and major exporters. Here’s a very illuminating chart from the Peterson Institute of International Economics.

Did you know…that protectionism imposes enormous losses on consumers and therefore is a net job destroyer?

There has been considerable research on the results of various protectionist policies and the results shared by Mark Perry of the American Enterprise Institute inevitably show substantial economic costs, which means that the jobs that are saved (the “seen“) are more than offset by the jobs that are lost or never created (the “unseen“).

Last but not least, did you know….that economists are nearly unanimous in their recognition that trade barriers undermine prosperity?

There are plenty of jokes (many well deserved!) about economists, including the stereotype that economists can’t agree on anything. But there’s near-unanimity in the profession that protectionism is misguided.

By the way, if you have protectionist friends, ask them if they have good answer for these eight questions. And also direct them to the wise words of Walter Williams.

P.S. I wrote a few weeks ago about former President Obama’s dismal legacy. I then augmented that analysis with a more recent postscript citing Ramesh Ponnuru’s observation that Obama failed in his effort to be the left’s Reagan. Now it’s time for another worthy postscript. The Wall Street Journal reviewed the new numbers for growth in 2016 and opined on what this means for Obama’s overall record.

…growth for all of 2016 clocked in at 1.6%, the slowest since 2011 and down from 2.6% in 2015. That marks the 11th consecutive year that GDP growth failed to reach 3%, the longest period since the Bureau of Economic Analysis began reporting the figure. The fourth quarter also rings out the Obama era with an average annual growth rate of 1.8%, which is right down there with George W. Bush for the lowest among modern Presidents. Mr. Obama inherited a deep recession, but that makes the 2.1% growth average since the recession ended all the more dismaying. You have to work hard to suppress growth after a deep downturn, and Mr. Obama did that by putting income redistribution ahead of growth as a policy priority.

Amen. When you fixate on how the pie is sliced, you wind up with policies that cause the pie to be smaller.

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For the next four years, I suspect I’m going to suffer a lot of whiplash as I yank myself back and forth, acting as both a critic and supporter of Donald Trump’s policy.

This happened a lot during the campaign, as Trump would say very good things one day and then say very bad things the next day.

And now that he’s President-Elect Trump, that pattern is continuing. Consider his approach to American businesses. In the space of just a few minutes, he manages to be a Reaganesque tax cutter and an Obamaesque cronyist.

I discussed this bizarre mix in a recent interview with Dana Loesch.

I guess the only way to make sense of Trump’s policy is that it’s a random collection of carrots and sticks. The carrots are policies to encourage companies to create jobs in America, and Trump is proposing both good carrots such as a much lower corporate tax rate and bad carrots such as special Solyndra-style handouts (except, instead of loot for green energy, firms get loot for maintaining production in America).

And the sticks are all bad, ranging for public shaming to explicit protectionism.

As I said during the interview, Trump is probably scoring political points, but what we should really care about is whether policy is moving in the right direction.

The Wall Street Journal is rather skeptical, opining that Republican-backed cronyism will be just as bad as Democrat-backed cronyism.

A giant flaw in President Obama’s economic policy has been the politicized allocation of capital, from green energy to housing. Donald Trump suffers from a similar industrial-policy temptation, as we’ve seen…with his arm-twisting of Carrier to change its decision to move a plant to Mexico from Indiana. …A mercantilist Trump trade policy that jeopardized those exports would throw far more Americans out of work than the relatively low-paying jobs he’s preserved for now in Indianapolis. Mr. Trump’s Carrier squeeze might even cost more U.S. jobs if it makes CEOs more reluctant to build plants in the U.S. because it would be politically difficult to close them. Mr. Trump has now muscled his way into at least two corporate decisions about where and how to do business. But who would you rather have making a decision about where to make furnaces or cars? A company whose profitability depends on making good decisions, or a branding executive turned politician who wants to claim political credit? The larger point is that America won’t become more prosperous by forcing companies to make noneconomic investments.

Here’s some of what Tyler Cowen wrote about Trump’s approach.

One of Donald Trump’s most consistent campaign promises has been to prevent U.S. businesses from moving good jobs to Mexico… Economists might regard this as a misguided form of protectionism, but in fact, it’s worse than that: If instituted, it could prove a major step toward imposing capital controls on the American economy and politicizing many business decisions. …Using the law to forbid factory closures would have serious negative consequences. For one thing, those factories may be losing money and end up going bankrupt. For another, stopping the closure of old plants would lock the U.S. into earlier technologies and modes of production, limiting progress and economic advancement. An alternative policy would prohibit companies from cutting American production and expanding in Mexico… The end result would be that Asian, European and Mexican investors would gain at the expense of U.S. companies. …Furthermore, if we limit the export of American capital to Mexico, the biggest winner would be China, as one of its most significant low-wage competitors — Mexico — suddenly would be hobbled.

Those are all very practical and sensible arguments against protectionism.

But Tyler points out that Trump’s agenda could lead to something even worse.

…a policy limiting the ability of American companies to move funds outside of the U.S. would create a dangerous new set of government powers. Imagine giving an administration the potential to rule whether a given transfer of funds would endanger job creation or job maintenance in the United States. That’s not exactly an objective standard, and so every capital transfer decision would be subject to the arbitrary diktats of politicians and bureaucrats. It’s not hard to imagine a Trump administration using such regulations to reward supportive businesses and to punish opponents. Even in the absence of explicit favoritism, companies wouldn’t know the rules of the game in advance, and they would be reluctant to speak out in ways that anger the powers that be. …It also could bring the kind of crony capitalist nightmare scenarios described by Ayn Rand in her novel “Atlas Shrugged,” a book many Republican legislators would be well advised to now read or reread.

Tyler’s best-case scenario is that Trump doesn’t try to change policy and instead just uses the bully pulpit to…well, be a bully.

…public jawboning  also would be an unfortunate form of politicizing the economy, but at least there wouldn’t be new laws or regulations to back it up in a systematic way.

Though I’ll close by noting that this best-case scenario is still a very bad case.

The mere fact that politicians think they have the right to interfere with the internal decisions of companies is a dangerous development.

It’s cronyism on steroids.

And even if Trump somehow restrains himself (how likely is that?!?), sooner or later that bad mentality will lead to bad policy.

Yes, I’m making a slippery-slope argument. But not just because I’m a libertarian who is paranoid about government power.

My fear is based on lots of real-world evidence. It turns out that slippery slopes are very slippery.

The bottom line is that politicians don’t even do a good job of running the government. Let’s not allow them to run private companies as well. And that’s true whether they have an R after their names or a D after their names.

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I wrote yesterday to praise the Better Way tax plan put forth by House Republicans, but I added a very important caveat: The “destination-based” nature of the revised corporate income tax could be a poison pill for reform.

I listed five concerns about a so-called destination-based cash flow tax (DBCFT), most notably my concerns that it would undermine tax competition (folks on the left think it creates a “race to the bottom” when governments have to compete with each other) and also that it could (because of international trade treaties) be an inadvertent stepping stone for a government-expanding value-added tax.

Brian Garst of the Center for Freedom and Prosperity has just authored a new study on the DBCFT. Here’s his summary description of the tax.

The DBCFT would be a new type of corporate income tax that disallows any deductions for imports while also exempting export-related revenue from taxation. This mercantilist system is based on the same “destination” principle as European value-added taxes, which means that it is explicitly designed to preclude tax competition.

Since CF&P was created to protect and promote tax competition, you won’t be surprised to learn that the DBCFT’s anti-tax competition structure is a primary objection to this new tax.

First, the DBCFT is likely to grow government in the long-run due to its weakening of international tax competition and the loss of its disciplinary impact on political behavior. … Tax competition works because assets are mobile. This provides pressure on politicians to keep rates from climbing too high. When the tax base shifts heavily toward immobile economic activity, such competition is dramatically weakened. This is cited as a benefit of the tax by those seeking higher and more progressive rates. …Alan Auerbach, touts that the DBCFT “alleviates the pressure to reduce the corporate tax rate,” and that it would “alter fundamentally the terms of international tax competition.” This raises the obvious question—would those businesses and economists that favor the DBCFT at a 20% rate be so supportive at a higher rate?

Brian also shares my concern that the plan may morph into a VAT if the WTO ultimately decides that is violates trade rules.

Second, the DBCFT almost certainly violates World Trade Organization commitments. …Unfortunately, it is quite possible that lawmakers will try to “fix” the tax by making it into an actual value-added tax rather than something that is merely based on the same anti-tax competition principles as European-style VATs. …the close similarity of the VAT and the DBCFT is worrisome… Before VATs were widely adopted, European nations featured similar levels of government spending as the United States… Feeding at least in part off the easy revenue generate by their VATs, European nations grew much more drastically over the last half century than the United States and now feature higher burdens of government spending. The lack of a VAT-like revenue engine in the U.S. constrained efforts to put the United States on a similar trajectory as European nations.

And if you’re wondering why a VAT would be a bad idea, here’s a chart from Brian’s paper showing how the burden of government spending in Europe increased once that tax was imposed.

In the new report, Brian elaborates on the downsides of a VAT.

If the DBCFT turns into a subtraction-method VAT, its costs would be further hidden from taxpayers. Workers would not easily understand that their employers were paying a big VAT withholding tax (in addition to withholding for income tax). This makes it easier for politicians to raise rates in the future. …Keep in mind that European nations have corporate income tax systems in addition to their onerous VAT regimes.

And he points out that those who support the DBCFT for protectionist reasons will be disappointed at the final outcome.

…if other nations were to follow suit and adopt a destination-based system as proponents suggest, it will mean more taxes on U.S. exports. Due to the resulting decline in competitive downward pressure on tax rates, the long-run result would be higher tax burdens across the board and a worse global economic environment.

Brian concludes with some advice for Republicans.

Lawmakers should always consider what is likely to happen once the other side eventually returns to power, especially when they embark upon politically risky endeavors… In this case, left-leaning politicians would see the DBCFT not as something to be undone, but as a jumping off point for new and higher taxes. A highly probable outcome is that the United States’ corporate tax environment becomes more like that of Europe, consisting of both consumption and income taxes. The long-run consequences will thus be the opposite of what today’s lawmakers hope to achieve. Instead of a less destructive tax code, the eventual result could be bigger government, higher taxes, and slower economic growth.

Amen.

My concern with the DBCFT is partly based on theoretical objections, but what really motivates me is that I don’t want to accidentally or inadvertently help statists expand the size and scope of government. And that will happen if we undermine tax competition and/or set in motion events that could lead to a value-added tax.

Let’s close with three hopefully helpful observations.

Helpful Reminder #1: Congressional supporters want a destination-based system as a “pay for” to help finance pro-growth tax reforms, but they should keep in mind that leftists want a destination-based system for bad reasons.

Based on dozens of conversations, I think it’s fair to say that the supporters of the Better Way plan don’t have strong feelings for destination-based taxation as an economic principle. Instead, they simply chose that approach because it is projected to generate $1.2 trillion of revenue and they want to use that money to “pay for” the good tax cuts in the overall plan.

That’s a legitimate choice. But they also should keep in mind why other people prefer that approach. Folks on the left want a destination-based tax system because they don’t like tax competition. They understand that tax competition restrains the ability of governments to over-tax and over-spend. Governments in Europe chose destination-based value-added taxes to prevent consumers from being able to buy goods and services where VAT rates are lower. In other words, to neuter tax competition. Some state governments with high sales taxes in the United States are pushing a destination-based system for sales taxes because they want to hinder consumers from buying goods and services from states with low (or no) sales taxes. Again, their goal is to cripple tax competition.

Something else to keep in mind is that leftist supporters of the DBCFT also presumably see the plan as being a big step toward achieving a value-added tax, which they support as the most effective way of enabling bigger government in the United States.

Helpful Reminder #2: Choosing the right tax base (i.e., taxing income only one time, otherwise known as a consumption-base system) does not require choosing a destination-based approach.

The proponents of the Better Way plan want a “consumption-base” tax. This is a worthy goal. After all, that principle means a system where economic activity is taxed only one time. But that choice is completely independent of the decision whether the tax system should be “origin-based” or “destination-based.”

The gold standard of tax reform has always been the Hall-Rabushka flat tax, which is a consumption-base tax because there is no double taxation of income that is saved and invested. It also is an “origin-based” tax because economic activity is taxed (only one time!) where income is earned rather than where income is consumed.

The bottom line is that you can have the right tax base with either an origin-based system or a destination-based system.

Helpful Reminder #3: The good reforms of the Better Way plan can be achieved without the downside risks of a destination-based tax system.

The Tax Foundation, even in rare instances when I disagree with its conclusions, always does very good work. And they are the go-to place for estimates of how policy changes will affect tax receipts and the economy. Here is a chart with their estimates of the revenue impact of various changes to business taxation in the Better Way plan. As you can see, the switch to a destination-based system (“border adjustment”) pulls in about $1.2 trillion over 10 years. And you can also see all the good reforms (expensing, rate reduction, etc) that are being financed with the various “pay fors” in the plan.

I am constantly asked how the numbers can work if “border adjustment” is removed from the plan. That’s a very fair question.

But there are lots of potential answers, including:

  • Make a virtue out of necessity by reducing government revenue by $1.2 trillion.
  • Reduce the growth of government spending to generate offsetting savings.
  • Find other “pay fors” in the tax code (my first choice would be the healthcare exclusion).
  • Reduce the size of the tax cuts in the Better Way plan by $1.2 trillion.

I’m not pretending that any of these options are politically easy. If they were, the drafters of the Better Way plan probably would have picked them already. But I am suggesting that any of those options would be better than adopting a destination-based system for business taxation.

Ultimately, the debate over the DBCFT is about how different people assess political risks. House Republicans advocating the plan want good things, and they obviously think the downside risks in the future are outweighed by the ability to finance a larger level of good tax reforms today. Skeptics appreciate that those proponents want good policy, but we worry about the long-run consequences of changes that may (especially when the left sooner or late regains control) enable bigger government.

P.S. This is not the first time that advocates of good policy have bickered with each other. During the 2016 nomination battle, Rand Paul and Ted Cruz plans proposed tax reform plans that fixed many of the bad problems in the tax code. But they financed some of those changes by including value-added taxes in their plans. In the short run, either plan would have been much better than the current system. But I was critical because I worried the inclusion of VATs would eventually give statists a tool to further increase the burden of government.

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The Republicans in the House of Representatives, led by Ways & Means Chairman Kevin Brady and Speaker Paul Ryan, have proposed a “Better Way” tax plan that has many very desirable features.

And there are many other provisions that would reduce penalties on work, saving, investment, and entrepreneurship. No, it’s not quite a flat tax, which is the gold standard of tax reform, but it is a very pro-growth initiative worthy of praise.

That being said, there is a feature of the plan that merits closer inspection. The plan would radically change the structure of business taxation by imposing a 20 percent tax on all imports and providing a special exemption for all export-related income. This approach, known as “border adjustability,” is part of the plan to create a “destination-based cash flow tax” (DBCFT).

When I spoke about the Better Way plan at the Heritage Foundation last month, I highlighted the good features of the plan in the first few minutes of my brief remarks, but raised my concerns about the DBCFT in my final few minutes.

Allow me to elaborate on those comments with five specific worries about the proposal.

Concern #1: Is the DBCFT protectionist?

It certainly sounds protectionist. Here’s how the Financial Times described the plan.

The border tax adjustment would work by denying US companies their current ability to deduct import costs from their taxable income, meaning companies selling imported products would effectively be taxed on the full value of the sale rather than just the profit. Export revenues, meanwhile, would be excluded from company tax bases, giving net exporters the equivalent of a subsidy that would make them big beneficiaries of the change.

Charles Lane of the Washington Post explains how it works.

…the DBCFT would impose a flat 20 percent tax only on earnings from sales of output consumed within the United States… It gets complicated, but the upshot is that the cost of imported supplies would no longer be deductible from taxable income, while all revenue from exports would be. This would be a huge incentive to import less and export more, significant change indeed for an economy deeply dependent on global supply chains.

That certainly sounds protectionist as well. A tax on imports and a special exemption for exports.

But proponents say there’s no protectionism because the tax is neutral if the benchmark is where products are consumed rather than where income is earned. Moreover, they claim exchange rates will adjust to offset the impact of the tax changes. Here’s how Lane explains the issue.

…the greenback would have to rise 25 percent to offset what would be a new 20 percent tax on imported inputs — propelling the U.S. currency to its highest level on record. The international consequences of that are unforeseeable, but unlikely to be totally benign for everyone. Bear in mind that many other countries — China comes to mind — can and will manipulate exchange rates to protect their own short-term interests.

For what it’s worth, I accept the argument that the dollar will rise in value, thus blunting the protectionist impact of border adjustability. It would remain to be seen, though, how quickly or how completely the value of the dollar would change.

Concern #2: Is the DBCFT compliant with WTO obligations?

The United States is part of the World Trade Organization (WTO) and we have ratified various agreements designed to liberalize world trade. This is great for the global economy, but it might not be good news for the Better Way plan because WTO rules only allow border adjustability for indirect taxes like a credit-invoice value-added tax. The DBCFT, by contrast, is a version of a corporate income tax, which is a direct tax.

The column by Charles Lane explains one of the specific problems.

Trading partners could also challenge the GOP plan as a discriminatory subsidy at the World Trade Organization. That’s because it includes a deduction for wages paid by U.S.-located firms, importers and exporters alike — a break that would obviously not be available to competitors abroad.

Advocates argue that the DBCFT is a consumption-base tax, like a VAT. And since credit-invoice VATs are border adjustable, they assert their plan also should get the same treatment. But the WTO rules say that only “indirect” taxes are eligible for border adjustability. The New York Times reports that the WTO therefore would almost surely reject the plan.

Michael Graetz, a tax expert at the Columbia Law School, said he doubted that argument would prevail in Geneva. “W.T.O. lawyers do not take the view that things that look the same economically are acceptable,” Mr. Graetz said.

A story in the Wall Street Journal considers the potential for an adverse ruling from the World Trade Organization.

Even though it’s economically similar to, and probably better than, the value-added taxes (VATs) many other countries use, it may be illegal under World Trade Organization rules. An international clash over taxes is something the world can ill afford when protectionist sentiment is already running high. …The controversy is over whether border adjustability discriminates against trade partners. …the WTO operates not according to economics but trade treaties, which generally treat tax exemptions on exports as illegal unless they are consumption taxes, such as the VAT. …the U.S. has lost similar disputes before. In 1971 it introduced a tax break for exporters that, despite several revamps, the WTO ruled illegal in 2002.

And a Washington Post editorial is similarly concerned.

Republicans are going to have to figure out how to make such a huge de facto shift in the U.S. tax treatment of imports compliant with international trade law. In its current iteration, the proposal would allow corporations to deduct the costs of wages paid within this country — a nice reward for hiring Americans and paying them well, which for complex reasons could be construed as a discriminatory subsidy under existing World Trade Organization doctrine.

Concern #3: Is the DBCFT a stepping stone to a VAT?

If the plan is adopted, it will be challenged. And if it is challenged, it presumably will be rejected by the WTO. At that point, we would be in uncharted territory.

Would that force the folks in Washington to entirely rewrite the tax system? Would they be more surgical and just repeal border adjustability? Would they ignore the WTO, which would give other nations the right to impose tariffs on American exports?

One worrisome option is that they might simply turn the DBCFT into a subtraction-method value-added tax (VAT) by tweaking the law so that employers no longer could deduct  expenses for labor compensation. This change would be seen as more likely to get approval from the WTO since credit-invoice VATs are border adjustable.

This possibility is already being discussed. The Wall Street Journal story about the WTO issue points out that there is a relatively simple way of making the DBCFT fit within America’s trade obligations, and that’s to turn it into a value-added tax.

One way to avoid such a confrontation would be to revise the cash flow tax to make it a de facto VAT.

The Economist shares this assessment.

…unless America switches to a full-fledged VAT, border adjustability may also be judged to breach World Trade Organisation rules.

Steve Forbes is blunt about this possibility.

One tax initiative that should be strangled before it sees the light of day is to give a tax rebate to exporters and to impose taxes on imports. …It’s a bad idea. Why do we want to make American consumers pay more for products while subsidizing foreign buyers? It also could put us on the slippery slope to our own VAT.

And that’s not a slope we want to be on. Unless the income tax is fully repealed (sadly not an option), a VAT would be a recipe for turning America into a European-style welfare state.

Concern #4: Does the DBCFT undermine tax competition and give politicians more ability to increase tax burdens?

Alan Auerbach, an academic from California who previously was an adviser for John Kerry and also worked at the Joint Committee on Taxation when Democrats controlled Capitol Hill, is the main advocate of a DBCFT (the New York Times wrote that he is the “principal intellectual champion” of the idea).

He wrote a paper several years ago for the Center for American Progress, a hard-left group closely associated with Hillary Clinton. Auerbach explicitly argued that this new tax scheme is good because politicians no longer would feel any pressure to lower tax rates.

This…alternative treatment of international transactions that would relieve the international pressure to reduce rates while attracting foreign business activity to the United States. It addresses concerns about the effect of rising international competition for multinational business operations on the sustainability of the current corporate tax system. With rising international capital flows, multinational corporations, and cross-border investment, countries’ tax rates and tax structures are of increasing importance. Indeed, part of the explanation for declining corporate tax rates abroad is competition among countries for business activity. …my proposed reforms…builds on the [Obama] Administration’s approach…and alleviates the pressure to reduce the corporate tax rate.

This is very troubling. Tax competition is a very valuable liberalizing force in the world economy. It partially offsets the public choice pressures on politicians to over-tax and over-spend. If governments no longer had to worry that taxable activity could escape across national borders, they would boost tax rates and engage in more class warfare.

Also, it’s worth noting that the so-called Marketplace Fairness Act, which is designed to undermine tax competition and create a sales tax cartel among American states, uses the same “destination-based” model as the DBCFT.

Concern #5: Does the DBCFT create needless conflict and division among supporters of tax reform?

As I pointed out in my remarks at the Heritage Foundation, there’s normally near-unanimous support from the business community for pro-growth tax reforms.

That’s not the case with the DBCFT.

The Washington Examiner reports on the divisions in the business community.

Major retailers are skeptical of the House Republican plan to revamp the tax code, fearing that the GOP call to border-adjust corporate taxes could harm them even if they win a significant cut to their tax rate. As a result, retailers, oil refiners and other industries that import goods to sell in the U.S. could provide a major obstacle to the Republican effort to reform taxes. …The effect of the border adjustment, retailers fear, would be that the goods they import to sell to consumers would face a 20 percent mark-up, one that would force retailers like Walmart, the Home Depot and Sears…to raise prices and lose customers.

A story from CNBC highlights why retailers are so concerned.

…retailers are nervous. Very nervous. …About 95 percent of clothing and shoes sold in the U.S. are manufactured overseas, which means imports make up a vast majority of many U.S. retailers’ merchandise. …If the GOP plan were adopted as it’s currently laid out, Gap pays 20 percent corporate tax on the $5 profit from the sweater, or $1. Plus, 20 percent tax on the $80 cost it paid for that sweater from the overseas supplier, or $16. That means the tax goes from $1.75 to $17 for that sweater, more than three times the profit on that sweater. Talk about a hit to margins. …Retailers certainly aren’t taking a lot of comfort in the economic theory of dollar appreciation. …the tax reform plan will dilute specialty retailers’ earnings by an average of 132 percent. …Athletic manufacturers could take a 40 percent earnings hit… Gap, Carter’s , Urban Outfitters , Fossil and Under Armour are most at risk under the plan.

And here’s another article from the Washington Examiner that explains why folks in the energy industry are concerned.

…the border adjustment would raise costs for refiners that import oil. In turn, that could raise prices for consumers. The border adjustment would amount to a $10-a-barrel tax on imported crude oil, raising costs for drivers buying gasoline by up to 25 cents a gallon, the energy analyst group PIRA Energy Group warned this week. The report warned of a “potential huge impact across the petroleum industry,” even while noting that the tax reform plan faces many obstacles to passage.

Concern #6: What happens when other nations adopt their versions of a DBCFT?

Advocates of the DBCFT plausibly argue that if the WTO somehow approves their plan, then other nations will almost certainly copy the new American system.

That will be a significant blow to tax competition, which would be very bad news for the global economy.

But is also has negative implications for the fight to protect America from a VAT. The main selling point for advocates of the DBCFT is that we need a border-adjustable tax to offset the supposed advantage that other nations have because of border-adjustable VATs (both Paul Krugman and I agree that this is nonsense, but it still manages to be persuasive for some people).

So what happens when other nations turn their corporate income taxes into DBCFTs, which presumably will happen? We’re than back where we started and misguided people will say we need our own VAT to balance out the VATs in other nations.

The bottom line is that a DBCFT is not the answer to America’s wretched business tax system. There are simply too many risks associated with this proposal. I’ll elaborate tomorrow in Part II and also explain some good ways of pursuing tax reform without a DBCFT.

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