Why are President Donald Trump’s tariffs such a bad deal for the U.S. economy? It’s not just because they might start a trade war. It’s because of tax theory.
Now, most tax theory is incredibly boring. (Hopefully my former economics professors aren’t reading this column!)
One reason is because it’s about taxes, which are not the most interesting subject to begin with. But another reason is that tax theory often involves very complicated mathematics describing highly abstract concepts. Many theories claiming to yield the “optimal” tax are only optimal in a world that doesn’t closely resemble the one in which we live. But the real world is so complicated – the federal tax code alone contains more than 70,000 pages – that beautiful theorems posited in economic papers are often next to useless in practice.
But still, there are some important insights to be gained from tax theory. One of these is the idea that intermediate goods shouldn’t be taxed. Intermediate goods are things used in the production of other, more complicated things – steel for cars, transistors for computer chips, screens for mobile phones. In 1971, economists Peter Diamond and James Mirrlees realized that under certain conditions, it makes sense not to tax these things at all.
The reason is that taxing inputs causes companies to produce less than they otherwise would. Lower production means a smaller economic pie to divide up. Better, Diamond and Mirrlees concluded, to let companies make as much stuff as they can, and then to focus on dividing up that stuff among consumers.
Diamond and Mirrlees’ result holds perfectly true only in the idealized setting of an unrealistic economic model. But it provides powerful intuition that many countries have actually used to design their tax systems. Many countries, as well as the European Union, have value-added taxes, or VATs. These let companies deduct the cost of their intermediate goods when paying their taxes. As a result, a VAT only taxes the amount of value that ends up reaching the consumer.
The U.S. could choose to implement a VAT. Instead, under Trump, it’s doing almost the exact opposite. Most of Trump’s tariffs fall directly on inputs that U.S. manufacturers need to make their products.
Chad Brown of the Peterson Institute for International Economics has the numbers. According to Brown’s calculations, most of the USD50 billion worth of Chinese products that Trump is threatening to impose tariffs on are things that U.S. producers use to make other things – either intermediate inputs used directly in production, or capital goods.
This is bad news for a lot of U.S. companies, although manufacturers will probably be hit the hardest. That would be another self-inflicted wound by an administration that was elected on promises to revive “Made in America.” Trump’s earlier round of tariffs on steel and aluminum were probably a key factor behind a rise in the prices U.S. factories pay for those metals.
Predictably, a large number of U.S. businesses have applied for relief from Trump’s metal tariffs. Granting exemptions helps keep U.S. manufacturers afloat, but also makes the tariffs themselves less effective. That just shows what a bad idea the tariffs are in the first place.
Diamond and Mirrlees’ theory may be just some abstract math on a page, but the insight is real and important – if you want to give American manufacturing a boost, don’t use taxes to starve U.S. factories of the materials and equipment they need.
So what should Trump be doing instead? If he wants to start a trade war, he could at least focus his tariffs on consumer goods instead, such as televisions or phones. But a better idea would be to simply forget about tariffs, and promote U.S. exports instead.
Another good idea, taking a page from Diamond and Mirrlees’ book, would be to have a VAT in the U.S. VATs are a highly efficient form of taxation. They do tend to hit the poor harder than the rich, because they’re similar to consumption taxes, and poor people consume a higher percent of their income. But this can be solved by using the VAT to fund health care, housing subsidies and other services for poor Americans.
A VAT might also satisfy Trump’s thirst for trade war. Trump seems to think VATs represent a kind of tariff on imported goods. They don’t, and most VATs are neutral with respect to trade. But if the president’s desire to look tough on trade could be satisfied with an efficient form of taxation that doesn’t actually hurt U.S. producers, so much the better. Noah Smith, Bloomberg