Trade Wars Slow Economic Growth, Harm Welfare, and Push Assets Abroad

In order to deliver a campaign promise of bringing manufacturing back to the US; reduce the trade deficit’ and make America competitive in attracting American capital back from abroad, the Trump administration has imposed tariffs on foreign steel and aluminium, $250 billion of Chinese goods and even threatened to place tariffs on EU car exports.

When tariffs are imposed, the increase in the costs of imported goods obviously reduces imports relative to output. What’s not obvious is the impact of tariffs on capital flows, the quantity and quality of output and productivity[1], and employment prospects.

Proponents of trade barriers often point to product quality to justify tariffs on imported products.

Champions of protectionist policies often cite consumer protection from cheap and inferior goods as a reason for tariffs. However, competition among businesses is what contributes to improving product quality. Trade liberalisation, perhaps the most common form of a competition shock, thereby improves the quality of output.

Overwhelming evidence suggests that attempts to insulate markets from competition have a negative impact on innovation and on product quality. Shielding certain industries or producers from competition does not benefit consumers nor does it raise the quality of the products they purchase. The behaviour of a vertically differentiated monopolist has received a lot of attention in the expert literature, mainly focusing on whether a monopolist has any incentives to supply the same quality that would be available under a competitive market, or to distort the market to induce self-selection on the part of consumers. The evidence points to an increase in product quality as a market becomes more competitive (see Spence, 1975[2]; Lambertini, 1998[3];   Mussa and Rosen, 1978[4], Dranove and White, 1994[5]; Cotterill, 1999[6]; Hamilton and Macauley, 1999[7];  Mazzeo, 2002[8], 2003[9],; Cohen and Mazzeo, 2004[10]).  

While market concentration can also be consistent with higher quality, it is not because of higher barriers to entry. Instead it is caused by innovators who drive out competitors who cannot afford to compete on quality (Demsetz, 1973[11]; Shaked and Sutton, 1987[12]; Sutton and Lampe, 1991[13]).

Proponents of trade barriers often point to employment losses to justify tariffs on imported goods. 

Evolving markets, changing consumer preferences, and global competition can negatively affect areas of a nation’s economy, as the optimal allocation of resources requires some re-shuffling. The oft-touted criticism of free trade is that employment losses can occur when international import competition can substitute for domestic production. Indeed, some research[14] shows that employment growth slowed in U.S. geographic regions where there are workers who are relatively more concentrated in industries of growth in China compared to those regions with industries that are less easily substituted by Chinese imports. In California, electronics companies like Panasonic have been closing plants and moving abroad. Meanwhile, in Illinois and Indiana, machine manufacturers have shuttered factories in light of foreign competition. Additionally, the gains from import competition may be skewed towards non-manufacturing and non-tradable industries. 

Although some evidence exists suggesting the China trade shock resulted in some displacement, trade can only explain 16 per cent of the decline in manufacturing employment between 2000-2007[15]. That means that the bulk – 84 per cent – of the decline in employment in these sectors was driven by faster productivity growth in goods-producing sectors[16].

It is also worth noting that international trade has increased the real wages of both skilled and unskilled workers, especially in industries that heavily rely on imports for their capital equipment[17]. This is because the bulk of U.S. imports are goods used as production inputs[18] – capital goods and intermediate goods – suggesting that tariffs simply raise production costs and result in declining labour productivity, while access to more capital equipment can make workers more productive. Higher labour productivity incentivises work, leads to greater labour market attachment and improves living standards.

Another mechanism by which import competition has led to productivity gains is by incentivising improvements in management quality[19]. Competitive pressures have led to improvements in management quality resulting in higher firm-level productivity.

While there is potential for marginal, temporary negative externalities - such as business deaths that lead to higher unemployment for some workers in the manufacturing sector - from trade, experts agree that trade liberalisation has led to large increases in aggregate productivity (see, Pavcnik, 2002[20]; Lai and Trefler, 2004[21]; Goldberg et al., 2010[22]; De Loecker, 2007[23]; Dunne et al, 2008[24]; Eslava et al., 2009[25]; Bloom et al., 2010[26] and Teshima, 2008[27]). Historically, productivity growth has led to gains in compensation for workers and greater profits for firms. In fact, trade liberalisation has delivered more business dynamism resulting in net positive employment gains and an increase in living standards across the U.S.

Proponents of trade barriers often point to ’tariff jumping’ as a means to attract capital to US soil. 

Aside from economic independence, one of the key pillars of the Trump campaign was to deliver sweeping tax cuts to individuals and businesses and to bring capital back to America from abroad. At the end of 2017, Trump delivered on his promise to bring tax reform with the passage of the Tax Cuts and Jobs Act (TCJA). 

It seems that the Trump administration was banking on ’tariff jumping’. There is some expert literature to suggest that tax cuts combined with tariffs can attract foreign investment. Companies, after all, may be willing to relocate to low-tax regimes, closer to the major consumers of their products in order to avoid large tariffs on their goods, a process known as ‘tariff jumping’ (see Schmitz and Bieri 1972[28], and Brander and Spencer 1987[29]). However, it is unlikely that this reform will have the intended result of attracting capital to American soil, as corporate taxes are still relatively higher and labour costs much greater in the US than elsewhere.

While both proponents and critics of the plan used colourful rhetoric to convey how drastic these reforms were, the tax cuts may not have been large enough. For starters, while the TCJA did reduce corporate taxes, the new corporate tax rate of 21 per cent is still far higher than the tax rates of other foreign countries to which companies have been fleeing. Additionally, the fine print of the legislation still retains components of a worldwide tax system, with exclusions and deductions on physical foreign capital that may continue to incentivise foreign investment.[30]

There is also healthy scepticism of just how long the reduced tax rates will be in place.  US national debt has increased since the tax cut, and entitlement liabilities – across all developed economies – will continue to grow for the foreseeable future. These rising debt obligations can create a fear of an upcoming substantial capital levy for governments to generate enough revenue to meet these obligations.

Protectionist trade policies may contribute to the growth of offshore financial centres.

The rise in protectionist policies, the potential for trade wars and uncertainty over the tax climate across the globe may induce stakeholders to send even more resources to the Offshore Financial Centres (OFCs) that have acted as financial safe havens.

Poor infrastructure, highly regulated and inefficient markets, protectionist trade policies and high corporate tax rates that reduce profitability are all factors that drive investments toward OFCs[31]. 

When bad domestic policies that raise production costs and lower productivity are enacted, more capital flows to OFCs. This is because OFCs provide the most efficient way for capital to meet its global demand. Investors are better able to re-allocate capital between sectors of the global economy, directing resources where they create the most value – i.e. where capital is more productive and the returns on investment are greater. For that reason, OFCs have been important contributors to global economic growth.

Recent policies to achieve ’economic independence’ may only push more capital abroad.

The escalating trade war between the US and China will have deleterious effects. The quantity and quality of goods available to consumers will be reduced; and while a small number of jobs in specific industries will be protected, the nation will suffer a reduction in aggregate employment. 

As developed economies return to more protectionist trade policies, the value and use of OFCs as an escape from highly regulated markets is expected to increase.

If the Trump administration is to incentivise US-bound investment, it may want to double down on their tax cuts; then jobs are much more likely to follow. However, this will also require massively unpopular entitlement reforms and deep cuts to discretionary spending in order to reduce public debt.

Dr Orphe Divounguy serves as chief economist at the Illinois Policy Institute, where he produces original quantitative research analysing the impact of various policies on the lives of the people of Illinois. Divounguy earned a Ph.D. from England’s University of Southampton. His previous work includes teaching and research fellow and international economic consultant focused on tax, labour and migration policies.

[1] Tybout, J. (1991), “Linking Trade and Productivity: New Research Directions”, The World Bank Economic Review, 6(2), 189-211

[2] Spence A.M. (1975). “Monopoly, Quality and Regulation”, Bell Journal of Economics, n. 6, 1975, pp. 417-429.

[3] Lambertini L. (1998). “Does Monopoly Undersupply Product Quality?”, wp 317, Dipartimento di Scienze Economiche

[4] Mussa M., Rosen S. (1978). “Monopoly and Product Quality”, Journal of Economic Theory, n. 18, pp. 301-317.

[5] Dranove, D., & White, W. D. (1994). “Recent theory and evidence on competition in hospital markets.” Journal of Economics & Management Strategy, 3(1), 169-209.

[6] Cotterill, R. W. (1999). “Market power and the Demsetz quality critique: An evaluation for food retailing.” Agribusiness: An International Journal, 15(1), 101-118.

[7] Hamilton, B. W., & Macauley, M. K. (1999). “Heredity or environment: Why is automobile longevity increasing?.” The Journal of Industrial Economics, 47(3), 251-261.

[8] Mazzeo, M. J. (2002). “Product choice and oligopoly market structure.” RAND Journal of Economics, 221-242.

[9] Mazzeo, M. J. (2003). “Competition and service quality in the US airline industry.” Review of industrial Organization, 22(4), 275-296.

[10] Cohen, A. M., & Mazzeo, M. J. (2004). “Competition, product differentiation and quality provision: An empirical equilibrium analysis of bank branching decisions.” FEDS Working Paper No. 2004-06.

[11] Demsetz, H. (1973). “Industry structure, market rivalry, and public policy.” The Journal of Law and Economics, 16(1), 1-9.

[12] Shaked, A., & Sutton, J. (1987). “Product differentiation and industrial structure.” The Journal of Industrial Economics, 131-146.

[13] Sutton, S. G., & Lampe, J. C. (1991). “A framework for evaluating process quality for audit engagements.” Accounting and Business Research, 21(83), 275-288.

[14] Autor, David H., David Dorn, and Gordon H. Hanson (2013). "The China Syndrome: Local Labor Market Effects of Import Competition in the United States." American Economic Review, 103 (6): 2121-68.

[15] Caliendo, Lorenzo & Dvorkin, Maximiliano & Parro, Fernando (2015). "Trade and Labor Market Dynamics: General Equilibrium Analysis of the China Trade Shock," Working Papers 2015-9, Federal Reserve Bank of St. Louis, revised 25 Jul 2017.

[16] Kehoe, T. J., Ruhl, K. J., & Steinberg, J. B. (2018). “Global imbalances and structural change in the United States.” Journal of Political Economy, 126(2), 761-796. DOI: 10.1086/696279

[17] Burstein, Cravino, and Vogel (2013). "Importing Skill-Biased Technology". American Economic Journal: Macroeconomics, 5 (2): 32-71.

[18] Brown, Chad. P; Jun, Eikin; and Zhiyao Lu (2018). “Trump, China, Tariffs: From Soybeans to Semiconductors”, Peterson Institute for International Economics.

[19] Bloom, Nick, Van Reenen, J. (2007). “Measuring and explaining management practices across firms and countries”. Quarterly Journal of Economics 122 (4), 1341–1408

[20] Pavcnik, N. (2002). “Trade liberalization, exit, and productivity improvements: Evidence from Chilean plants.” The Review of Economic Studies, 69(1), 245-276.

[21] Lai, H., & Trefler, D. (2004). “On estimating the welfare gains from trade liberalization.” unpublished, University of Toronto.

[22] Goldberg, P. K., Khandelwal, A. K., Pavcnik, N., & Topalova, P. (2010). “Imported intermediate inputs and domestic product growth: Evidence from India.” The Quarterly journal of economics, 125(4), 1727-1767.

[23] De Loecker, J. (2007). “Product differentiation, multi-product firms and estimating the impact of trade liberalization on productivity.” National Bureau of Economic Research Working Paper No. 1155

[24] Dunne, T., Klimek, S., & Schmitz, J. (2008). “Does Foreign competition spur productivity? Evidence from Post WWII US cement manufacturing.” Work. Pap., Fed. Reserve Bank Minneapolis.

[25] Eslava, M., Haltiwanger, J., Kugler, A., & Kugler, M. (2013). “Trade and market selection: Evidence from manufacturing plants in Colombia.” Review of Economic Dynamics, 16(1), 135-158.

[26] Bloom, N., Sadun, R., & Van Reenen, J. (2010). “Does product market competition lead firms to decentralize?.” American Economic Review, 100(2), 434-38.

[27] Teshima, K. (2008). “Import Competition and Innovation at the plant level: evidence from Mexico.” Unpublished paper, Columbia University.

[28] Schmitz, A., & Bieri, J. (1972). “EEC tariffs and US direct investment.” European Economic Review, 3(3), 259-270.

[29] Brander, J. A., & Spencer, B. J. (1987). “Foreign direct investment with unemployment and endogenous taxes and tariffs.” Journal of International Economics, 22(3-4), 257-279.

[30] Talley, E. Sulzbacher, I. & Sulzbacher S. (2018).“Could US Tax Reform See Increased Offshore Investment?” IFC Review

[31] Foad, H. and Lundberg (2017). “The determinants of portfolio investment in offshore financial centers”. International Review of Financial Analysis, 54, 76-86.

Dr Orphe Divounguy
Orphe Divounguy is a Senior Economist at Zillow Group Inc. Divounguy is the former Chief Economist at the Illinois Policy Institute. Divounguy is also the founder of the Quantitative Research Group and the co-host of the Everyday Economics podcast. Divounguy’s columns and articles cover fiscal policy, labor economics, and quantitative methods for programme and policy evaluation. Contact: orphe@policyquants.com. The views presented here do not necessarily reflect the views of his employers.