Foreign Relations: Tariffs and the Paradox of Gifts

Is Free Trade a free gift?

What is good for the goose is good for the gander is a popular idiom that presumes equal treatment of individuals or entities, under the same or identical situation. The discussion that follows explores this concept in a contemporary application and strives to be as apolitical as possible as this is a purely economic discourse despite having a political undertone. I am also aware that unfortunately today even the most basic aspect of economics – free exchange – has become politicized, so it will still be an uphill task to convince those who will read this through political lenses that is not a political discussion, but I would still encourage you to do your best to see it as it truly is, an economic discourse, and my aim is to inform.

The "free" paradox

Recently President Trump stated that it would be foolish for us Americans (or anyone in general) not to accept a free gift. This was said in the context of Qatar gifting the U.S. a luxury jet, which was subsequently accepted by the President. While there are arguably ethical concerns about the appropriateness of his decision, and the fact that gifts that are of great value typically pose the greatest ethical concern in terms of an expectation of future benefit by the Qataris in a quid pro quo sense, and there were the other perhaps equally plausible Trojan Horse concerns, those are not of immediate concern in this post. So, what then is the paradox? The gift paradox is the economic policy position championed by President Trump on tariffs which effectively rejects free resources, while he contends that it is foolish not to accept a free product.

I have in other posts discussed some of the different facets of protectionist policies, in some of which I have pointed out the traditional economic position, and in others, I have noted the potential strategic aspect of such policies that may make them political winners, even if not entirely economic winners for the U.S. However here I wish to point out the very core of why economists in general tend to side with free trade instead of imposing restrictions including tariffs by first reiterating Frederic Bastiat’s rhetorical argument in his 1845 excellent satire titled, The French candlestick makers’ petition, that I have drawn attention to in a prior blog post.  The petition essentially argues that protectionist policies on any level are misguided if they cannot be taken to their fullest logical conclusion, which would include the rejection of a free resource - sunlight, by granting the candlemakers' petition in blocking off the sunlight, so that their candle business can prosper and boost the economy. The point of the satire is that free trade as its name sort of implies, even if inadvertently, provides countries engaged in the same with “free resources”, much like the sunlight provided the French with “free” light. Bastiat states, "Make your choice, but be logical; for as long as you ban, as you do, foreign coal, iron, wheat, and textiles, in proportion as their price approaches zero, how inconsistent it would be to admit the light of the sun, whose price is zero all day long!" (Bastiat, 1845).

Imagine longing for the days when the Sun would not be out, so that the candlestick makers could remain in business selling candles and being profitable. Worse, imagine putting in place policies to prevent or block out the Sun from shining through, so that candlestick makers can continue to remain in business selling candles. That was Bastiat’s point in his satire. The Sun represents a free resource, its availability (or our ability to harness it for use in the dark) puts the candlestick makers out of business, but it benefits society as a whole, such that it “frees up” resources toward other productive endeavors rather than toward candle making, perhaps other endeavors that harness the use of the Sunlight and creates greater productive outcomes compared to producing and using candles. But no, the candlemakers will petition and the government will be prone to respond to the demands of the candlestick makers perhaps because by doing so, the government secures its position of power (think of the candlemakers as a powerful trade union, with both deep pockets and a powerful voting block). Should the government do otherwise because it is absurd to reject the sunlight, and indeed to refuse a free gift, it is argued as equally absurd to to turn around and have tariffs or any other policies that restrict trade.

How exactly does free trade provide us with free resources? What about when other countries are choosing to impose tariffs on us (analogously, what about when other countries have relatively higher tariffs on our exports than we do on theirs) is it not fair to reciprocate?

Let me address these.

What is free is free

First, consider a somewhat realistic but simplified to be hypothetical scenario where the U.S. can produce lithium batteries but domestic manufacturers need to sell them at about $30 per-kilogram to be profitable. Now let us consider that we currently import lithium batteries from say China at $25 per-kilogram (inclusive of all shipping costs to make the analysis tractable). Global prices are quoted in various forms including kilowatt-hours, but when using the weight, it is in kilograms but the conversion to pounds (lbs) can be made. A kilogram is about 2.2 lbs. In what follows I will continue to use kilograms for ease of exposition.

The concern is that when we choose to import this product, because it is cheaper to do so, domestic producers of lithium batteries lose out as their businesses suffer from reduced demand and they are forced to lay off workers and even close down operations. So domestic jobs are lost. Let us continue to keep in mind that this is the analogy of the sunlight at play here, only on a different scale. To see this, since by default the Sun’s light is free, we can think of the same thing by assuming, if it helps, that we can produce lithium batteries at the price of $5 per-kilogram, or we can get it free from China, at $0. It is the same $5 difference as in the beginning illustration. So long as we can obtain something cheaper, we are able to get other things “for free”. I could either get a kilogram of the product in the U.S for $30 or get it from abroad for $25, and have $5 which I could spend on other things. Should we forgo this "free" product “from China” because we want to protect the $5 per-kilogram domestic lithium battery industry? Would, to paraphrase President Trump, it not be foolish to reject a free product?

Is the U.S. not able to produce a similar luxurious jet, that we are getting from Qatar? We absolutely can, but at what cost? That is the same analogy. We can, but it is something the President is happy to get for free rather than for us to employ our resources, including U.S. labor, domestically to produce it, so essentially we are forgoing the opportunity for people to earn incomes associated with producing the luxury jet by getting it free from the Qataris. We need not tie up resources in inefficient production of what we can get cheaper elsewhere, that is wasteful. This is what also lies at the core of free trade. Why waste resources when we can get the same product (or other products) for free through trade?

Reciprocating Tariffs?

To the second question. Let us suppose we, here in the U.S., are doing the "right thing" and engaging in free trade and we are importing lithium batteries from China with no tariffs, but China has a tariff of say 20% on our soybean exports to them. The question is, should retaliatory tariffs not be put in place on these lithium imports if China continues to put a 20% tariff on our soybean exports? Again, tariffs are rejecting a free product, for the most part. So, if we are not imposing any tariffs, we are obtaining resources for free relatively. If China on the other hand is imposing tariffs on our products, then they are rejecting an “analogous free” product. However, should we retaliate because they are not being fair to us, (while also being seemingly foolish by harming themselves)?

Tariffs potentially hurt the country or more precisely the industry which gets hit by the tariffs, because it potentially raises their product’s price, and leads to reduced demand, so the unfairness of the tariff is that it hurts U.S. soybean producers (but also Chinese soybean purchasers and consumers). Where businesses within the U.S. soybean industry may find it preferable to keep the product (export) price the same, so that there is no reduction in Chinese demand, they end up bearing the full cost of the tariffs imposed, so they are harmed, as their profit margins are reduced by the amount of the tariff. They are similarly harmed if they pass on some or all of the tariff in the form of higher prices on their soybean exports, because there will be a reduction in Chinese import of U.S. soybeans due to the higher tariff-induced import prices. Note that if U.S. soybean producers' profits increased under this scenario, they would not have needed the tariffs to induce them to raise prices, as they would have raised soybean export prices already. Businesses do not consciously leave money on the table. So their profits are necessarily reduced in all scenarios.

So, the question is, should the U.S. not therefore inflict the same type of harm on Chinese exporting producers in order to dissuade China from maintaining those tariffs on our exports?

The threat of a retaliatory tariff that causes the trade partner to reduce or eliminate their existing tariffs is arguably good policy. However, talk is cheap because of the self-inflicted harm from tariffs, and if the trade partner does not believe that the threat is credible, it may call the bluff and decide to leave their tariffs in place or even threaten to escalate. So, it would make sense for the government, in our case, for President Trump, to follow through with his tariff policy. This is typically the only sure way to demonstrate credibility to the trade partner that they intend to make good on their threat, and here is where things get murky. If countries dig deep we have a war of attrition on our hands. I have discussed trade policy from this perspective in a prior post, but here it makes sense for President Trump to appear resolute even if he knows that reciprocating tariffs, while imposing costs on our trade partners, also hurts us as well, if the objective is one in which the tariffs are intended to make our trade partners adjust their trade policies from being protectionist with respect to U.S. exports. I use the term protectionist broadly because there are policies that have the same or similar outcomes as tariffs, and these come in all forms including quotas, local content requirements, some domestic subsidies and exchange rate manipulation. In fact, under World Trade Organization (WTO) adjudication processes, when there are trade disputes some resolutions include provisions for reciprocal (retaliatory) tariffs to be imposed by the country that is deemed to be harmed by the trade policies of the other member nation(s).

However, tariff policies still hurt the country imposing the tariffs, or to be more precise, it does provide protection for domestic import competing industries, but overall it hurts the country imposing the tariffs. There is, in economic theory, an assumedly optimal tariff in which a country could on the net be better off from imposing such tariffs, but the assumptions needed to satisfy this are usually stringent.  The country must have a really large share of global demand for the product being imported, for which, even though the U.S. is a large country, typically that assumption is difficult to satisfy when taking into account all other countries’ demands as well for globally sold products. Then the elasticity of export supply for the product must be low. This means that the exporting industry that faces the tariff is not too sensitive to any induced changes in the price of its exports. It supplies roughly the same amount at any price (that is, it will very likely bear the burden of any tariffs than pass them on through higher product prices). So, the foreign country’s exporting firms facing the tariffs will rather keep exports at roughly the same levels while paying the tariffs almost entirely. The point is that any losses to say U.S. importers and consumers associated with any small bump in prices, and any reduced demand, if these happen at all, could be fully offset by tariff revenues generated because foreign exports to the U.S. do not fall by much, and the exporting firms pay most (or all) of the tariffs. This setting is unfortunately not the norm for most global trade scenarios, so even if tariff revenues are being generated, there is greater loss to the country imposing the tariffs through the inefficiencies from reduced demand and higher priced products whether domestically produced or the imports (where some of the tariff might be passed on through higher prices for U.S. importers and consumers, because the export supply function is not perfectly inelastic).

To use our trade illustration, if the U.S. imposed tariffs equivalent to $6 per-kilogram of lithium batteries coming in from China, then if Chinese exporters seek to pass on the entirety of the tariff, their imports would fall to zero because domestically lithium batteries can be obtained cheaper at $30 per-kilogram instead of the now $31 per-kilogram from China. If the Chinese exporters instead absorb the entire tariff by keeping their export price the same, then the U.S. government will get revenues associated with the total volume of exports from China, which may be the same or only slightly reduced depending on how closely the market satisfies the assumptions for the tariff to be optimal. However, if absorbing the full amount of the tariff is too expensive for the Chinese lithium battery exporters, then they will try to pass on some of the tariff cost for example $4 while bearing only $2 on every kilogram of lithium batteries they export. Exports will continue as it is still cheaper to import for U.S. importers, at $29 compared to buying domestic at $30, but now the U.S. government tariff revenues include not only Chinese exporters payments but also U.S. lithium battery importers’ contribution as well. For example if exports to the U.S. after the tariff drop from 100 million kilograms to 80 million kilograms. The tariff revenues of $480 million includes $160 million from Chinese exporters and $320 million from U.S. importers, because U.S. importers are paying the higher price of $29 per-kilogram of lithium batteries as opposed to $25 per-kilogram of lithium batteries (from before the tariff) on the 80 million kilograms of lithium batteries imported, even though the Chinese exporters are the ones remitting the tariff revenues to the U.S government. This works the same as with sales taxes, we pay them as part of total expenditures for a product but the businesses remit them to the government.

Foreign Relations and Tariffs

So, we need to be very clear about what tariffs imply. Tariffs on their own, imposed in a setting where there is already free trade per se is harmful to the country imposing them, the imposing country effectively is rejecting “free resources” and choosing to engage in inefficient and costly production, that only saves jobs in select industries, but jobs are lost in other industries because of reduced spending in those industries. This is the same as increasing existing tariffs. Tariffs indeed can be used strategically to negotiate existing unfair trade relations, but they work best as a threat, otherwise a full-blown war means we may only be able to exact acquiescence from trade partners at a steep price, if at all. Using tariffs as a way to negotiate any other outcomes while potentially feasible especially if those countries rely heavily on their exports to us, still imposes harm to us for reasons already explained.

Sanctions in general have the same characteristics, they impose hurt on the countries being sanctioned, but they sometimes also affect the imposing country to the extent that the sanctions reduce trade and financial flows between the sanctioning and the sanctioned countries. So, on the one hand the use of tariffs as a “sanctioning device” is not necessarily unreasonable, but it is perhaps a blunt instrument, which is why economists in general do not advocate for tariffs for any reason. I think the success of a sanctioning device lies in if it imposes significant hurt to the sanctioned country to induce correct behavior while minimizing any usually inevitable harm to the sanctioning country, it is here that sanctions work more as a game of attrition in which it is optimal for the sanctioned country to acquiesce early. Tariffs lack that delayed or reduced self-harm dimension, as they hit more directly and immediately, all parties involved.

The perhaps big political advantages that tariffs have is the appearance of being nationalist, and the fact that it is distributive – providing large, concentrated benefits to the import competing domestic businesses, while dispersing the costs among the public. It is no surprise that political parties on both sides of the aisle either put in place tariffs on a whim or are slow to remove them, because they provide ballot box winners, especially when couched with the right sounding labels.

On Tariff Revenues...

It is however important to keep the following in mind. Tariff policies in general will lead to one of two outcomes in terms of potential revenues:

First, they could provide the government with revenues, which means imports of the foreign products are still taking place, and this also means that the domestic industry purportedly being helped by the tariffs is actually not being helped, but only marginally at best. These revenues are being paid either by U.S. importers and consumers of the product, or the exporting foreign companies (or U.S. firms domiciled in foreign countries doing the exporting). If the share of global demand coming from the U.S. is not large, then consumers are paying most or all of that tariff. If the opposite is true, then the foreign firms are paying much or all of that tariff. The former is more likely the case than the latter as noted above, however in many bilateral trade relations, the latter could be true, as might be the case for the U.S. and Canada trade relations. Canada is heavily dependent on its exporting industries and a nontrivial amount of their exports are to the U.S. However, it is not clear that their export supply function for these exports is insensitive to induced price changes, so tariffs on their exports will likely raise prices for U.S. importers.

The second outcome for tariff policy is that it may not provide the government with revenues. This happens when the tariffs are prohibitive, i.e. very high and results in shutting down exports from the country hit with the tariffs. This effectively means rejecting “free resources or products” and this will result in higher domestic prices for U.S. households, as we encourage inefficient and costly domestic production. We will have to buy lithium batteries at the much higher price of $30 per kilogram, which is akin to supporting the French candlestick makers, by blocking off the Sun’s light.

If the ethical and national security hurdles associated with accepting the luxurious jet from Qatar are cleared and the gift defended as being a “free product”, then analogously, free trade indeed provides us with relatively free products as well, and we would be unwise to refuse that through protectionist policies including tariffs. Fortunately, there are little ethical and national security concerns with trade, oh, wait there could be, but I have addressed these and other concerns about trade elsewhere.