The New Protectionism and Negative Engineering

Dynamic markets produce innovation. Financial markets have innovated around regulation, internet content providers innovate around censorship, and now we are seeing the political marketplace drive innovations to get around constraints on protectionism. Following the global experience of the 1930s, the post-War multilateral system has been surprisingly successful at driving a process of collective tariff reductions and restrictions on backsliding through treaty-bound bindings on tariff increases. Political safety valves (antidumping, countervailing duties, etc) greased the wheels that keep this negotiating machinery moving forward.     Adam Smith would not have been surprised by the result: falling trade costs and generally rising trade, innovation, and prosperity.

Figure 1b: Trade cost indices, 1921-1939 (1921=100) [1]



While the system has targeted tariffs, it has been less successful at limiting export subsidies, procurement preferences, exchange rate manipulation, and production and R&D subsidies. With the rise of multinationals and the globalization of service firms, which rely on mobility of information and workers, the global market for goods and services has also moved into regions largely unregulated by the multilateral system.

Not surprisingly, in the current economic crisis, the political market place is innovating, selling protection through channels not tightly regulated by the global and regional bindings on import tariffs that are at the core of the NAFTA, WTO, and European Economic Area. Instead of tariffs, governments are moving to provide tax breaks, subsidies, procurement preferences, and the like. They are also under pressure to limit the ability of global firms to operate on the global labor market, in the belief that this will weaken the bargaining position of business vis-a-vis local workers. We are witnessing a new protectionism: less transparent, couched in resurgent xenophobic rhetoric, and outside the mechanisms regulated by international treaties.

Some musings on what have we seen in the past weeks:

Strikes in Britain over foreign workers: Technically, the United Kingdom is a member of the European Union. This means that British goods and services have free access to European markets, and vice-versa. This also means British workers must compete with European workers, but are also allowed to compete on the broader European labor market. This past week British labor unions have called strikes to protest Italian workers in Britain. This is where the political class should be cold and clinical, and try to calm emotions with facts. According to estimates published by the OECD (2008), there are roughly 28 thousand British workers in Italy, and 57 thousand Italian born workers in Britain. The bigger picture though is one of millions of Brits working abroad, and millions of OECD-born workers in Britain. On net, from these same data, there are roughly 100,000 more British born workers elsewhere in the OECD than there are OECD-born workers in Britain: 2.66 million workers from the OECD in Britain; and 2.76 British workers in other OECD countries. Segmenting labor markets geographically is not the answer to the crisis. Otherwise, perhaps the English should be banned from working in Scotland, workers in Glasgow should be prohibited from working in Belfast, and the 3 millions Brits working overseas in the OECD should be sent home? This would be a sad day for British pubs abroad, but a great one for the competing Irish pubs. Hopefully, obligations in various treaties governing the European Union will preclude truly stupid actions by leaders tempted to act irresponsibly. [2,3]

Buy America: After years of pressing foreign governments to give improved access conditions to U.S. suppliers (reflected in The plurilateral Agreement on Government Procurement (GPA) in the WTO), the U.S. Congress is now turning a general economic stimulus package into a vehicle for subsidies through "Buy America" provisions, where contracts involving U.S. funds would be forced to buy from U.S. suppliers. Of course, what's good for the goose if good for the gander, and such a move will quickly lock U.S. multinationals out of foreign contracts as there will be no moral high ground left for the U.S. Trade Representative to stand on. If the U.S. wants a level playing field when selling Caterpillar equipment, Boeing planes, and engineering expertise on foreign projects, this is a really bad idea. [4]

Agricultural export subsidies: OECD Members have spent over a decade on negotiations and economic research (through the OECD Secretariat) to move towards a rational set of farm policies that benefits tax payers and does not punish low income producers. So what are they now doing? The EU has resumed farm export subsidy payments. Operationally, they are exporting the impact of low prices onto the rest of the world. This means they are moving back to policies that cost the tax payer money and punish producers in low income countries. [5]

This is the time for responsible political dialog on managing a global crisis. Cutting the world economy into pieces does not seem a logical step in this direction. We risk building what Bastiat called a negative railroad.  Extending this metaphor, we should call the builders of the new protectionism what they are: negative engineers, building new systems to destroy jobs and prosperity. [6]

Notes:


[1] The figure is from "Globalisation and the costs of international trade from 1870 to the present," David Jacks, Christopher M. Meissner, and Dennis Novy, VoxEU, 16 August 2008.


[2] Foreign labour row deal rejected, BBC news, Wednesday, 4 February 2009.


[3] Database on Immigrants in OECD countries (DIOC), OECD 2008.


[4] Will US stimulus trigger a trade war?, BBC news, Wednesday, 4 February 2009.


[5] EU Dairy Export Subsidy Measures Requires U.S. Response, Cattle network 1/16/2009 9:11:00 AM .


[6] The Negative Railroad

M. Simiot raises the following question:

"Should there be a break in the tracks at Bordeaux on the railroad from Paris to Spain?"

He answers the question in the affirmative and offers a number of reasons, of which I propose to examine only this:

"There should be a break in the railroad from Paris to Bayonne at Bordeaux; for, if goods and passengers are forced to stop at that city, this will be profitable for boatmen, porters, owners of hotels, etc."

Here again we see clearly how the interests of those who perform services are given priority over the interests of the consumers.

But if Bordeaux has a right to profit from a break in the tracks, and if this profit is consistent with the public interest, then Angoulême, Poitiers, Tours, Orléans, and, in fact, all the intermediate points, including Ruffec, Châtellerault, etc., etc., ought also to demand breaks in the tracks, on the ground of the general interest—in the interest, that is, of domestic industry—for the more there are of these breaks in the line, the greater will be the amount paid for storage, porters, and cartage at every point along the way. By this means, we shall end by having a railroad composed of a whole series of breaks in the tracks, i.e., a negative railroad.

Whatever the protectionists may say, it is no less certain that the basic principle of restriction is the same as the basic principle of breaks in the tracks: the sacrifice of the consumer to the producer, of the end to the means.

Frédéric Bastiat
Economic Sophisms: First Series, Chapter 17
A Negative Railroad
I.17.3-I.17.19

The Undiscovered Country -- overhauling public finance in America

"Cutting taxes" has been the political snake oil, the magic elixir, sold to the American people by a generation of politicians as a way to promote everything from prosperity to family values. Sadly, tax cuts are being argued even in the current crisis. Yet, recent tax cuts have been saved rather than spent, and recent research suggests that despite past tax cuts the average tax burden is not lower than elsewhere in the OECD, given the services taxes pay for (or fail to). [1] On net, the combined state, local, and federal system is also more regressive than we like to believe. In the real world of politics, lobbying, and the rhetoric of class conflict, income tax-based systems, even if progressively structured in theory, tend toward regressive structures in fact once set adrift on the sea of lobbying, exemptions, and special interest. This appears to be a stylized political fact in representative systems -- perhaps even a law of political economy. The 30-year focus on tax cuts has served as a deliberate distraction from hard choices and uncomfortable debate. At the same time, the "cut taxes" mantra at the state and local level, where government and public services are closer to the people, has led to an increasingly regressive public system -- held together by a combination of duct tape, the municipal bond market, a wobbly property tax base, and a tax on hope (also known as the lottery) -- to fund schools, local police, and other essential services. (My sister maintains that the lottery is a tax on people who cannot do math. Either way, given the state of American education, a bad math tax and a hope tax both hit the poor disproportionately hard). [2] Once we admit to the effective use of Federal trust fund money (social security, gasoline excise taxes, etc...) to offset the otherwise even bleaker Federal budget picture, the system is also drifting markedly toward regressive features at the Federal level.


The American voter has been a ready mark in this game, willing to believe many things: that public services are free or otherwise unnecessary; roads were created and are apparently maintained by our divine creator; bridges and tunnels last forever without maintenance; an innovative economy does not hinge on broad merit-based access to a world class science and education system; markets do not need regulators; and a functional representative democracy does not need to invest in the basic education of its voters. Apparently, it is also morally OK to borrow heavily against the incomes of our grandchildren at unsustainable rates, even if we are not quite sure how the money is being used.

Public finance in the United States needs to be overhauled. This is a critical housecleaning issue if America is to move ahead. It took Nixon -- a conservative Republican -- to normalize relations with Communist China, and it may take Obama -- a liberal Democrat -- to overhaul taxes and forge a pro-growth, pro-business system suitable for the post-Crisis 21st Century. [3] Unless this is done, whatever the rhetoric from the ascendant political class in Washington, the scope for substantive initiatives in the present crisis will remain greatly hindered. As it stands, the current system is complicated, multi-layered, and opaque, with features (like the alternative minimum tax) the middle class does not understand and temporary tax cuts that cannot politically be allowed to expire. Altogether, this set of features makes members of the general public feel the system treats them unfairly. It has even caught appointees who, like the middle class they aim to represent, made good faith efforts to pay taxes yet stillwere tripped up by the system. While the situation has provided a convenient whipping boy at election time, it has also fostered a sense of fiscal persecution and injustice in entrepreneurs and middle class alike, eroding the collective sense of being vested in what is supposed to be a system of self-governance. Taxes need to be defanged as a political stalking tool. Since the system in America actually does rest on its citizens, the result is that America's innate tenacity in the face of tough issues -- public health, care for our elderly parents, global responsibility, managing foreign threats, responding to natural disasters at home -- is also eroded. Also important, the system needs to be made transparent and simple, to both ensure that the snake oil salesmen still lurking about do not again distract from real economic policy debate, and to ensure that the people feel vested in the policy decisions to be made. To be blunt, America needs a relatively (politically) neutral mechanism to raise revenue. If Obamam wants to focus on positive programs, he has to take the class-conflict and otherwise distracting debates over tax cuts off the table. This is best done if taxes are made neutral and transparent. Public works programs, income support, health care initiatives, national defense, education programs, national highways, and the like represent alternative uses for the national treasure. This is how the choices should be framed for discussion. "How do we invest what resources we have?" is an appropriate approach to the challenges ahead, not "how do we avoid paying for what is necessary?"

How did we get here ? The inflation of the 1970s escalated middle income Americans into punitive high income tax brackets. This led to high growth in the tax dodging and tax planning industry. In the voter revolt that followed, Ronald Reagan was elected with a mandate to simplify the system. At the Federal level, the system was indeed streamlined. However, because the system relies on personal and corporate income tax, lobbying by those same persons and corporations has led again to an increasingly complex system of exemptions, diversions into debate over capital gains taxation, and the making of "Joe the Plumber" as a household name during the 2008 election. Adding to the Rube Goldberg nature of public finance in America is the problem of global taxation of income. America's major trading partners rely, to a great extent, on value added taxes that tax economic activity targeting the domestic market (including U.S. companies selling in those markets) while not taxing economic activity destined for foreign markets. U.S. companies do not get this same treatment, and so are at a disadvantage in foreign markets. The extension of income tax abroad also makes multinationals reluctant to rely on American scientists, engineers, and management overseas, further eroding the competitiveness of American firms abroad and the scope for export of high value-added services. The result is a politically poisonous mix: a suspicion about off-shoring of U.S. activity; a reality of U.S. firms keeping their income abroad; a perceived loss of competitiveness; a relatively soft market for U.S. expertise; and a complicated system of corporate tax credits that repeatedly violates U.S. treaty obligations and further erodes the sustainability of current public finance structures.[4] Given the last point, there is also the risk that, at some point, U.S. trade partners will respond to the current U.S. corporate tax "offsets" with punitive tariffs on American exports. (This is sometimes known as the "nuclear option" in trade policy circles.)

Just as a lark, imagine that American voters had the collective brass kahunas needed to demand that their elected leaders dump the system of personal and corporate taxes -- duct tape and all -- and engineer a shift to a straightforward and fully transparent value added system. Such a move has the potential to broaden the tax base substantially, exorcise failed mantras from the policy debate, make possible a deep, full, and permanent income tax cut for all households, level the playing field for U.S. goods and services sold abroad and competing at home, and provide scope for a big short-run injection of capital into the U.S. economy. The left and right could still fight -- over how much to raise in tax and how to spend it, not how to raise it operationally. In practice, this means income and related capital taxes could be eliminated at the household level. They could also be eliminated for firms, replaced by the VAT system. (VAT requirements could also be relaxed for small businesses and the self-employed.) With such a switch, the risk of off-shoring to escape taxes is also cut out, as the full value of foreign labor used by American firms abroad to produce goods and services at home would be taxed. In addition, like European nations, the United States would then impose VAT on goods and services entering and sold in the U.S., while exempting goods and services produced in the U.S. for export. This has the potential to broaden the tax base in an un-distorting way (the same tax rate would apply to domestic and foreign goods and services sold in the United States). Debate over equity polices could focus on how money is spent -- education, health care, job creation, community revitalization, science and energy research programs, infrastructure, defense -- rather than on how it is raised. Subsidy schemes might even be somewhat more transparent. (Admittedly, any system can be gamed). In addition, when Washington mandates programs to be provided at the state and local level, VAT collected centrally could be shifted (or even required to be shifted) to the sub-Federal (i.e. State) level. With the system already operationally in place nationally, it could also help wean the other half of the public finance system -- the non-Federal one -- off of regressive funding structures and put state and local governments on a more stable fiscal foundation. There is even scope for a short-run bonus in the current crisis. According to rumor, corporate America has money parked abroad because of the current system. By some accounts, they have quite a lot of it. This may or may not be the case. There is one way to find out, though. With the logic of the current system suspended, they could be invited to bring it back without penalty, but with the stipulation that perhaps half be invested for 15 years in Federal or municipal debt obligations, helping ease short-run public policy constraints. As a bonus, the incentive is gone for them to keep such funds abroad in the future. In contrast, "the current U.S. tax system appears to discourage companies from returning foreign earnings to the United States." [5]

Of course, such musings are highly unrealistic. On the political economy front, huge rents (meaning money taken indirectly from the public in general and given to a more narrow set of recipients from across the political spectrum) rest on the current system. Short of a mix of outright bribery and thuggery, it may be well nigh impossible to overcome the influence these rents buy. My academic colleagues are also right to point out that value added systems can also be distorting and regressive (though certainly in more subtle and gentler ways than what we have now[6]). There is also a myth in the United States that somehow, like the metric system, value added tax systems are a foreign idea not to be trusted. Yet America is itself a synthesis of brilliantly re-spun "foreign" culture and ideas. President Eisenhower built a modern Federal highway system based on the "foreign" autobahn system (actually the Nazi-built system, for goodness sake) he saw in Germany, Benjamin Franklin and party built the constitution in Philadelphia around ideas born of the Enlightenment in France and England, and it was a Prussian who whipped Washington's troops into shape over the bleak winter at Valley Forge. The information technology revolution was also fueled by fresh immigrants with bright ideas from Europe and Asia. Americans are a practical people. They see problems, they adopt solutions, and when necessary they change their minds and listen to the ideas of others. If the country is to emerge from the current economic crisis with a stronger and more robust economic foundation, the one horse shay that is the current public finance system needs a complete overhaul. [7] More duct tape is not going to do it.

References:

[1] "Did Reagan Rule In Vain? A Closer Look at True Expenditure Levels in the United States and Europe."
      Jacob Funk Kirkegaard, Peterson Institute for International Economics, POLICY BRIEF 09-1, 2009.
    http://www.iie.com/publications/interstitial.cfm?ResearchID=1096

[2] Many state/local tax systems are regressive, and this is important to keep in mind when contemplating potential regressive bias in a VA system. See "Washington State Has Low Average Taxes... But Also the Most Regressive Tax Structure in America," The Tax Justice Digest 2007, http://www.ctj.org/taxjusticedigest/2007/06/washington-state-has-low-avera.html, and also "Florida Tax System is Nation’s Second Most Regressive," Institute on Taxation and Economic Policy (2003) http://www.itepnet.org/wp2000/fl%20pr.pdf. Also see "STATE TAX SYSTEMS ARE BECOMING INCREASINGLY INEQUITABLE," Senate on Budget and Policy Priorities (2002), http://www.cbpp.org/1-15-02sfp-pr.htm.

[3] After World War II, the conservative stream of American politics forged an identity around the twin poles of fighting communism and assigning blame for those who "lost China." This identity provided ideological underpinnings for a political witch-hunt in the 1950s, and framed the culture wars that echoed from the 1960s until the election of 2002, finally crashing on the rocks of generational shift in the 2008 election. During this period, as it became obvious that America had to normalize relations with China, it proved necessary for Richard Nixon, a leader with impeccable anti-Communist credentials,to be the one to sit down with the Communists. To quote Spock in the movie The Undiscovered Country, "We have a saying on Vulcan: Only Nixon can go to China." See Wikipedia, "The phrase "Nixon going to China" is thus an analogy that refers to the unique ability that hardline politicians have to challenge political taboos and third-rail issues. Only a proven hardline right-wing politician can succeed in challenging a conservative sacred cow and vice versa for left-wingers." http://en.wikipedia.org/wiki/Nixon_in_China_(phrase)

[4] "United States — Tax Treatment for 'Foreign Sales Corporations',” WTO (as of May 2008), http://www.wto.org/english/tratop_e/dispu_e/cases_e/ds108_e.htm, "US-FTC," DS 108, http://www.wto.org/english/tratop_e/dispu_e/cases_e/1pagesum_e/ds108sum_e.pdf.

[5] "Is it Always a Good Time for a Holiday?" by Rosanne Altshuler on Mon 12 Jan 2009 02:29 PM EST
      http://taxvox.taxpolicycenter.org/blog/_archives/2009/1/12/4054705.html.

[6] See "Value Added Tax," http://en.wikipedia.org/wiki/Value-added_tax. Also see "Is A Value Added Tax Progressive? Annual Versus Lifetime Incidence Measures," E. Caspersen and G. Metcal, National Bureau of Economic Research, working paper 4387, http://ideas.repec.org/p/nbr/nberwo/4387.html. The latter states "Using two different measures of lifetime income, we find that a VAT in the United States would be proportional to slightly progressive over the lifetime."

[7] Oliver Wendell Holmes (1809-1894), " The Deacon's Masterpiece or, the Wonderful "One-hoss Shay": A Logica.
    http://rpo.library.utoronto.ca/poem/1028.html.