Follow the Bouncing Ball

The current recession has been accompanied by dramatic changes in trade. Figure 1 presents the pattern of OECD trade as the crisis unfolded. There is a time lag in these data. The trends in trade in late 2008, first spotted in early 2009, invited a mix of consternation and hyperbole in the business and economics press and blogosphere alike. Through the summer of 2009, discussion ranged from worries about export credit shortfalls to resurgent import protection. The focus has been on finding the cause, and the assumption has been that the collapse in trade is unprecedented, inconsistent with the general level of economic downturn, and indicative of a trade-related set of problems calling for trade-specific solutions. Yet, there may actually be two puzzles here. The first is the dramatic fall in trade as the recession deepened. The second is the apparent rebound in trade in the most recent data. What we may be witnessing is an exaggerated collapse and bounce, greater that the corresponding drop and recovery in OECD GDP levels. Applying Occam’s razor, the simple explanation fits the data nicely. Trade has followed the sector composition of the recession.

In the emerging academic literature on trade and the crisis, the papers closest to the points we highlight here focus on the sector composition of the downturn and trade. One set of explanations for the increased sensitivity of trade to GDP swings includes increased complexity in production. Freund (2009), for example, highlights fragmentation in production. She also notes that durable goods are most affected, historically, by financial downturns. This includes iron and steel. McKibbin and Stoeckel (2009) work with a CGE model modified to include elements of the financial crisis. They find that the drop in durables is much higher than for non-durables. In addition, the bursting of housing bubble was identified as being most responsible for the drop in consumption and imports, while the change in assessment of risk was largely responsible for the drop in investment. Also working with a CGE model, Bénassy-Quéré, Decreux, Fontagné, and Khoudour-Castéras (2009) emphasize that a large part of the recent drop in the level of trade is linked to price rather than volume effects. They also stress the importance of using appropriate price deflators. GDP price deflators can lead to substantial overestimating of trade volume changes in economic downturns. Willenbockel and Robinson (2009) also use a CGE model, focusing on developing countries and the collapse in global commodity prices as the downturn unfolded. Borchert and Mattoo (2009) focus instead on the relative stability of trade in the crisis. Indeed, in the case of India, the relative service intensity of India’s trade profile served to dampen swings in total trade during the crisis.

Figure 2 presents a quarterly breakdown for the U.S. of GDP and export trends as the recession unfolded in 2008 and early 2009. In the first quarter of 2009, GDP was down at an annual rate of 6.5%, while exports fell 29.9% at an annual rate. Production of goods was down at an annualized 16.4% in the fourth quarter of 2008 and another 8.7% in the first quarter of 2009. Exports of goods were down a striking 25.5% in the fourth quarter of 2008 and 36.9% in the first quarter of 2009. Services production, on the other hand, only fell at an annualized 0.9% in the first quarter 2009, while exports fell at a rate of 13.6%, roughly 1/3 the fall in goods trade in the same period. This pattern is similar to the observations made by Borchert and Mattoo (2009) regarding India. Even at this level of aggregation, it is clear that the goods-side of the U.S. economy has been hit harder than the services side, both in terms of production, and also trade volumes.

To better understand what has been happening to total trade flows in goods, we now turn to a more detailed discussion of the sector composition of production and trade. Figure 3 presents the change in real U.S. goods exports by quarter, in 2007 dollars, by major end use category. From the figure, almost all of the drop has been in investment & durable goods, and industrial supplies. Indeed, motor vehicles alone account for roughly one-third of the total decline. Basically, the recession has been hardest on heavy manufacturing – machinery, vehicles, and related raw materials. This has translated into a deep manufacturing recession, and a correspondingly deep drop in trade. From the import data, it is clear that roughly half of the drop in U.S. import values at the depth of the trade collapse was actually due to a drop in raw materials like oil (Francois and Woerz 2009). The drop in motor vehicle trade actually maps almost exactly to the drop in U.S. production, a point we return to below.

An important point to keep in mind is that manufacturing has a much greater weight in total trade values than it does in value added. While this is obviously true for the OECD countries (where services are typically 70% of value added but only 20% of trade values), it also holds for major developing economies as well. This is illustrated in Figure 4 below. In the figure, we present a breakdown of China’s patterns of production and trade by major sector. The first column presents value added shares, while the second and third present export and import shares. Transportation and other services account for almost half (48%) of value added in China, but only 11% of imports and 7% of exports. Mechanical and electrical machinery dominates both imports (41%) and exports (40%) yet is only 9% of value added. Textiles and clothing, and resource-based manufacturing, account for another 31% of exports, yet only 11% of value added. Indeed, a great deal of China’s value added is in sectors that, on a gross value basis, contribute relatively little to the external accounts. Like the OECD, such patterns mean that for China, a global recession that hits industrial goods sectors the hardest will also have a disproportionate impact on trade relative to GDP. In contrast, for countries where for historical reasons value added is concentrated in industrial supply and machinery sectors (like much of Eastern Europe) the impact of the recession on GDP has been much greater.

Finally, Figure 5 presents the evolution of U.S. production, imports, and exports in the motor vehicles sector. These are all indexes of production, and so reflect “real” trends from 2007 to 2009. Production is based on number of vehicles, while the trade data are deflated using BEA real and nominal price data for Census-based trade categories. What is clear is that, at the sector level, we have an almost exact mapping between trade and production trends. The collapse of U.S. trade in motor vehicles corresponds to the global crisis in the vehicles sector. Because the motor vehicle sector is a large share of U.S. trade, this has also helped drive the collapse in total U.S. trade (again, see also Figure 4). Indeed, the recovery of U.S. vehicle trade in the third quarter of 2009 as restructuring has progressed and credit lines have been re-established has also contributed to almost half of the annualized 21.4% increase in U.S. goods exports in the third quarter of 2009.

There are potentially important public policy questions lurking behind the trade-recession linkages. Has the recession been compounded by a set of trade-specific problems and issues? If so, how big are these, and should we be worried? In confronting these questions, we need to be careful when comparing real and nominal changes in trade. We have clearly witnessed a dramatic drop in world trade, and may also see an equally dramatic surge. For policy purposes though, an important question is whether the decline is out of line with the global shock to GDP and the underlying credit crisis. At the moment, trade seems to be a victim, but one reflecting non-trade weaknesses in credit and demand. The countries with the greatest trade shocks were also more exposed to sectors hit hard by the recession. They are victims, so far, of the general pattern of recession rather than of systemic protection.

This does not mean we should let down our guard against protection. There may be risks for protection on the upside of the trade cycle that did not materialize on the downside. Antidumping regimes are backward looking, using recent trends in data to establish causal links between injury and trade. If trade surges on the upside as rapidly as it fell on the downside, it may be relatively easily to establish spurious links between recovering import volumes and recession-related ill health at the firm level. Indeed, there is evidence that findings of injury in past business cycles have been a function of general macroeconomic conditions in both OECD and developing country regimes. (Feinberg 1989, Knetter and Prusa 2003, Francois and Niels 2006). So, while the cure for the symptoms lies in curing the underlying illness -- recession linked to a deep credit crisis – it is important to maintain a rearguard action on the import protection front.

Notes:
This post also appears in a slightly different format as part of Richard Baldwin's e-book The great trade collapse on VoxEU: "Follow the bouncing ball – trade and the great recession redux," with Julia Woerz. You can download a pdf version here.

REFERENCES:

Bénassy-Quéré, A., Y. Decreux , L. Fontagné, D. Khoudour-Castéras (2009), “Explaining the steep drop in international trade with mirage,” CEPII working paper.

Borchert, Ingo; Mattoo, Aaditya (2009), “The Crisis-Resilience of Services Trade,” World Bank Working Papers 4917, April.

Robert M. Feinberg (1989), “Exchange Rates and "Unfair Trade," The Review of Economics and Statistics, Vol. 71, No. 4 (Nov., 1989), pp. 704-707.

Francois, J. and J. Woerz (2009), “The Big Drop: Trade and the Great Recession,” VoxEU, March.

Francois, J. and G. Niels (2006), “Business Cycles, the Exchange Rate, and Demand for Antidumping Protection in Mexico,” Review of Development Economics, (3):388-399.

Freund, Caroline (2009), “The Trade Response to Global Downturns. Historical Evidence,” World Bank Working Papers 5015, August 2009.

McKibbin, W.J., and A. Stoeckel, (2009), “Modelling the Global Financial Crisis. Centre for Applied Macroeconomic Analysis,” The Australian National University, Working Paper 25/2009.

Knetter, M. and T. Prusa (2003), “Macroeconomic factors and antidumping filings: evidence from four countries,” Journal of International Economics, 61(1): 1-17.

Willenbockel, Dirk; Robinson, Sherman (2009), “The Global Financial Crisis, LDC Exports and Welfare: Analysis with a World Trade Model,” Munich Personal RePEc Archive Working Paper No. 15377, April.

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.

Prizes for Everyone [1]

The motor vehicle industry is playing an interesting game. General Motors produces in Europe under various names (Opel, Vauxhall) [2], produces as Holden in Australia, and has plants scattered elsewhere across the globe as well. As the economic downturn forces rationalization of the global capacity glut in motor vehicles, this places GM in a position to play off local governments against each other. GM announced plans to reduce production in Thailand, [3,4] while holding this as an example in extracting subsidies from the Australian government. GM is not the only one playing this game. Indeed, U.S. automakers (GM and Ford), together with Toyota, have already extracted 4.3 billion US dollars in subsidies (to be stretched out over the next decade) [4], even as they lobby Washington for more assistance. [5] In the U.S., we have the same mix of players lobbying against each other rather than cooperating, as Japanese MNEs (multinational enterprises) in the Southern United States try to block assistance to their U.S. based competitors. Not surprisingly, this is also shaping up as an inter-state game within the Federal system to support various local producers across the United States.

There have been worries surfacing in the policy research community about the death of the Doha Round, and the risk of rising protectionism. Narrowly read, the dominant risk is not really old fashioned protectionism -- higher import tariffs (see my VoxEU column on this. [6] ) Yes, we are seeing some of this (so far at the margins). Far more interseting is tax competition, seen through a lens darkly. There has been an emerging literature on competition between jurisdications to attract MNEs. [7,8,10,11,13,14] Emphasis is on new plants, and the tendency for firms to extract extra tax payer largesse by locating in multiple locations. Much of this literature is theoretical, though the empirical evidence already shows that global firms make local taxation difficult. We are learning much more as the current economic crisis causes a game of industrial musical chairs. Everyone is circling, and when the music stops, not all motor vehicle MNEs will be sitting comfortably. [2,3] As some go, some local jurisdictions will see their factories close as well. This reveals more elements to the tax competition game. Multiple plants mean more degrees of flexibility for extracting rents (i.e. Blackmailing) local tax payers. In addition, the game can be run in reverse. Open plants (creating a local constituency of suppliers and labor and government), threaten to close some, and demand compensation. In such a game, it may even make sense to build far too much capacity, if the losses from excess plants are covered by an increased expected taxpayer financed subsidy.

There is another important element to this game as well. In the U.S. for example, the rhetoric has become predictably nationalistic.[5] U.S. firms vs. European firms vs. Japanese firms. Yet, if we look closely at the set of automakers, where they operate, and who owns them, the national labels make less and less sense. European pension funds own American firms, Japanese firms are listed on the American stock exchanges, and American firms lobby in Europe as European producers and ask Australia for R&D subsidies. Capital markets are global, ownership of the corporate world is global, and the challenges posed are therefore global as well. U.S. subsidies to GM will be a subsidy for European pension funds, and the Australians are hoping the American taxpayer will subsidize their industry as well.

The European Union has taken steps to limit tax competition [9] -- hence the intervention the the European Commission against the GM subsidy game in Europe. The OECD has also flagged this as a problem issue. It may be time to take this global. [12] In a world with global firms and local tax authorities, WTO discussions limiting public assistance would help level the paying field for local taxpayers against blackmail by global firms.

References

[1] Lewis Carroll (1865), Alice in Wonderland, "Everybody has won, and all must have prizes," in CHAPTER III: A Caucus-Race and a Long Tale

[2] "EU warns against car subsidy race," BBC 21 November 2008.

[3] "Isuzu aims to avoid Thai layoffs," Bankok Post, 18 December 2008.

[4] "Car sales crash in Australia," The Earth Times, Thu, 04 Dec 2008.

[5] "Tax Fairness for U.S. Auto Makers," editorial letter, Wall Street Journal, 16 December 2008. (from Stephen Collins, President, Automotive Trade Policy Council Washington.

[6] "The economic crisis, Doha completion, and protectionist pressure," 17 December 2008 VoxEU column.

[7] Baldwin, R.E. and P. Krugman (2004), "Agglomeration, integration and tax harmonisation," European Economic Review, Volume 48, Issue 1, February 2004, Pages 1-23.

[8] Davies, R.B. (2005), "State tax competition for foreign direct investment: a winnable war?," Journal of International Economics, Elsevier, vol. 67(2), pages 498-512, December.

[9] European Commission, "Harmful tax competition," Europe website.

[10] Hauflera, A. and I. Wooton (1999), "Country size and tax competition for foreign direct investment, Journal of Public Economics," Volume 71, Issue 1, 1 January 1999, Pages 121-139.

[11] King,I., R.P. McAfee & L. Welling, (1993), "Industrial Blackmail: Dynamic Tax Competition and Public Investment," Canadian Journal of Economics, Canadian Economics Association, vol. 26(3), pages 590-608, August.

[12] OECD, "Harmful Tax Competition: An Emerging Global Issue," 1998.

[13] Ottavianoa, G.I.P and T. van Ypersel (2005) "Market size and tax competition," Journal of International Economics, Volume 67, Issue 1, September: Pages 25-46.

[14] Winner, H. (2005) "Has Tax Competition Emerged in OECD Countries? Evidence from Panel Data," International Tax and Public Finance, Volume 12, Number 5/September.