“If Higher Tariffs Generate More Revenue, Why Are There So Many Free Trade Agreements?”

By Heather Benjamin

 

Prior to the ratification of the U.S. Revenue Act of 1913, which instituted the modern income tax, tariffs represented the United States government’s chief source of revenue.  Replacing these proceeds with the income tax, this legislation effectively lowered import tariff rates from roughly 40% to 25% (Van Marrewijk).  This shift is indicative of the broader tendency of governments to move towards free trade policies on a global scale.  While this trend it has not been linear, it is clear that the global economy has decisively moved away from higher tariffs and towards a reduction in barriers to international trade, most notably, vis-à-vis free trade agreements (FTA).  This is illustrated by the fact that, 100 years later, the United States now has an average import tariff rate of only 2% on all industrial goods, which accounts for 96% of all merchandise imports (Office of U.S. Trade Representative), and that there are now approximately 300 preferential trade agreements in force among nations throughout the world (World Trade Organization). 

 

The objective of this paper is to explore two key questions.  First, what influences drove the world’s economies toward policies that have fostered the proliferation of free trade over the historically favored tariff?  Secondly, why has there been such a dramatic increase in the number of FTA in recent years?  While the answers to these questions are incredibly complex issues that have been the fodder of economic theorists for centuries, it is the most compelling theories that have driven policy creation and provide a basic understanding of the rationale behind these global economic trends.  By considering these theories and how their applications have played out in the real world of international trade, we can shed light on what has brought about the widespread adoption of FTAs.

 

Stepping back, tariffs function as revenue raising devices and protective measures instituted for the benefit of specific security or strategic interests.  Winters concisely describes their role as being the “equivalent to a consumption tax and a production subsidy” (p. 90).  In this way, tariffs are designed to protect domestic producers of a particular commodity by imposing prohibitive costs on the same imported commodity.  As demonstrated though the work of David Ricardo, building on that of Adam Smith, these interventions distort the market and ultimately create additional costs which burden the consumer.  While a tariff results in an accrual of some benefit to the domestic producers of a commodity, by initially reducing foreign competition and the government benefits through the collection of revenue, it is the public at large that suffers the consequence of the higher prices due to a reduced supply and less competition from international manufacturers.    The higher prices and government revenue generated by import tariffs are ultimately subsidized by consumers, making the societal loss greater than the net gains made by a limited group of manufacturing interests and the government (Van Marrewijk). 

 

Ricardo illustrates this through his discussion of corn.  In his example, he demonstrates how an import tariff on corn artificially raises the nominal but not the real value of the good, that is, “that value [which] is equal to the quantity of labour which it can maintain” (368).  An increased domestic demand, caused by a government tariff, will result in the corn exceeding its natural price, and the market will respond with an increased supply.  To meet this increase in demand, however, resources will be redirected and less suitable land must be cultivated, which will require greater resources and labor to yield the same quantity that was being produced on more fertile land.  This amounts to increased inefficiencies in production that will tend to affect a permanent rise in prices which, Ricardo argues, will result in increases in rent.  The benefits from an increase in rent, due to the higher demand for land, will accrue exclusively to landowners who constitute a small segment of the population.  While Ricardo’s example focuses on an agricultural product, the same logic can be extended to manufactured goods.  Essentially, tariffs encourage inefficiencies in production and result in higher prices which harm the public while manufacturers accumulate greater profits.  In this way, tariffs lead to an outcome which is merely individual (the land owner or manufacturer) rather than a societally beneficial exchange for the economy as a whole. 

 

The basis of Ricardo’s argument against tariffs and in favor of free trade generally rests on the concept of comparative advantage.    Theoretically, international trade allows a country to specialize in the production of a particular good, in which the real cost of production is lower than the production cost in other counties.  If a country can export goods that it is relatively more efficient at producing to countries who are less efficient producers of the same good, both countries will benefit from trading with each other (Krugman).  In the former example, this means that if corn could be imported from a country that produces it more efficiently, it could be brought to market at a lower price, improving societal welfare and allowing domestic efforts to be properly directed to the production of those commodities to which they are better suited.   However, the benefits offered by comparative advantage are contingent upon the market being free from the distorting effects of tariffs:

“Under a system of perfectly free commerce, each country naturally devotes its capital and labor to such employments as are most beneficial to each. . . .  By stimulating industry, by rewarding ingenuity, and using most efficaciously the peculiar powers bestowed by nature, it distributes labor most effectively and most economically.” (Ricardo, 139)

 

In fits and starts, these arguments in favor of free trade took root in the minds of American economists and politicians following the Civil War and continuing into the post-World War II era, finding their way into legislation.  Policies, such as the U.S. Revenue Act of 1913 and the Tariff Act of 1930, were instituted with the objective of increasing U. S. exports and reducing discrimination among potential trade partners, controlling foreign policy, and reducing the exploitation of consumers by industrial special interest groups (Eckes, 49).   This freer approach to international trade had likewise been gaining traction in other countries’ economic policies.  The global materialization of these ideas took shape through the creation of the General Agreement on Tariffs and Trade (GATT), the foundation of today’s numerous free trade agreements.  GATT formed in 1947 in the wake of World War II and signaled the beginning of a new system of international trade relations.  One of the primary purposes driving the formation of GATT was, according to Brown, “to construct an international economic system that would prevent a return to the financial instability and trade bloc rivalry that led to the outbreak of war” (World Trade Organization).  At the heart of GATT, however, was the growing belief in freer trade as theorized by Ricardo, which sought lower tariffs and reduction in trade barriers that would ultimately increase the competitiveness of the world market and benefit all parties.

 

While the argument for perfectly free trade that underpins the creation of these economic relationships is fairly straightforward, their real world application and ramifications have been far less clear cut.  GATT, which was subsumed by the formation of the World Trade Organization (WTO) in 1995, sought to develop a multilaterally negotiated rules-based trading system among member nations, but  this process has been slow and, consequently, seen the parallel development of additional policy approaches to liberalizing trade, namely, the many bilateral and regional free trade agreements that dominate today (Cooper).  Multilateral negotiations through the GATT/WTO have been stagnant and lack mechanisms for policy enforcement.  This fact, combined with the pursuit of economies of scale , new markets, and a desire to secure economic and political interests and relationships, have driven the sharp increase of free trade agreements since the early 1990s (Baccini). 

 

While a theoretical framework is useful to understand why a government would opt into a free trade agreement, the actual operation and effects of free trade agreements in the global economy have proved more difficult to measure and created disagreement about their utility among scholars and policy makers.  In an effort to analyze the impact of particular free trade arrangements, economists base their evaluation on the concepts of trade creation and trade diversion.  According to Cooper,

“Trade creation occurs when a member of an FTA replaces domestic production of a good with imports of the good from another member of the FTA, because the FTA has made it cheaper to import rather than produce domestically. . . . Trade diversion occurs when a member of an FTA switches its import of a good from an efficient nonmember to a less efficient member because the removal of tariffs within the group and the continuation of tariffs on imports from nonmembers make it cheaper to do so.”  (9)

 

While it is agreed that most FTAs lead to both, an effective FTA should create more trade than it diverts if it is to have a positive net effect on economic welfare.  Economists hypothesizes that the desire to avoid trade diversion is the key factor driving the sharp increase in the signing of FTAs.  The domino theory of new regionalism argues that the proliferation of FTAs is, in part, a response to the free trade policies of other countries in an effort to avoid the negative impact of trade diversion by securing their own new agreements (Baccini).    This framework posits that the potential of trade diversion introduced by new agreements between two nations urges third party nations to enter into new FTAs to mitigate the threat of diversion posed by the first agreement.  In turn, this engages additional nations to respond likewise, creating “a sort of political economy that can make it seem that FTAs are ‘contagious’“ (Baldwin, 3).

 

Despite the general acceptance of the Ricardian model of international trade and recent proliferation in FTA, free trade policy has its opponents and remains a single, though significant, policy strategy employed in a complex global market.  Tariffs may no longer be the vital revenue source and default economic policy that they once were, but they are still employed by governments for a variety of reasons, such as an infant industry protection and as a political tool.  The complexity of international trade policy is further reflected in today’s trade cooperation as it has become deeper and broader more generally, with trade agreements including provisions that go beyond eliminating trade barriers to addressing integrative measures in such areas as labor practices, foreign investment, and intellectual property (WTO).   While the optimal method of implementation and effectiveness of these policies is a source of debate, the continuing multiplication of agreements provides incontrovertible evidence that free trade has gained momentum with economic policy makers and that the role of FTA will continue to increase in significance as a key strategy in growing domestic economies through the deeper integration of a progressively global market.

 

References

  • Baccini, Leonardo, and Andreas Dür. "The New Regionalism and Policy Interdependence."  British Journal of Political Science 42.1 (2012): 57-79.
  • Baldwin, Richard and Dany Jaimovich.  “Are Free Trade Agreements Contagious.”  CEPR Discussion Paper 7904 (2010).
  • Cooper, William H.  Free Trade Agreements:  Impact on U.S. Trade and Implications for U.S. Trade Policy.  Congressional Research Service (June 18, 2012).
  • Krugman, Paul R., Maurice Obstfeld, and Marc J. Melitz.  International Economics:  Theory and Policy.   9th ed.  Berkeley:  University of California, 2012.
  • United States of America.  Congressional Research Service. Executive Office of the President. Industrial Tariffs.  N.p., n.d. Web. 31 Dec. 2013:  http://www.ustr.gov/trade-topics/industry-manufacturing/industrial-tariffs
  • Ricardo, David.  The Principles of Political Economy and Taxation.  3rd ed.  London:  1821.
  • Van Marrewijk. Charles.  International Economics:  Theory, Application, and Policy.  London:  Oxford International Press, 2007.  157-160.
  • World Trade Organization.  “The WTO and Preferential Trade Agreements:  From Co-existence to Coherence.”  World Trade Report:  2011.
  • Winters, L. Alan.  International Economics.  4th ed.  New York:  Routledge, 1992.

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