Goods, services and prices – Econlib

The U.S. economy has been shifting away from goods to services for a long time. If the U.S. adopts a high tariff policy, it will accelerate the shift toward services. To understand why, we need to review some basic concepts of trade theory.

To illustrate some of these ideas, I would like to consider a 20% tax on all imported goods. Services are hypothetically exempt. Let us begin by considering the example of imported oil. For simplicity, we will assume that the United States imports most of its oil (an assumption that is no longer valid).

If the world price of oil were $80 a barrel, a 20 percent tax would tend to raise the price by $16. However, the price would probably increase by a little less than $16, because the tariff would encourage domestic production and discourage domestic consumption. Thus, $16 would be the upper limit on the resulting price increase. That works out to about 40 cents a gallon. I think the actual increase would be somewhat less, say about 37 cents, which is about double the federal tax on gasoline of 18.4 cents.

Today, the United States is a major oil producer. We still import a lot of oil, but we also export a significant amount. In this case, the net effect of tariffs is more complex. Some of the oil currently exported could be diverted to domestic consumption in parts of the United States that currently import oil. In this case, the main effect could be an increase in transportation costs, as the oil would be rerouted.

Most economists assume that tariffs are paid by consumers in the domestic economy. In principle, some of the burden could be borne by foreign exporters if the tariffs had the effect of lowering the world price of the imported good. On the other hand, if other countries retaliate by imposing their own tariffs (which seems plausible), then it makes sense to assume that almost all of the tariffs are borne by domestic consumers. In my view, this is the most reasonable assumption.

So is a 20% tariff comparable to a 20% VAT? Not quite, because VAT applies to both goods and services, whereas a tariff only applies to goods.

Do tariffs improve the current account? Probably not, because the current account is domestic saving minus domestic investment. In most cases, they would increase the current account only if they boosted domestic saving, which would happen only if the tariff revenues were used to reduce the deficit. And even in that unlikely case, the effect would be rather small. The main effect of tariffs is to reduce all trade in goodsboth imports and exports. With a high tariff policy, our imports and exports would decrease. More importantly, the goods sector of the economy would be taxed at a much higher rate than the services sector, which would reduce the share of goods in GDP.

This may seem counterintuitive, because we tend to think of tariffs as increasing the production of goods that were previously imported. And they do. But the negative effects on the production of goods are even larger. Indeed, the positive effect on domestic production of a decrease in imports is offset by the negative effect of a decrease in exports. But tariffs also shift consumption from goods to services. It is this additional effect (beyond the trade balance) that shifts the economy from producing goods to producing services.

Would a 20 percent tariff increase inflation? That depends on how the Fed reacts. The Fed would likely allow a one-time price increase, arguing that the effect of tariffs is “transitory.” If the Fed wanted to prevent a price increase, it would be forced to adopt a contractionary monetary policy that would reduce nominal wages. In any case, tariffs tend to reduce real after-tax wages, unless they are offset by tax cuts elsewhere.

High tariffs on imported oil would discourage oil consumption, which many environmentalists support. I leave it to the reader to determine whether this is the goal of most advocates of high tariffs.

PS. The world is obviously complex and one can make assumptions that give different results. But I suspect that many people do not understand that the first-order effects predicted by standard trade models are that tariffs will stimulate the production of services and reduce the production of goods.

Here is the simple trade graph in the special case where the importing country has no effect on the world price: