US President-elect Donald Trump is planning substantial restrictions on international trade in order to strengthen the US economy. Raising import duties on foreign products has been announced as a means of achieving this. However, there is good reason to believe this approach would weaken growth and employment in the USA.
What effect does Trump hope higher import duties will have?
The hope of strengthening one’s own economy by placing restrictions on imports is age-old. It dates back to mercantilism and is based on the following considerations:
- Exports increase the production levels of domestic exporting companies and therefore have a positive impact on growth and employment.
- Imports displace domestic products and thus reduce production and employment levels at home.
- Consequently efforts are made to obtain the greatest possible export surplus or current account surplus, because on balance this is associated with a positive effect on growth and employment.
Raising import duties promotes this objective, since it causes foreign products to become less attractive for domestic consumers.
Import duties and current account balance – what does empirical analysis say?
Provided the aforementioned relationships are accurate, a higher import duty ought to lead to an export or current account surplus. But in reality, this is by no means always the case.
Figure 1 presents the average import tariffs for manufactured goods, ores and metals in selected countries in 2015 according to the statistics of the United Nations Conference on Trade and Development (UNCTAD). It is evident that high import duties do not automatically lead to a current account surplus. On the contrary: Argentina, Brazil and Uruguay have the highest import duties of the countries under consideration. At the same time, all three countries have current account deficits of between 2.5 and 3.5 percent of their respective gross domestic product (GDP). Japan, Switzerland and Germany have considerably lower tariffs. Yet they still achieve high current account surpluses.
The member states of the European Union (EU) offer further proof that the relationship between import duties and current account balances is rather unclear. All EU countries have an identical tariff. Nonetheless, they have very different current account balances. In 2015, Germany boasted a current account surplus of almost 8.5 percent of its GDP. The United Kingdom, on the other hand, had a current account deficit amounting to 5.4 percent.
Analysis of individual countries also shows that changes to import duty rates do not always have the expected effects. Figure 2 shows the development of the average import duty and current account balance in Brazil, a country with relatively high charges on imports. Between 1998 and 2006, the import duty rate dropped from 15 percent to around 11 percent.
Provided the relationships outlined at the start are accurate, this ought to have caused the current account deficit to rise. In reality, however, the Brazilian current account deficit of four percent of GDP in 1998 had developed into a surplus of 1.2 percent by 2006. The import duty was subsequently raised to around 12 percent. But the current account surplus did not grow. Instead there was a current account deficit of between three and four percent of GDP in the years 2010-2015.
Why can import duties weaken the domestic economy?
Many factors are important in determining a country’s current account balance: unit labor costs, the quality of domestic products, the development of the exchange rate and much more besides. The desired improvement of the domestic current account balance resulting from a rise in import duties can therefore be prevented by a simultaneous increase in labor costs or an appreciation of one’s own currency.
However, there are also good arguments that higher import duties themselves can weaken the domestic economy. Four aspects are particularly important here:
- Imported consumer goods become more expensive: a higher import duty makes consumer goods imported from abroad more expensive for domestic consumers. Higher consumer prices diminish the purchasing power of a given income. This means local consumers have less money to purchase domestic products. This has a negative impact on domestic production and employment.
- Imported intermediate consumption goods become more expensive: a country does not only import consumer goods, but also intermediate consumption goods that undergo further processing by domestic companies. If an import duty makes these imports more expensive, the production costs of domestic companies will increase. This worsens their international competitiveness and therefore has a negative impact on domestic exports. Declining exports in turn lead to a decrease in domestic production and employment levels.
- Retaliatory measures from overseas: if a country adopts measures restricting imports, then it is very likely its trade partners that are affected by this will also implement such measures. This restricts domestic export opportunities and weakens growth and employment levels at home.
- Weak economic growth abroad dampens domestic growth: if a country restricts export opportunities from overseas by means of an import duty, this reduces economic growth overseas. A lower level of production and employment overseas means that other countries will demand fewer goods. This also worsens domestic export opportunities. Domestic production and employment levels thus decline.
At first glance, import duties appear to be a suitable means of improving economic performance in one’s own country. In reality, however, this restriction on international trade weakens growth and employment levels in all national economies which are affected by these trade restrictions – including the country that introduces them. It is to be hoped that the future US government will recognize these relationships and forego the announced trade restrictions.