Before the election, I wrote that I intended to spend the time after in an orgy of serious policy analysis – because I thought we were going to have a president serious about policy. Sad! And in some ways it’s hard to stay motivated about economic analysis when we’re in fact going to have a government that is completely uninterested in analysis, evidence, or truth of any kind.
Still, I’m going to be doing some policy analysis anyway. Partly it’s personal therapy, a temporary break from the political nightmare and a return to the pursuits of my younger years. But it’s also relevant: power may have no interest in reality, but the rest of us still have an interest in knowing how things will work.
So today’s Chautauqua is about how protectionism, Trump style, will affect the trade deficit.
Actually, start with proposals for something like a U.S. VAT, which would include taxes on imports and rebates on exports. There is widespread confusion about what a VAT does to trade. No, it isn’t like a combination of an import tariff and an export subsidy; it’s like a sales tax, and to a first approximation it doesn’t affect trade at all.
To see why, think about competition between domestically-produced and foreign-produced goods in two markets: at home and abroad. How does the VAT or VAT-like tax affect competition in each market?
Not at all. In the foreign market, domestic firms pay no tax on their sales, because the VAT is rebated; neither do foreign firms. In the domestic market, foreign firms pay the VAT-rate tariff, and domestic firms pay the VAT. So the playing field is level in the domestic markets as well.
In short, a VAT isn’t a protectionist policy; it shouldn’t even lead to a change in the exchange rate.
What about straight tariffs? Here things get a bit more complicated.
The starting point for a simple analysis of trade balances is the accounting identity,
Current account + Capital account = 0
where the current account is the trade balance broadly defined to include services and income from investments. The standard story then runs as follows: the capital account is determined by international differences in savings and investment opportunities, with capital inflows to countries that offer good returns. The real exchange rate then adjusts to ensure that the trade balance offsets these desired capital flows.
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