Recap of alternatives to a tariff for non-economic policy goals

When a small open economy has something that the world is willing to pay more for than it costs to make domestically, it should get busy exporting it! The difference in domestic and global relative prices is the indicator of that advantageous situation. In the eponymous theorem due to Heckscher and Ohlin, if world prices are at all different from domestic prices in autarky, there are opportunities for beneficial trade from playing to the production strengths implied by the small open economy’s endowments. It is these relative price differences that are the source of the gains from trade manifest in being able to consume a bundle of goods off the production possibilities frontier.

The same global prices that signal the small open economy to export come to replace the pretrade (autarky) relative prices. Producers will produce more of the relatively more valuable export good and less of the good with the falling price that can be imported for less than it costs to make. Consumers will naturally adjust their consumption pattern to substitute away from more expensive goods and will consume more of both goods as globalization creates wealth for the country.

Trade expands some sectors and contracts others, creating domestic winners and losers in the process. There is a role for government to address unemployment in contracting sectors and soften the transition to a more outward-looking economy. Democratic governments have the authority to legislate changes affecting the economic landscape, including policies shaping international relations such as trade agreements or tariffs. Sometimes, declining sectors will organize to lobby the government for tariff protection to slow down the economy’s adjustment to globalization. But a tariff is problematic for the small open economy because it distorts two decision margins: the production choice and the consumption choice. Helping the import-competing sector adjust to globalization comes at a much higher cost than necessary because of the distortion to consumption.

Historically, tariffs have been used to achieve a number of goals: to generate revenues for a government not yet ready or willing to fund itself through other forms of domestic taxation; to protect a new industry; to protect an old industry; or to constrain consumption of an imported good. Part of the popularity of a tariff is undoubtedly the story accompanying it. Lobby groups promote the idea that the problem is “out there” with another country behaving unfairly by producing cheap imports, so that restoring the status quo sounds more reasonable than changing the production mix to realize new global opportunities. While the smaller number of displaced workers means each individual worker bear a proportionately higher cost from globalization than their benefits from buying the imported good at a better price, the typical consumer may not realize that they alone pay the tariff, not the foreign producers of those imports. Equally, the cost of the tariff on consumers may be partially hidden by the wealth created by selling more to a welcoming world. Regardless of how the argument for a tariff is motivated, the thinking nationalist should engage with the economics of the situation.

Anything a government chooses to do will distort the underlying economic fundamentals of a competitive economy. The key is to choose a supportive policy that is targeted directly at the heart of the concern, imposing the smallest distortion necessary to achieve the policy goal. An intelligent way to start is to first clarify the specific disruption that the policy should be targeting. A lump-sum tax is ideal for raising funds for specific project, while a consumption tax is well suited to limiting the purchase of a socially problematic good (imported or not). To achieve a certain level of domestic production of a strategic good like energy or national defense, a great choice is a production subsidy. To help workers displaced by lower-cost imports find new employment situations, the most cost-effective, least distortionary intervention is subsidies directly to labour while they retrain.

More fundamentally, a small open economy can prepare itself proactively for swings in globalization by fostering a strong education sector. Prioritizing education and training builds an adaptable labour force that is resilient and flexibly open to new trade opportunities. A social safety net including student loans, unemployment insurance and portable health care insurance makes ongoing tariff protection unnecessary, and also normalizes support for retraining so that specific subsidies are not needed. With those fundamentals in place, the small open economy can simply play to its strengths in global export markets and reap the benefits of having interesting products to sell to the world.

Responding to global demand for the goods produced domestically creates wealth for the country. By selling more of what a country produces relatively cheaply on the export market, there is more available to spend on public goods and services to improve its citizens’ well-being. Globalization is credited with lifting countries out of poverty (WB/WTO 2015). The wealth that globalization creates makes other policy choices and social supports more affordable. The free trading equilibrium is the best the world can do, because it locates global production wherever in the world it is most cost effective to produce given the prevailing global production technology and demand conditions.

The flip side of selling what a country is good at producing is importing lower cost goods, and consumers of every trading country benefit. Tariffs arbitrarily increase the cost of imports and reduce the volume of global trade, which necessarily lowers the benefits from consumption of the world’s output. By curtailing the amount of stuff produced on the planet, a tariff partially reverses the underlying production advantages that are the source of prosperity in a global market.

There are very few things that economists agree on, but the optimality of tariff-free trade for a small open economy is one of those things. Tariffs simultaneously distort both the consumption decision and the production decision. Even if a government had both a production goal and a consumption goal at the same time, the chances that a tariff could serve the appropriately sized distortion for each goal is vanishingly small; more likely, two directly targeted non-tariff policy interventions would be less distortionary. Better to approach tariffs with skepticism.

For any country, trade is preferable to no trade. There is no denying that globalization creates new opportunities and closes the door on old ones, but trying to hold back a productive advantage is no answer. A small open economy should always avoid using a tariff to achieve a policy goal, because its production and consumption changes do not affect global relative prices so making imports cost more has no potential for strategic upside. A more directed policy is always preferable to a tariff.