Assuming all countries have the same rates, what is the optimal average tariff? Is it 0%, or does a small nominal rate produce better outcomes?

My answer on Quora:

I do not believe there is such a thing as a common optimal tariff rate across countries. I also do not believe that a world with zero tariffs will produce better outcomes than having a range of country- and industry-specific tariffs (from zero to above zero). This is because countries differ in their stages of economic development, and different industries have different relative strategic importance to different countries.

The benefits of international trade are clear. Countries focus on their comparative advantage and trade with other countries who focus on theirs. The result is higher productivity (from focusing on what you are relatively better at, plus possible spillovers into other parts of the economy), lower prices, and greater purchasing power. The access to world markets and the transfer of know-how and technology that come with international trade have made the world a more prosperous place.

So, why don’t we eliminate all barriers to completely free trade? The world market is a competitive place. Some less developed economies prioritize developing their domestic industries before being fully exposed to the world stage. There can be rational reasons for doing this.

Protecting Domestic Industries in Lower Income Countries

Suppose an economy is resource-rich but has little manufacturing capacity. It exports a lot of its natural resources, and imports manufactured goods. In its effort to develop its capability in higher value-add economic activities, it may erect some trade barriers so that instead of only exporting natural resources, it can also develop the capability to export manufactured goods (that may need the natural resources). The benefit to the country would be a more diversified, higher-productivity, higher value-add economy.

This, of course, is a simplistic example. The idea is that developing countries sometimes raise trade barriers to protect those developing domestic industries that still have little chance at competing on the world stage. Some of those industries may be of high priority for the country because of their role in developing the economy. What would the optimal tariff rate be (if the trade barrier here is indeed a tariff)? As always, it depends, but it would be higher than zero. It can be too large as well. The idea is not to close that industry off, because it benefits from interacting with the world frontier.

Now, it is very important to remember that trade supports economic development, but there can exist a balancing act between domestic industrial policies and exposure to international competition.

Balancing the Benefits of Trade with Industrial Policy

Today’s developed economies have not always been free traders. In the late 1800s and early 1900s, the average tariff in the US was over 40 percent (Table 1). In 1950, three years after the General Agreement on Trade and Tariffs was signed, tariffs in Western countries were between 10 and 25 percent. Notably, there was indeed a general agreement on trade and tariffs, because of the recognition that freer trade can lead to higher welfare gains. This was at a time when the world was largely divided between core and periphery nations. The core, developed nations, did the high value-add activities, while the periphery exported their resources and imported the others. The world economy became more balanced in recent times, largely because of increased trade and lower barriers. But those barriers did not go to zero, and many countries still have industrial policies to help them develop domestic capacity.

In the end, one hundred percent free trade works in theory but lower income countries often need some level of protection to protect domestic industries. It’s a balancing act between taking advantage of the benefits of trade while protecting yourself from the negative externalities. You often can’t have your cake and eat it too. That is why it can be as much an art as it is a science. After all, economics itself is both an art and a science, something many economists forget!

What About Developed Countries?

Now, what about developed economies raising trade tariffs to protect domestic priorities? This is different than the case of lower income countries who are still trying to reach a basic level of economic security and get on a stable growth path (one can throw in the historical relationship between today’s rich and poor countries, but I won’t even go there).

The kinds of tariffs being proposed by the Trump administration are meant to punish other countries’ trade practices, not to overcome the lack of domestic capacity and institutional development. Instead of going through the internationally agreed system of settling disputes, Trump is going his own way. This is highly problematic because it paves the way for the kind of retaliatory measures from other countries that are not intended to promote economic welfare, but are instead geopolitical. Trade disputes are real. Countries don’t always stick to agreements. Raising tariffs bilaterally, outside of the multilateral system, risks trade wars. And no, trade wars are not “easy to win”. See Five myths about tariffs.

 

 

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