For a long time, the US economy has shifted from goods to services. If the US switches to a higher tax policy, this could accelerate the shift to services. To see why, we need to review some basic concepts in trade theory.
To illustrate some of the ideas, I would like to consider a 20% tax on all imported goods. In consideration, the services are free. Let’s start by considering the example of imported oil. For simplicity, we will assume that the US imports most of its oil (an assumption that is no longer valid.)
If the world price of oil were $80/barrel, a 20% tariff would tend to increase the price by $16. However, the price may rise slightly above $16, because prices will encourage domestic production and not domestic consumption. So $16 would be the upper limit of the resulting price increase. That equates to 40 cents a litre. I suspect the actual increase will be small, say around 37 cents, which is roughly double the federal fuel tax of 18.4 cents.
Today, the US is the largest producer of oil. We still import a lot of oil, but we also export a significant amount. If so, the impact of the tariff is very severe. Some of the oil that is currently exported may be diverted to domestic consumption in parts of the US that currently import oil. In that case, the main effect could be higher transportation costs, as the oil is re-transported.
Most economists think that prices are paid by consumers in the domestic economy. In fact, part of the burden may be borne by exporters if the tariff has the effect of lowering the world price of imports. On the other hand, if other countries retaliate with their own taxes (which seems reasonable), then it is reasonable to assume that almost all the taxes are borne by domestic consumers. In my opinion, that is a very reasonable thought.
So is 20% tax the same as 20% VAT? It is not, because VAT applies to both goods and services, while excise duty applies only to goods.
Does the tax improve the current account balance? Probably not, since the current account balance is domestic savings minus domestic investment. In most cases, it will only increase the current account balance if it increases domestic savings, which can only happen if tax revenue is used to reduce the deficit. And even in that unlikely scenario, the effect will be very small. The main effect of cost prices is to reduce all trade in goodsboth import and export. With a high tariff policy, both our imports and exports will be less. Most importantly, the goods sector of the economy would be taxed at a higher rate than the services sector, which would reduce goods as a share of GDP.
This may seem counterintuitive, since we tend to think of tariffs as leading to more production of goods that were previously imported. And they do. But the negative effects on production are even greater. This is because a positive effect on domestic product from fewer imports is offset by a negative effect from fewer exports. But prices also skew consumption away from goods and services. It is this surplus effect (over and above the trade balance) that leads the economy to shift from goods to service production.
Would a 20% tax increase inflation? That depends on the Fed’s response. It is likely that the Fed will allow one rate hike, on the grounds that the cost impact is “transient”. If the Fed wishes to avoid higher rates, they will be forced to have a tighter monetary policy that lowers nominal wages. Either way, prices tend to fall behind real incomes after taxes, unless there are tax cuts elsewhere.
The high cost of imported oil can discourage oil consumption, which is favored by many environmentalists. I will leave it to the reader to decide whether this is the intention of many of the advocates of high tax policy.
PS. Obviously the world is complex, and you can make assumptions that yield 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 increase the production of services and reduce the production of goods.
Here is a simple trade graph for the special case where the importing country has no effect on the world price:
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