Tariffs: for better or worse - usually worse

If anyone wants evidence of the destructiveness of trade barriers they need only look at the surge in Australia's productivity growth after it demolished most of its tariff wall.

“Economists and the government claimed the tariff reform would boost growth, but critics of the reform predicted disaster.” -Alan Mitchell, former economics editor, The Australian Financial Review

The greater part of that tariff reduction occurred through the second half of the 1980s and the 1990s. In 1997, the effective rate of assistance to Australian manufacturers was estimated at just 5 per cent, compared with about 22 per cent in 1984 and 35 per cent in 1973. 

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That’s a big drop. But here’s an even bigger point about the Australian experiment: the tariff cuts were unilateral.

Economists and the government claimed the tariff reform would boost growth but critics of the reform predicted disaster.

The economists and the government were right. The highly protected manufacturing industries contracted, as everyone expected. But other industries, including manufacturers more suited to the Australian economic environment, expanded. Manufactured exports took off.

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What happened?

Economists had argued tariffs were a hidden tax on exports because they curbed imports and thereby increased the exchange rate.

In the event the reduction in tariffs was accompanied by a sustained reduction in the exchange rate: the average real effective exchange rate in the late 1980s and 1990s when tariffs were falling was 23 per cent lower than in the pre-reform period.

Also, lower tariffs meant cheaper imported business inputs. Tariffs on business inputs such as steel impose a tax on the businesses which must pay the artificially inflated prices. This would have been particularly damaging to exporters who could not pass the tax on to their foreign customers.

But Australia’s high tariffs (and substitutes such as anti-dumping duties) imposed an insidious tax on all efficient industries.

By protecting uneconomic industries, the tariffs enabled them to hold on to skilled labour and other scarce resources which could have been used more productively by efficient, unprotected industries, including the innovative start-ups which play an important role in generating competition and productivity growth.

The tariffs were also a hidden tax on households and were a particularly heavy burden on low-income households which were forced to pay tariff-inflated prices for necessities such as clothing.

An economy gains from international trade in two ways: first, by exchanging goods and services it can produce relatively cheaply for foreign-made goods and services it would find difficult and expensive to produce itself; and second from the specialisation such exchanges allow. Like people, countries maximise their living standards by specialising in what they do best.

Australia’s high tariff wall effectively had tilted its production away from the things it did best, towards the things it did least well.

It allowed Australia's inefficient manufacturers to keep producing goods newly industrialised countries of Asia, with their large pools of low-cost labour, could make more cheaply - and it limited Australia's capacity to expand the production of more efficient industries based on our highly skilled workforce and our rich natural resources. 

It kept the Australian economy partially frozen in the past when it should have been embracing the structural change needed to be competitive in the new economic environment.

Looking back

There can be no looking back. The industrial revolution transforming Asia and the other emerging market economies still has decades to run.

India is still emerging from its long period of high protection and low growth and there is a queue of ambitious nations, including Vietnam and Bangladesh, waiting for the rising wages in China to push more investment their way.

The challenge for high-income countries now is to let market forces direct their labour and capital away from the industries which are no longer competitive.

That’s not an easy process: it means people must retrain and relocate.

For unskilled and semi-skilled workers, the advanced economies are becoming an increasingly challenging environment. However, the answer should be education and training and temporary financial assistance - not protection against change.

Australia finally got the message in the 1980s and was rewarded with a one percentage point increase in annual productivity growth in the 1990s. It went from being a productivity growth laggard to one of the OECD’s frontrunners.

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Of course, the reduction in tariffs was not the only reform of the 1980s and 1990s. The exchange rate was floated, capital markets were deregulated, labour markets were made more flexible, product markets were made more competitive, and state-owned enterprises were privatised or at least 'corporatised'.  

Nevertheless, the Productivity Commission economist, Dean Parham, estimates opening the economy to the rest of the world, in which tariff reform played a major part, added about the 0.5 percentage points to annual productivity growth.

The economy’s strong response to the unilateral tariff reform of the 1980s and 1990s was further evidence of the point often made by economists: most of the benefits of tariff reform go to the economies that reduce their tariffs.

That is, the bulk of the economic benefits come mainly from the more efficient allocation of resources made possible by increased access to better and cheaper imports.

That of course is the direct opposite of what President Trump seems to believe.

Trump’s tariffs on steel and aluminium alone will not have much effect on US growth unless they spark a serious trade war. However, the President has signalled there are more tariff measures to come. 

A danger he may not fully anticipate is the political and economic dynamic his policies may unleash within the US.

Risk

Trump's actions risk sending a destructive message to US business: that, instead of investing in increased efficiency and innovation, it can now look to the government to solve its competitiveness problems. That’s a world in which senior executives are selected as much for their lobbying skills as their business acumen.

Give one industry protection and the next day you’ll have a queue of industry leaders at your door with persuasive arguments as to why they are just as deserving of assistance.

No sooner had Trump announced his steel and aluminium tariffs, then Elon Musk, the founder of Tesla, was complaining loudly about China’s 25 per cent tariff on imported cars, which is 10 times the US tariff.

“I am against import duties in general but the current rules make things very difficult,” Musk said. “It’s like competing in an Olympic race wearing lead shoes.”

A sympathetic president responded by repeated his threat of tit-for-tat import taxes.

"We are going to be doing a reciprocal tax program at some point, so that if China is going to charge us 25 per cent or if India is going to charge us 75 per cent and we charge them nothing," Trump said. "We're going to be at those same numbers. It's called reciprocal, a mirror tax.”

Many of the people who queue for protection will have come with promises of investment and innovation, if only President Trump can 'level the playing field'. But most will not deliver on their promises.

As an old joke goes, governments don’t pick winners, losers pick governments.

Alan Mitchell is a former economics editor of the Australian Financial Review.