If something sounds too good to be true, it probably is.
That is especially true when it comes to economic policy. Take, for example, a recent column by the Coalition for a Prosperous America (CPA) which claimed that a 10 percent increase in tariff rates, as recently proposed by Donald Trump, will increase real household incomes “by nearly $8000,” create “3.3 million new jobs,” and generate $300 billion in new tax revenue.
Those results are too good to be true. And you could only get such results by torturing the data (or the model) until it confesses.
The CAP claims that the standard Global Trade Analysis Project model has incorrect elasticities for productivity and factor supply. They also claim that US prices are often meaningfully different and independent of world prices, and that prices adjust imperfectly because of imperfect competition which means output changes in the face of higher tariffs rather than prices.
Correct these errors and “voila,” tariffs generate massive economic growth! The problem, however, is that they will not.
If the CPA think they can overturn two centuries of theory and evidence about the economic damage caused by protectionism, they will have to do better than tweak a few variables.
For one thing, the CPA assumes that creating new domestic productive capacity will be easy and quick. It won’t. Such things take time. For another, they discount the possibility of export-demand falling significantly—especially if other countries retaliate with higher tariffs on American goods.
Nor does the CPA report account adequately for how consumers will be worse off due to higher prices. Furthermore, they seem to ignore the increased costs of doing business in the rest of the economy due to higher tariffs increasing the cost of labor, materials, and other inputs.
But here is the main problem with the CPA report: Economists disagree about many things, but they overwhelmingly agree that free trade generates greater production and wealth than protectionist policies like tariffs. The textbook logic of comparative advantage, that specializing and trading improves our lives, can be seen at every level of life.
People don’t cook every meal at home in order to increase their family output. Nor do they make their own clothes, cars, or electronics. Instead, they specialize in their employment activity and trade for everything else. The same phenomenon occurs between businesses, between towns and cities, and between countries.
The father of economics, Adam Smith, explained how specialization brought about through the division of labor increases productivity. People become far better at specialized tasks they perform routinely and waste less time switching between tasks when they have fewer of them. This specialization increases people’s knowledge of their specific tasks, and it rewards them for developing even minor time or labor-saving improvements.
But why do some nations have more extensive division of labor, deeper specialization, and therefore much greater productivity than other nations?
Smith argued that it is not profitable for companies to specialize in making pins (to take Smith’s famous example), if they end up producing far more pins than consumers are willing to buy. But as the pin producer cuts back on his production, and scales back his workforce, he also reduces the specialization, and therefore the productivity, of his employees. As more industries scale back production and reduce specialization, a country becomes less productive.
Larger markets, by contrast, generate greater specialization. Observe how one’s consumer and job options multiply when you move from a small town to a large city. Specialized producers—whether of food, music, finance, fashion, or industry—are far more numerous in urban centers because of larger markets. Specialization and productivity also increase when the market’s size extends across national borders.
But tariffs like those proposed by the CPA reduce the extent of the market and thereby reduce specialization. They place barriers on the flow of goods and services, and they increase the costs of doing business, thereby undermining productivity. Consider the likely effects of raising tariffs along the lines proposed by the CPA.
Protected industries will face less competition from abroad as foreign competitors pay higher taxes to sell their goods in the US. Prices of protected goods will rise. The subsequent decline of competitive pressures means that prices will rise.
That’s good for protected domestic producers (the people that the CPA represents) because they will see windfall profits, at least initially. This will lead to expansion by existing producers, entry by new domestic competitors, and an increase in employment and output of the protected industries.
The gains to protected industry come not from increased productivity, however, but from higher prices. Unfortunately, marginal productivity in protected industries will decline over time as the costs of industry-specific goods rise—such as capital equipment, specialized labor, specific inputs, and the like.
As for non-protected industries, they will also find the cost of doing business rising, because inputs are more expensive, labor is more expensive, and higher prices in protected industries will take a higher share of consumer dollars. American exporters will see foreign demand for their goods decline—both because foreigners have less revenue to spend and because other countries will likely enact retaliatory tariffs. Overall, the economy loses productivity because specialization must lessen as the extent of the market shrinks.
Finally, this proposal ignores the significant costs of rent-seeking. Raising tariffs encourages waste and corruption as protected firms devote more resources to lobbying federal and state legislators and regulators, and fewer resources to innovating or increasing production.
When we take all these facts into account, the CPA’s claims about how tariffs will make Americans and the American economy better off look more than shaky.
They become, in a word, unbelievable.