Graduated Scales, Leverage and Security

The last trade war saw gradations of tariff rates for different types of Chinese imports.

Scott Bessent, a Trump advisor and potential Treasury Secretary, has proposed putting countries into different groups based on:

• their currency policies
• the terms of bilateral trade agreements and security agreements
• their values and more.

Supply chains might have ultimately had greater adjustments if the Phase 1 deal reached in the fall of 2019 had been enforced.

China abandoned it as soon as the Biden Administration took over.

The Biden Administration had no interest to enforce it.

And so it is unclear if the trade war of 2018-2019 would have had more lasting consequences.

Tariffs create negotiating leverage for incentivizing better terms from the rest of the world on both trade and security terms.

America would encourage other nations to move to lower tariff tiers, improving burden sharing.

Access to the U.S. consumer market is a privilege that must be earned, not a right.

For example, maybe the U.S. wants to discriminate based on:

Does the nation:

• apply similar tariffs on US imports as America applies to their exports here?
• have a history of suppressing its currency by accumulating excessive foreign exchange reserves?
• open its markets to U.S. firms in the same way America opens its markets to foreign firms?
• respect American intellectual property rights?
• help China evade tariffs via re-export?
• pay its NATO obligations in full?
• side with China, Russia, and Iran in key international disputes?
• help sanctioned entities evade sanctions, or trade with sanctioned entities?
• support or oppose U.S. security efforts?
• harbor enemies of the United States, e.g. terrorists or cybercriminals?
• have leaders that grandstand against the United States in the international theater?

Tariffs may impact global markets.

And so, a Trump Administration should use a rate phase-in approach.

• It should start with low tariffs, only hitting the maximum 10% rate over time.

Such a system can begin with few criteria as it is tested out.

• Then the criteria can grow in number.

The system could eventually have a top tariff rate much higher than 10% if the system is effective over time either at:

• raising revenue or
• incentivizing more favorable treatment from trading partners

Similar to the domestic tax code, once the government starts carving out exclusions and deductions for various behaviors, it needs to raise rates to achieve the same revenue goals.

Such a system can embody the view that national security and trade are joined at the hip.

Trade terms can be a means of procuring better security outcomes and burden sharing.

Bessent says that “more clearly segmenting the international economy into zones based on common security and economic systems.. highlight the persistence of imbalances and introduce more friction points to deal with them.”

Countries that want to be inside the defense umbrella must also be inside the fair trade umbrella.

Such a tool can be used to pressure other nations to join our tariffs against China, creating a multilateral approach toward tariffs.

Forced to choose between facing a tariff on their exports to the American consumer or applying tariffs to their imports from China, which will they choose?

It depends on the relative tariff rates and how significant each is to their economies and security.

The attempt to create a global tariff wall around China would increase the pressure on China to reform its economic system, at the risk of significantly more global volatility as supply chains come under greater pressure to adjust.

From America’s perspective, if other nations choose to keep their current policies vis China but accept the higher U.S. tariff, that’s not terrible—because then, in this framework, at least they’re paying revenue to Treasury, and limiting the security obligations of the United States. Joining a tariff wall with a security umbrella is a high-risk strategy, but if it works, it is also high reward.

Tariffs and Competitiveness

Government revenue must come from somewhere, and requires some form of taxation. The characteristics of the tax code will affect overall economic growth and international competitiveness. Many in the Trump camp see them as joined. The relative cost of producing goods for export, or importing from elsewhere, can be affected by whether a nation taxes labor, consumption, capital, or trade. This argument was given explicitly for the Tax Cuts and Jobs Act in Council of Economic Advisers (2018).

Fiscal Devaluations

The literature on so-called fiscal devaluations fleshes out this idea. For instance, Fahri, Gopinath and Itskhoki (2013) show that the economic effects of devaluation in the exchange rate can be perfectly replicated either by two combinations of policies: either an import tariff and an export subsidy, or a consumption tax increase and payroll tax cut. These combinations discourage domestic use of goods and services and encourage domestic production, and result in identical economic outcomes to currency devaluations. Tax policies and currencies are two avenues for achieving a boost to competitiveness—and this equivalency helps build the intuition for currency-tariff. (Note that what is not the same in each of these policy mixes is the net amount of revenue raised.)

Because of the emphasis on competitiveness, it is unlikely that a second Trump Administration will support an increase in domestic tax rates, whether corporate or income. Its goal will be, in large part, to make America a more attractive place to invest and hire than other countries, particularly China, and higher domestic tax rates undermine that goal. Indeed, the Tax Cuts and Jobs Act of 2017 reduced in the United States’ statutory corporate rate from the second-highest in the OECD in 2016 (after Colombia) to the average (21.2% in 2021)12. Work by Chodorow-Reich, Smith, Zidar and Zwick (2024) estimated that the domestic investment of firms with mean tax changes increased by 20% relative to a no-change baseline. 13 In that sense, the preservation of low tax rates is a means of generating investment and jobs in America—and even better when financed in part by tariffs on foreign imports.

This argument extends to income tax rates as well. As long as labor supply is not perfectly elastic, an income tax will reduce the after-tax wage received by workers and require firms to offset some of the tax with higher wages. An increase in taxes on labor income thereby makes it more expensive to employ workers in the United States relative to employing workers abroad or investing in labor-saving capital. More expensive workers, all else equal, means fewer jobs relative to machines or imports.

Distortions and Optimal Tariff Rates

Economists have also spent much time studying how the tax code affects economic decisions, known as “distortions,” if they take the economy away from a first-best, efficiency-maximizing equilibrium. The economic distortions are the loss of welfare that occur beyond the revenue raised. For example, suppose a taxpayer reduces her working hours from 45 per week to 40 per week because her income tax rate increased. While she enjoys more leisure, the goods or services she would have produced in those five hours, and the salary she would have received, cease to exist and are lost to the economy forever. The “deadweight loss” or “excess burden” in this stylized example is the lost production, net of the increased leisure she enjoys and revenue raised by the government. Of course, there are many decisions that can get adjusted, not just the number of hours worked—job choice, education choice, entrepreneurship, whether compensation is in the form of cash or fringe benefits, location, and much more.

These distortions are a function of the marginal tax rate paid, not the average tax rate, since the decision whether 12 See https://www.oecd.org/en/about/news/press-releases/2024/07/new-oecd-data-highlight-stabilisation-in-statutory-corporatetax-rates-worldwide.html 13 A 20% boost resulting from a 14-point cut in statutory rates might sound small, but that is because the effective marginal rate paid by many firms was well below the statutory rate due to numerous carve-outs and extensive transfer pricing incentives which were in part eliminated via TCJA. In that sense, TCJA was a base-broadening but rate-reducing reform to the corporate tax code, and the effective reduction in marginal tax rates was much lower than the statutory reduction (on average, 7 points, per Chodorow-Reich et al).

to work those last few hours depends on the marginal and not average rate. And some of these distortions can have enormous consequences over time—for instance, if firm location decision is affected by taxes, agglomeration economies may be strongly inhibited, sharply decreasing innovation and productivity growth over the long term. The distortionary costs of taxation are convex, i.e. tax hikes are much more costly when starting from already-high rates. A one-point hike from 35% to 36% marginal tax rates is much more damaging to the economy than a onepoint hike from 2% to 3%. Costs are convex because the higher tax rates move, the more intensely households and firms adjust their behavior to avoid the tax burden.

Because marginal rates are already much higher on labor and capital income than they are on imports, the economic consequences of an increase in tariff rates might well be less problematic than an increase in income or corporate rates. For instance, Saez, Slemrod and Giertz (2012) provide a benchmark for what economists call the “marginal excess burden” of raising a further $1 of revenue. They calculate that the marginal excess burden is equal to 38% of revenue raised. To understand what this means, go back to the example of labor supply: when the government chooses to extract $1 from the worker’s salary, she reduces her work by an additional amount worth a total of 38c, net of the increased leisure she enjoys and revenue collected.

By contrast, trade economists argue that for a large economy, imposing a positive tariff level is modestly welfareenhancing, up to a point. Classically, modest tariffs can improve welfare because reduced demand from the tariffimposing country depresses prices of the imported goods.14 While the tariff produces distortionary welfare losses due to reduced imports and more expensive home production, up to a point, those losses are dominated by the gains that result from the lower prices of imports. Once import reduction becomes sufficiently large, the benefits from lower prices of imports cease to outweigh the costs, and the tariff reduces welfare. That tariffs initially increase and then subsequently decrease welfare implies an “optimal” tariff rate, at which point the country has reaped all possible benefit from tariffs and a higher tariff rate reduces welfare.

For a benchmark, the Handbook of International Economics chapter by Costinot and Rodriguez-Clare (2014) indicates that the optimal tariff for the United States under plausible parametrizations is around 20%. Indeed, as long as tariffs don’t exceed 50%, they are still welfare-enhancing relative to completely open trade. In other words, increasing effective overall tariffs from currently low levels near 2% will actually boost aggregate welfare in the United States. Once tariffs begin increasing beyond 20% (on a broad, effective basis), they become welfare-reducing. Investment houses are now projecting that the projected effective rate of the tariffs proposed by President Trump will jump from 2.3% to 17%, just shy of this 20% level.15

Moreover, tariffs can address pre-existing distortions due to other nations’ trade policies. The list of China’s abuses of the international trade system is long and storied, and ranges from state subsidies for export-oriented industries to outright theft of intellectual property and corporate sabotage. These distortions interfere with the discovery of comparative advantage and a free and open system of international trade. Applying corrective tariffs to address these distortions may improve overall efficiency.

Where these arguments run into trouble is when other nations begin retaliating against U.S. tariffs, as China did modestly in 2018-2019. If the U.S. raises a tariff and other nations passively accept it, then it can be welfare-enhancing overall as in the optimal tariff literature.

However, retaliatory tariffs impose additional costs on America and run the risk of tit-for-tat escalations in excess of optimal tariffs that lead to a breakdown in global trade. Retaliatory tariffs by other nations can nullify the welfare benefits of tariffs for the U.S.

Thus, preventing retaliation will be of great importance. Because the United States is a large source of consumer demand for the world with robust capital markets, it can withstand tit-for-tat escalation more easily than other nations and is likelier to win a game of chicken.

China’s economy is dependent on capital controls.

• These keep savings invested in increasingly inefficient allocations of capital to unproductive assets like empty apartment buildings.*

If tit-for-tat escalation causes increasing pressure on those capital controls for money to leave China, their economy can experience far more severe volatility than the American economy.

This natural advantage limits the ability of China to respond to tariff increases.

Merging national security and trade policy might provide some incentives against retaliation.

For instance, it could declare that it views joint defense obligations and the American defense umbrella as less binding or reliable for nations which implement retaliatory tariffs.

Additionally, it’s not clear whether one should view the failure of this deterrent as a bad outcome.

Suppose the U.S. levels tariffs on NATO partners and threatens to weaken its NATO joint defense obligations if it is hit with retaliatory tariffs.

If Europe retaliates but dramatically boosts its own defense expenditures alleviating the US burden for global security and threatening less overextension of our capabilities, it will have accomplished several goals.

Europe taking a greater role in its own defense allows the U.S. to concentrate more on China, which is a far greater threat to America than Russia is, while generating revenue.

Trump will view tariffs as effective taxes on foreigners to pay for retaining low tax rates on Americans.*

The reduced personal income tax rates introduced by the Tax Cuts and Jobs Act will expire in 2026.

Extending them will need a $5 trillion of new revenue or debt over 10 years.

Tariffs are the answer for extending the tax cuts. *

Revenue must come from somewhere*.