Free Trade Isn’t

Free Trade is great! It allows countries to specialize in their strengths. For example, the United States has huge tracts of land suitable for growing corn, but very limited area suitable for growing coffee and coconuts. It makes sense for the United States to export corn to tropical countries in return for coffee and coconuts.

It can even make sense for a country to import items which it can make itself, in order to free up capacity for making goods that it is even better at making. A country that is good at making pickup trucks and personal computers might profit from importing pickup trucks so it can redirect labor towards making more personal computers. David Ricardo presented an elegant mathematical proof of the principle over two centuries ago. Look up the Principle of Comparative Advantage.

The United States has embraced the principle to the max, and as a result we have a cornucopia of cheap items available at the local Wal Mart. We used to make clothes, televisions, and toys here using expensive domestic labor. Our labor unions became powerful and pesky as a result. Today, we outsource most of these mundane products to China, freeing up labor to build weapons, master Modern Indignation Studies, play video games, collect welfare, brew crystal meth, guard prisoners, and engage in quality rioting.

Hmmmm...something doesn’t seem quite right. This country became an economic superpower while we were protectionist, and now we are falling apart. Is Free Trade Theory wrong?

Not exactly. What we have in the US today is not true Free Trade, even though our tariffs average a mere 3%. We have an income tax. We have payroll taxes. We have stringent environmental regulations on our domestic manufacturers. We have onerous employment rules designed to remedy past injustices. We have a minimum wage and a very expensive welfare state. The takedowns of tariffs found in first year economics books fail to take into account these very major factors. As such, our current Caveman in Chief is wiser than the Neener Dancing Know-It-Alls.

“Free Trade” isn’t. Low tariffs combined with high taxes on domestic labor is not Free Trade. It’s Subsidized Outsourcing, subsidized destruction of our industrial base and our national character. We tax domestic manufacturing in order to pay unemployment and welfare to those who lose their jobs to foreign competition. This is an evil positive feedback loop that has been crushing our working classes since the 70s. Our core cities are turning into uncivilized war zones and our college campuses into communist indoctrination centers.

But at least we are subsidizing a rising fascist superpower with a terrible environmental record.

The Stealth Protectionist

Trivia question: Who was the most protectionist presidential candidate on the ballot in all 50 states in 2016?

If you answered Donald Trump, you are wrong. The correction answer is Gary Johnson, the Libertarian Candidate(!)

Gary Johnson did not bill himself as a protectionist. He probably even used the term Free Trade during his campaign. He might have even been unaware that he was protectionist. He may have been as clueless about trade as he was about Aleppo.

But protectionist he was. Gary Johnson called for an across the board 30% tax on all Chinese made consumer goods, all Japanese made electronics, all consumer goods made in Mexico, all consumer goods made in Canada… Unlike Trump, Johnson wasn’t interested in cutting deals. His taxes would be unconditional, deterministic, and merciless.

But Johnson was not calling for tariffs, or quotas, or anti-dumping laws. Johnson was not calling for any special taxes on imports whatsoever. Johnson was calling for taxing foreign goods in the exact same manner that he would tax US. made goods. Gary Johnson was an advocate for the Fair Tax.

The Fair Tax was a plan dreamed up by libertarian talk show host Neal Boortz and Congressman John Linder to simplify the US. tax code by replacing federal income and payroll taxes with an across the board 30% national sales tax. At first glance this would be a huge simplification. Income is an inherently tricky metric. How do we depreciate that 15 year-old machine tool which will still be useful 30 years from now? How much did good will change this year? Was that capital spending on a new accounting system a net gain or a complete waste of effort? Sales, on the other hand, are readily measured. The numbers are in the cash register.

(There are problems with the Fair Tax. For example, cheating would be way too easy. We are not advocating the Fair Tax here; we are simply using it for illustrative purposes.)

The Fair Tax has an interesting side-effect: it taxes domestic and foreign goods equally. Mathematically, the Fair Tax approximates our system of income and payroll taxes plus revenue tariffs of comparable magnitude on all consumer goods. The creators of the Fair Tax made no secret of this feature. See Chapter 6 of The Fair Tax Book. So maybe Gary Johnson wasn’t clueless on this feature. He just didn’t consider it protectionist.

If so, he would have been correct. Gary Johnson was protectionist only in relative terms. Our current promiscuous granting of Most Favored Nation Status is not Free Trade; it is subsidized outsourcing. Anti-protectionism if you will. Gary Johnson was an anti-anti-protectionist.

Orange Man...Wimpy

Keep the above in mind when the Bad Orange Man slapped a 10% tariff on Chinese steel and The Experts whined bitterly about a potential trade war. The mild-mannered pothead was calling for a 30% tax, and that tax would have been perfectly fair. If all countries were to go to national sales taxes, then we would have conditions similar to the Free Trade Ideal advocated by the classical economists.

But given our high income and labor taxes, a mere 10% tariff on Chinese steel products was a subsidy for buying Chinese. We tax American steel at a higher rate. Just look at the taxes we collect on the labor used to make steel domestically. The federal government gets income tax, FICA tax, and Medicare tax. States with a steel mill get property and state income taxes. (States also charge sales taxes, but these apply to both domestic and imported goods.)

Let's run some numbers. According to the St. Louis Federal Reserve bank, the median family income in 2018 was $63,179. Suppose steel workers families get the median income and use the Standard Deduction for computing their income tax. With a standard deduction of $24,800 in 2020, that’s $38,379 in taxable income. The first $19,750 of this is taxed at 10% for $1,975, with the remaining $18,629 taxed at 12% for $2,235 for a total of $4,210.

On top of this we have employee FICA tax of 6.2% and Medicare tax of 1.45% or 7.65% total, or $4833. This brings our total up to $9043. But we aren’t done! Employers have to match the employee contribution. So, we add in another $4833 for $13,876. That’s almost 22%. But we cheated. The gross employee pay is really nominal pay plus the employer matching payroll taxes or $68,012. Total tax divided by total pay comes out to 20.4%. Pay to executives would be taxed at a higher rate, but not that much higher since FICA taxes cut out above $137,700 per employee.

20.4% is twice the Trump tariff rate, but well below the Fair Tax 30% rate. What gives? Answer: tariffs and sales taxes are computed differently from income taxes. For income taxes the gross goes in the denominator. For sales taxes the net goes into the denominator. For our example above, the median family nets $68,012 - $13,876 = $54,226. The government collects $13,876 when the family gets $54,226; that is, the government charges 25.6% of what the employee gets.

The advocates of the Fair Tax often use 23% instead of 30% for this reason. If you use the conventions we use for income and payroll taxes, the Fair Tax is indeed a 23% tax. But if you use the conventions used for tariffs and sales taxes, the Fair Tax is actually a 30% tax.

Still, our calculations came out below the Fair Tax. Why? The Fair Tax is flat with a “prebate” given to all citizens to make the tax progressive on the bottom. If we did the calculations above with a flat 10% income tax and no Standard Deduction, we would have come much closer to the Fair Tax figure. (23.4% using income tax conventions.)

Our system of low tariffs plus high wage taxes mathematically resembles the Fair Tax, but with lower rates granted to imported merchandise.

Those Trumpy Europeans

We now have a partial answer to how those European nations with high costs of living and generous welfare systems can still keep some of their industrial base going: they tax Chinese imports more than we do. All of the EU nations have a Value Added Tax. A Value Added Tax is mathematically similar to a sales tax, but in terms of reporting resembles an income tax. Have a look at this map from the Tax Foundation. Most of the EU nations have VAT rates higher than 20%. Compare these rates to US. sales tax rates.

Were we to enact the Fair Tax, we would indeed be Trumpier in this regard. VAT rates should be compared to sales tax rates, which would be 30% federal for the Fair Tax, plus whatever states collect.

We leave it as an exercise for the reader to determine tariff rates for the EU nations. (Perhaps this needs to be added to our TBD list.)

Free Trade vs. National Independence

If every nation funded itself with sales or value added taxes, then imports and domestic merchandise would be taxed similarly. In theory, there would be no need for trade deals to keep trade fair. Minimal states and high tax welfare states could coexist. In practice there would need to be trade deals between nearby small countries, otherwise you get a problem with shoppers arbitraging tax rates.

This is why the EU is important for Europe. But note the danger of an organization like the EU! Nations lose sovereignty. Far away bureaucrats get enormous power. There is something to be said for suffering some trade friction in return for getting government close to The People.

The problem grows worse for income taxes. Far worse. Multinational corporations can arbitrage tax systems by the shipload – literally. If countries don’t coordinate their tax codes in detail, there are indeed winners and losers in the game of trade. Cheating becomes incredibly profitable. Approximating Free Trade requires an international body with even more power than the EU. Borderline world government. The alternative is mercantilist countries growing and Free Trade countries going into decline.

We will go into more details in future posts. For now, we leave you with this thought: the United States is losing. China is winning. Our fascination with Fake Free Trade is making fascism look good.

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