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International trade allows countries to specialize in the production of those things in which they have a comparative cost advantage, trading them for things they are relatively poor at producing. This specialization and exchange is of benefit to each country and harms no country. Trade is a positive-sum activity.

A U.S. surcharge of 20 percent on the value of imported goods, while benefiting some sectors of the economy, would unambiguously result in a net overall loss of worldwide economic efficiency and welfare by moving away from specialization and trade. The only real question is how this loss would materialize and who would bear its burden. In general, the country that imposes a restriction on its trade is likely to be one of the major losers as resources shift away from its most efficient (exporting) industries to less efficient (import-competing) industries that will be partly protected by the trade restriction.

The distribution, and even the form, of the welfare losses among countries is less clear. A small country imposing a tariff might have little effect on world prices and trade, and thus might bear nearly all of the losses itself. A large country, like the United States, might be able to shift part of the tariff burden onto the rest of the world by forcing down the world price of its imports (that is, forcing foreign producers to pay part of the tariff by lowering their prices). This could conceivably be enough to at least offset the internal loss of economic efficiency resulting from the reallocation of resources away from low-cost industries to high-cost industries. By imposing the right tariff on each good imported, a large country might, in theory, even gain from protection. But it is unlikely that an across-the-board surcharge would have such an effect. Moreover, retaliation would be likely, and if that was followed by counter-retaliation everyone would be almost certain to lose, and by large amounts.
 

CAPITAL FLOWS AND EMPLOYMENT EFFECTS; THE BASE CASE

The above analysis draws largely on the pure theory of international trade, assuming full employment and easy substitution of resources and goods for one another in response to price changes. While many of the conclusions derived from this analysis are directly applicable to other situations, the effects of a surcharge become more complex in the context of a modern economy open to international capital flows and subject to some unemployment of labor and capital. These complexities relate largely to the potential effects the surcharge might have on international prices through exchange rate movements induced by capital flows, and on aggregate demand and supply. None of these complexities, however, would fundamentally change the results of the previous analysis.

To simplify the task of analyzing highly interrelated phenomena, the following analysis focuses on a base case that can later be modified. The base case is constructed so as to allow examination of the efficiency costs and sectoral effects of the surcharge. It assumes the following: no retaliation, no imposition of capital controls, and the use of the surcharge revenue to reduce the government budget deficit. In addition, private markets believe the surcharge to be permanent, despite official protestations to the contrary. This last assumption is necessary if the private sector is to be willing to undergo the adjustment costs necessary to reallocate resources and if foreigners are to consider direct investment in the United States as an alternative to trade. Finally, aggregate demand and real GNP are assumed to be unchanged. This assumption is derived from the fact that the surcharge would raise the domestic price of imports, thus encouraging the substitution of domestic goods for imported ones. At the same time, it would produce a contractive fiscal-policy effect by removing purchasing power from the economy. The substitution of domestic goods for imported goods would tend to raise total domestic output, whereas the contractive fiscal policy would tend to lower it. As a simplifying assumption, it is convenient to postulate that these opposite effects would offset one another.

Under these assumptions, if the surcharge had no immediate effect on exchange rates, it would: reduce foreign real GNP, lower the federal deficit, and improve the U.S. trade balance. But it would in fact have an effect on the exchange rate because the combined GNP of all other countries will fall relative to U.S. GNP, strengthening capital flows to the United States and putting upward pressure on the dollar. Even if capital flows were not responsive to the relative strengthening of the U.S. economy, but were instead solely reflective of trade financing needs, the foreign exchange value of the dollar would rise in response to the surcharge-induced decline in U.S. imports.

To the extent that the import surcharge was considered by some to be a remedy for an overvalued dollar, it would be partially self-defeating. Since the surcharge would lower foreign real GNP, import-competing industries might be helped but exporters would be worse off: the dollar would be stronger while foreign real incomes would be lower, thus reducing overseas demand for U.S. exports; and the U.S. price level would be higher, as a result of the surcharge itself and because of higher domestic prices of close substitutes. Indeed, the strength of the foreign feedback effect on U.S. exports might by itself lower U.S. real GNP, unless a stimulative monetary policy was used to achieve the base-case assumption of no change in aggregate demand and real GNP.

Under the base-case assumptions, the main impact of the surcharge would be on the composition of production and final demand. It would raise domestic prices of imports and import-competing goods, thereby increasing revenues of import-competing industries and the prices paid for resources used intensively in these industries. Conversely, industries that rely heavily on foreign imports would experience higher production costs, leading to fewer sales and ultimately less income. On the consumption side, higher costs of both imported and domestic products would cause welfare losses. Although the base case assumes no foreign retaliation, which restricts but far from eliminates the negative effect of the surcharge on U.S. exports, some negative effects could nonetheless be expected, as exporting industries would have to contend with a higher-valued dollar. Moreover, the foreign feedback effect mentioned earlier would also lower demand for U.S. export goods as lower incomes abroad translated into reduced foreign consumption. And, finally, should there be foreign retaliation in kind, the domestic compositional effects would be even more pronounced.
 

OTHER SCENARIOS

Some of the above conclusions could change if the surcharge was viewed as being truly temporary. One possibility is that consumers would not switch into domestic substitutes but would dip into savings to absorb the impact of the surcharge. This would reduce the stimulative effect discussed earlier. At the same time, continued spending on imports would bring in greater revenue to reduce the federal deficit. Since the effects of reduced private saving and the reduced public deficit would cancel each other out, no significant effect would be likely on real interest rates.

Another possibility is that import buyers would simply postpone their purchases in expectation that the tariff would elapse in three years (quite likely under a declining rate surcharge). In the extreme case, where most import purchases were postponed but U.S. citizens did not switch to domestic substitutes: the U.S. trade balance would improve dramatically, there would be no stimulative expenditure-switching effect, there would be no contractive fiscal policy effect because of the lack of tariff revenue, but the relative increase in private savings (as a result of postponed consumption) could lower interest rates.

Under either extreme possibility, the potential effects on capital flows and exchange rates are unclear. If GNP rose, capital inflows might be stimulated. But if the surcharge Was viewed as temporary, foreigners might lack the incentive to jump the tariff wall and invest in the United States.

Finally, there is the possibility (indeed, history suggests the probability) of retaliation. Since the surcharge would impose large losses on other countries, they would have a strong incentive to retaliate (either individually or collectively) to recoup some of their losses. It is unlikely, however, that they could recoup much, and the most probable outcome is that everyone would be worse off. The volume of world trade would almost certainly decline, leading to even greater losses in economic efficiency and welfare.

It is quite possible that retaliation would lead to capital controls, heightened financial risk, and a reduction in foreign capital available to the United States. If so, U.S. interest rates could rise significantly, output and income would fall, and the federal debt would skyrocket.

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