Tariffs, Sales Tax, and a Stronger Dollar

President Trump has proposed placing a 25% tariff on foreign steel and a 10% tariff on foreign aluminum. How in the world are we supposed to analyze that action?!

Well, maybe it's not so hard. This would be the United States government imposing a tax on all steel and aluminum that moved across borders. The tax would be paid in American dollars, not in the currency of the country of origin. It would be paid by the customer buying steel or aluminum should the customer chose a foreign made source.

Hence, we see here that an American steel consumer would be asked to make a choice of supplier, knowing that choosing foreign would result in a higher price due to the tax imposed. Considering only the tax implications, what is the relationship between the domestic and foreign prices?

Tariffs are a sales tax

A customer may have a choice between two governmental taxation schemes. If a customer has the choice of paying a sales tax or not, it makes no difference to the customer which government imposes the tax. The only differentiation is the relative price for the product. With this in mind, a tariff can be considered the same as a sales tax, the only difference being which government imposed the tax. This realization allows us to consider the situation of a customer living very close to a border between states, one state charging a sales tax and one not charging a sales tax. (The states of Oregon and Washington come to mind.)

A steel customer in Oregon (no sales tax) buying steel made in Washington would pay a 8% (about) sales tax. How would this customer make a purchase decision?

The sales tax or tariff decision

We will ignore the cost of transportation and other distance and time considerations to focus only on the tax consequences.

Our customer would find the point of price indifference where the price of product from each source is the same. In mathematical terms, the point of indifference occurs when

Oregon Price = Washington Price + Washington Price X Tax Rate

                        = WP + (WP X TR)
                        = WP(1+TR)

Transposing, we see that the point of indifference occurs when

Washington Price = OP/(1+TR).

Still ignoring transportation cost and using the 8% sales tax rate,  we can calculate that the Washington Price must be 0.926 or about 7.4% less than Oregon price before the price advantage shifts to Washington's favor.

With this background, we can consider President Trump's proposal from the standpoint of a steel purchaser. If a American steel customer must choose between foreign steel which carries a 25% tax and tax free domestic made steel, the foreign steel must be priced at less than 1/ (1 + 0.25) = 0.80 of domestic price.

Of course, in the real economy, transportation cost and other factors would be considered additionally.

A new tariff impacts three groups

Everyone dislikes taxes so it is certainly understandable that proposal for a new tariff would bring protest from the impacted parties. We can broadly group impacted parties into three groups: tax payers, disfavored suppliers and favored suppliers.

Broadly speaking, the domestic taxpayer will be the customer who must pony-up the tax payment. With a new tariff, government is raising the cost of product to the consuming public. This invokes the cost related supply-demand factors that we commonly study in economics.

Disfavored suppliers can be expected to lose sales to favored suppliers. This will again set into motion the supply-demand factors that we commonly study in economics, with opposite-trending local effects on the two supply groups.

It is interesting to consider the longer term macro-economic interactions of these three groups. A tariff will quickly cause a reduction of foreign trade accompanied by a transferred increase in domestic demand for the tariff-taxed product. Moreover, because domestic taxes are increasing for the tariff imposing nation, the strength of the domestic currency will INCREASE. This makes it more difficult for the foreign nation to obtain currency so we would expect an immediate decline in purchases of all products. It follows that a tariff imposing nation should expect to see fewer sales to other national economies as well as slower domestic sales.

The economy shifting effects of tariffs

In the longer term, the macro-economies of the victimized economies can expect to see permanent economy shifting effects. In the case of steel, the local price of steel should fall (due to less demand) but that makes the cost of producing other products less expensive which would (in the longer term) improve sales (including foreign sales) of products made using steel.

The general effect of tax streams on governments

We need to further consider the effect of a tariff on the finances of the imposing country. The most important part of this consideration is that the tax will be paid in the currency of the imposing government.

The tariff imposing government will have a new income stream. This stream will come from tariff paying customers. Additionally, if the taxed product is a basic building material like steel, then we can certainly expect to see the cost of the tax flow into all new construction. To the extent that cost increases result in higher tax flows (such as results for Washington state sales tax) general governmental revenues increase.

In the case of the American federal government, the imposition of a tariff should rapidly increase income taxes coming from the steel industry as wages and profits rise in response to increased/transferred domestic demand.

The foreign taxation dilemma

The last tax effect that we will consider in this post will be the dilemma faced by governments as they tax to pay for government needs. How do you tax labor and production facilities that reside outside national boundaries?

Consider a government dependent upon the income tax to meet a large portion of government cost. Apply that dependency to build a contrast between domestic production and foreign production. It is safe to assume that domestic producers will be subject to the income tax while foreign producers will avoid this tax. How does this difference distort trade?

The effects are not immediately obvious. What is clear is that foreign workers would not contribute to the tax needs of domestic government. In that sense, foreign production arrives at the border tax free. On the other hand, these same foreign workers have better incomes earned from the economy supporting the tax deprived government. Presumable these foreign workers pay taxes to their own government, but the money paid comes from the tax deprived economy. [Post Note: Yet, foreign workers are paid in a second currency, not the currency of final sale. In the absence of balanced trade, some entity must absorb a trade of paper for product.]

The synergy described sets up conditions encouraging every government to support foreign sales, with a goal of increased government revenue due to more income tax paid. Of course imports have the opposite effect.

As if it were a surprise, we can conclude that taxation can have economy shifting effects.

Conclusion

It seems to me that a better sales effort needs to be made to sell a new tariff on steel and aluminum. This new tax would be easier to accept if the need to bring foreign production into a tax sharing mode is made clear (to the public). Domestic governments would like all producers to fairly help pay for government programs, (thus sharing the tax burden laid upon domestic producers). Of course, domestic customers prefer buying foreign if they can get a less expensive product, ignoring (or even relishing) the probability that avoidance of domestic taxes may be the reason for lower price.

To the extent that tariffs better-balance the tax burdens of government, tariffs seem reasonable.

An afterthought

Disfavored suppliers, victimized by a new tariff, will be understandably upset by what is perceived as being discrimination against them. They will take it personally.

Governments housing these same disfavored suppliers are likely to attempt to find new markets, keeping workers and factories in a production mode. New markets, if peaceful, can be good. However, these same (in the case of steel) production facilities can be used in markets producing ships, tanks and other weapons, which would not be good. Thus we see a danger in forcing rapid changes in economies by using blunt trade weapons such as tariffs.