Tariffs, taxes and inflation
How things really work, most of the time
There is a lot of headline ink being spilled today now that Biden is out of the race, claiming that Trump tariffs will cause inflation and that Trump tax cuts will cause the fiscal deficit to swell. Those claims don’t line up very well with basic economic theory, since they ignore the competitive process. It is worth thinking about the average American industrial corporation in a steady state with an abridged set of statements that look like this:
For many years, the centre of American industrial results have been a 5% ratio of net income to sales, three investment turns and a 15% return on invested capital. Those metrics were so ingrained they became the benchmarks for businesses within General Electric at the time I was a Vice President of that company. The table above assumes a 40% corporate tax rate (the U.S. corporate tax rate was at least 40% from 1950 to 1987, peaking at over 58%, falling to about 20% ever since). Since the left wing of politics keeps clamoring for higher corporate taxes, I have used the 40% rate as a reference point.
The fundamental assumption I will make is that the revenue figure is the result of open competition from both domestic and foreign competitors - it is the amount customers in a free market were willing to pay, and a company that tried to charge a higher price lost market share and one that cut prices saw their price cuts matched by competitors so the entire industry suffered and the price war failed quite quickly with a new equilibrium manifesting itself with metric just like the old one. Competition, not regulation, is the most effective way to control prices.
Now let’s look at policy wonks interventions through elected bodies, first corporate taxes:
CORPORATE TAXES
If the corporate tax rate is cut to 20% from 40% (as it was after 1987) revenue stays the same (unless price changes) while net income rises to $20 and return on capital employed (ROCE) rsies to 20%. But now the domestic suppliers have economics that dont’ punish them from competiting with offshore suppliers for market share, and prices fall. Offshore suppliers must match the price cuts or lose share and (reluctantly I am sure) match and prices fall. Result - lower prices for conumers. We have over 40 years of history that demonstrate that the cut in corporate taxes to 20% did not result in higher corporate profits, which have been stubbornly at or below 15% ROCE throughout that period.
Reality is that corporate taxes are passed on to their customers to preserve the targeted 15% ROCE and higher corporate taxes are in effect a tax on the poorest in society since they must pay more for the same goods. And similarly, cuts in corporate taxes manifest themselves in lower prices in a free and open market, with all competitors adjusting their marketing strategies to retain share and meet their ROCE targets.
The 1960’s large scale study carried out by GE called “Profit Impact of Marketing Strategies” confirmed this, finding that in any industry while the average ROCE was 15% the supplier with the largest market share enjoyed a higher ROCE and the one with the lower share a commensuratley lower ROCE or even a loss.
Sure there are variables that make the foregoing an oversimplification, but the core conclusion is indisputable - higher corporate taxes are a tax on the poorest, corporations don’t “pay taxes” but collect them and pass them on in price, and the most effective corporate tax rate for society is “nil”. It is certain that lower corporate taxes are not a “giveaway” to corporate elites but instead give consumers a break.
TARIFFS
The claim is that tariffs are inflationary, since they tend to increase the price of goods from the offshore supplier. Tend to - perhaps - but the customer is the ultimate arbiter and will buy from the domestic supplier at the prevailing price rather than pay an offshore supplier a premium. If the offshore supplier does not “eat” the tariff and match prices with domestic suppliers, the result will be a loss of market share. The tariffs have two possible outcomes - the offshore supplier becomes less profitable or loses share. As long as there is an open market and domestic suppliers with the capacity and economics to compete, tariffs won’t result in higher prices - just higher government revenues to the extent the offshore suppliers keep supplying rather than concede all of their market share.
Higher domestic volumes will result if offshore suppliers allow their market shares to fall. Domestic suppliers will be more profitable but will still have one another to contend with. With higher market shares they will reach their ROCE targets at lower prices and the result will be the opposite of infaltion - lower prices.
HISTORY
The Tariff Act of 1789 was enacted to raise money to pay off debts incurred in the revolutionary war. From 1789 until 1914 when the first Income Tax Act was passed, tariffs were the main source of revenue for the United States government.
The use of tariffs to pay for government services reigned for 125 years, years during which the American economy flourished, and the industrial revolution took place. The average inflation rate for that 125 years was insignificant, with aggregate increase in prices over 125 years of 14% or an average annual rate of inflation of one tenth of one percent.
APPLICATION TO TODAY’S WORLD ECONOMY
Globalization has made today’s economies far more complex, and a century of changes to the Income Tax codes in every jurisdiction have had an impact on the way the world works today. There are many products U.S. consumers and industries need that are not made domestically and there is no doubt that tariffs on these items will fuel inflation unless those needing the imports can find alternatives to their use. Substitution of materials and goods would be the result of tariffs in addition to upward pressure on inflation. Those goods become negotiating chips for the offshore suppliers.
Tariffs that lower profitability for offshore suppliers may trigger reciprocal tariffs that hit domestic suppliers who wish to export to the country enacting the reciprocal tariff. A “trade war” results. Trade wars hit the income statements of suppliers on both sides of the trade war and ultimately manifest themselves in higher prices, as those businesses adjust to maintain their ROCE. No one wins a trade war, and it is virtually certain that consumers will lose.
As a result, the area of tariffs has to be approached with caution, a bit of circumspection, and policies that are selective. Tariffs already exist between United States and other countries including Canada, and have done little harm since they have been highly targeted and incidental in scale. Non-tariff barriers like Canada’s dairy “supply management” has been a thorn in the side of U.S. dairy farmers, for example, but have persisted for decades since both countries can live with the dysfunction they have created in the respective markets.
At the time the original North American Free Trade Agreement (NAFTA) was being negotiated, I had the good fortune to be a guest at a conference hosted by Merrill Lynch Canada and was at a table with the late Malcolm Baldridge, at the time Secretary of Commerce of the United States, and the late Arnold Weinstock, President of General Electric Company of the U.K. (unaffiliated with GE U.S.) During the discussion of the possible terms I and my dinner guests speculated might emerge from the NAFTA negotiations, Weinstock had the most telling comment. He said, correctly: “Free trade is the absence of an agreement”.
As an aside, Baldridge (an impressive diplomat) was also a rodeo rider and was killed in a rodeo accident a few months after the dinner.
The political rhetoric about the economic impact of Trump’s stated polices is misplaced or at least premature. The devil will be in the details and all we have today is headlines. I have acquaintances who are very senior lawyers with a good grasp of the complexities of international trade, but who seem to have concluded that if Trump is elected it will signal serious damage to our automotive industry. I spent about 25 years as an executive in that industry and tell them to relax. First, Canada’s automotive industry is owned by its U.S. and European parents by and large, with the exception of a few large parts suppliers like Magna, Linamar and Martinrea who are independent. I see little risk the U.S. will enact tariffs that impose additonal costly changes on its own automotive industry to spite Canada, since the damage will be on their own Canadian assembly plants and risk denying them supply from very large and very competitive parts suppliers whose skills and technologies would be hard to replace and who can organize themselves to supply Asian, South Korean and European car assemblers (who they already supply to a certain extent) if U.S. policies affected their supplying U.S. assembly plants.
The recently agreed U.S., Mexico and Canada (USMCA) agreement has many benefits for all signatories, was a hallmark accomplishment of Trump’s last administration, and it would be a surprise if Trump abrogated it for some reason, and I can think of no such reason.
CONCLUSION
Railing against Trump and claiming he is both “a threat to democracy” and “a risk to Canada” is typical leftist nonsense. He is neither. Since he is likely to be the U.S. President in November, most Canadians should turn their attention towards how we as a country should act to get along with Trump rather than make unsubstantiated claims about how bad his coming administration will be for us. It is far better to face reality and deal with it than to bitch and pretend anyone cares about your complaints.
Trump tariffs are inflationary but Biden ones probably wouldn't be :)That's my read
We, the boomers, became so focussed on and enamoured with getting richer and richer that we too often forget about life balance and the future (of your kids, grandkids etc.). It is worth to stop and reflect. Just like prof. Scott Galloway does https://youtu.be/7M6rexFnBvw?si=Vl9rUXIMOY6F4cUe It should never be just about the money we'll make the next quarter, year or five.