Taxes And Tariffs

Today I'm going to discuss two forms of government revenue - taxation and the levying of tariffs. While they are both sources of revenue, I will mainly be exploring the economic consequences of taxation.

Taxation is the simpler of the two, so we'll begin here.

As previously discussed, the free market is the process by which private companies and consumers communicate through prices and purchasing behavior to achieve maximum social surplus. This maximization is achieved at the equilibrium point on the supply and demand curves.

The placement of taxes disrupts the operation of the free market, causing it to be less efficient. Assuming a market is at equilibrium, the incidence of a tax falling upon any party within the market causes deadweight loss.

Essentially, in addition to removing a certain amount of money from the hands of the individuals bearing the incidence of the tax, taxation also harms the market, costing more than the amount of revenue the government collects.

As such, a tax can only be considered a good thing when tax dollars generate more than the sum of the value of the dollars and the value of the deadweight loss within affected markets when used to fund government programs.

Tariffs are similar to taxes in many ways. In fact, they basically are taxes, except the incidence of the tax falls on suppliers that wish to supply specific goods within the borders of the country levying the tariff.

However, tariffs are not like taxes in one crucial way: while always harmful to the global market in the long-run, it is possible for tariffs to provide substantial short-term benefits to domestic markets.

To understand this, we need to understand international trade. Trade occurs because of comparative advantage - it is better for two nations capable of trade to produce mostly what they are best at producing and to trade away the excess production for goods they are not so good at producing.

(This sort of trade theory even explains why America, which can produce nearly any manufactured good more efficiently than other nations, still trades for many cheap goods: we are better, comparatively, at producing expensive durable goods, and are better off producing mainly these goods.)

From this we can deduce that two static economies capable of trade would, eventually, come to a point where each produced the optimal amount of every possible good, based upon the comparative advantages each economy possessed. This would lead to the greatest possible size and efficiency for the two economies.

Real economies, however, are not static. They change all the time. Some are industrializing, some are beginning to exploit natural resources, some are expanding certain branches of education. All of this results in constantly shifting comparative advantages.

For instance, let's take a look at South Korea. Over the past fifty years, South Korea has went from being able to produce no motor vehicles to being one of the foremost auto producers in the world. At the beginning of the fifty years automobile manufacturing was not something they could do efficiently, but now they are, in many ways, more efficient in production than America is.

Now, let us assume you're the government official in charge of all tariffs levied upon South Korean automobiles during this time period.

At the beginning, you would have nothing to do, as South Korea did not produce any automobiles at all, let alone attempt to export them to the United States. On top of this, your domestic auto industry is going strong and providing for a very large portion of domestic demand. At this point, comparative advantage favors American production of automobiles.

Let's move on a little bit. You start seeing that South Korea is producing automobiles. However, they only produce a few and are not exporting any at all. They attempt to meet only some portion of domestic demand. Again, comparative advantage is in the favor of America, albeit not so heavily. Tariffs are unnecessary at this point.

As South Korea moves closer and closer to being able to compete with American production of automobiles, something important happens - America begins to import South Korean vehicles. Not many at first, but the number continues to grow.

At this point, you realize something important - if left unchecked, South Korea will take over a large portion of the domestic automobile market in America. This, of course, is a natural and healthy process, so you might come to the conclusion that simply allowing it to happen is the best possible course of action.

However, the takeover may occur too quickly. Markets are not perfect - they need time to adjust. If the South Koreans absorb a large portion of the domestic automobile market in a short period of time, many individuals will be left without a job and the economy in places that rely heavily on that industry will take quite some time to recover.

Now, you could simply put in place a heavy tariff and leave it there indefinitely. This would help to soften the blow to domestic industry, allowing a larger portion of the industry to be left untouched then otherwise would be. However, you've now created a problem - South Korea and America are no longer producing the efficient amount of automobiles and demand is being met inappropriately.

What can you do? You don't win with the tariffs, and you don't win without them. It's a losing battle, right?

Not quite. The solution, in most cases, is to begin with a high tariff to protect important domestic industries as other nations begin to compete with you on them. As competition continues, steadily lower the tariffs until they are no longer in place.

This system allows global competition to exist in the long-run, where it is most important and most effective. In the short-run, however, you soften the impact of competition on domestic industry, allowing the economy more time to shift resources away from that industry and into other, more efficient, industries.

And there we are. Tariffs and taxes, all nicely laid out. There are many other things to know about them, but this covers the bit I wanted to do for today. Let me know if there's anything else you'd like to have discussed in the comments section.