Rules-based, automatically-adjusting trade policy for freer trade

A major contemporary worry is that threats of tariffs, preservation of subsidies and licensing and standards restrictions for imports and exports will derail any progress that has been made towards true free trade. Indeed, one of the issues is that as politicians seek to satisfy particular Special Interest Groups over others, the risks of a trade war escalating as tariffs on particular products correspond to the other nation reciprocating and so on and so forth are very real.


One way to deal with this may be, rather counter-intuitively, to set up a system of automatically-adjusting subsidies and tariffs that is ‘rules-based’ rather than what is essentially discretion. In the same way that many argue that ‘rules-based’ monetary policies are far less susceptible to political business cycles (although the author’s own theories and research indicate this may not necessarily be the case) and also far more effective at stabilizing them, the same logic may be applied to tariffs and subsidies and other trade restrictions. This particular idea could be especially relevant to Britain as it could save a whole lot of trouble, money and time rather than negotiating ‘Free Trade Deals’ as opposed to true free trade.


So, for example, rather than having a discretionary regime wherein some tariffs are applied to some products, some subsidies are granted to particular goods and not others, the regime would work in proportion to the reactions and policies of the other country. The following illustrations will work between two countries, A and B, where country A operates this rules-based regime and country B operates a discretionary regime.


Scenario 1: Country B increases its subsidy for Good X produced in Country B which is exported to Country A.

Rule-based response: Country A increases tariff on Good X in exact proportion to the increase in rate of the subsidy.


The reactionary, rules-based tariff imposed by country A on Good X produced in country B would have a more detrimental impact on the consumers in country A if the price-elasticity of demand for Good X is relatively inelastic (if there are few substitutes and many complementary goods, for example); however, if this was the case then it would not have made sense for country B to increase its subsidy in the first place since the decrease in price in order to remain ‘competitive’ would not correspond to a proportionate or more-than-proportionate increase in the quantity demanded of the good and, therefore, it could actually lead to a decrease in revenue. As such, the tariff imposed by country A on Good X from country B as country B increases its subsidy would offset the expected, purported benefit of the subsidy and work to discourage the introduction of it in the first place.


Scenario 2: Country B increases its tariff on Good Y produced in Country A.

Rule-based response: Country A increases tariff on the same Good Y produced in Country B proportionately to the rate of tariff imposed by Country B and revenue raised by it.


Of course, this only works as an effective deterrent against tariffs if Good Y is produced in both countries and where the industries are of comparable significance to each country’s economy. In practice, this does not always occur so one country could benefit unevenly from a unilateral increase in tariffs even if this were met with an exactly proportionate reactionary tariff imposition. The rule-based response could be calibrated based on revenues raised; that is, the tariff that is counter-imposed is designed to exactly offset the revenue raised from the initially imposed tariff. For example, if the total revenue raised from sales of Good Y from country A to country B is $500m and a tariff of 10% was imposed upon it (so that, ceteris paribus, $50m in tariff-based revenue is raised) then suppose that the total revenue raised from sales of Good Y from country B to country A is $200m. If country A wants to raise exactly $50m (in the same way that country B has from its tariff increase) it would impose, ceteris paribus, a tariff of 25% (25% of $200m being $50m). However, this is a far higher tariff rate and would be a far more substantial blow to the industry.


However, this would mean that the government which could raise the tariff rate in the first place and which knows of the other country’s rule-based regime will have perfect knowledge that this could (or would) destroy their own domestic industry and, as such, they would face significant backlash from special interest groups, the media, workers, businesspeople and so on for taking such a course of action. As such, this would act as a deterrent on imposing/increasing tariffs in the first place since there is absolute certainty regarding the response and there is no room for favoritism in negotiations.


Scenario 3: Country B decreases its subsidy for Good X produced in Country B.

Rule-based response: Country A decreases tariff on Good X in proportion to the decrease in rate of the subsidy.


Where a subsidy is decreased and is followed-up with an exactly proportionate decrease in the tariff, this would mean that there could potentially be no change in the price at which the good is sold (and, therefore, it could remain competitive in the marketplace) but the added benefit is that country B no longer needs to distribute the subsidy from redistributed tax revenue; as such, when there is close to complete certainty that the other country will reciprocate due to its rule-based regime, the country would have incentive to reduce its subsidy (and the other, its tariff) and also therefore reduce the tax burden upon its own citizens and the other country will also save the costs related to administering a tariff. This is essentially a win-win situation for all (so there is always incentive to decrease subsidies unless policy makers find the ‘sweet spot’ in terms optimal prices according to elasticities but this is very difficult to discern and is subject to change over time so it’s near-impossible to compute accurately).



Scenario 4: Country B decreases its tariff on Good Y produced in Country A.

Rule-based response: Country A decreases tariff on the same Good Y produced in Country B proportionately to the reduction in the rate of tariff by Country B and/or the revenue lost from it.


Like Scenario 2, the rules-based response in terms of a reduction of the tariff rate would depend upon the volume and value of the goods sold and produced by each country, the loss of revenue that the tariff entailed for country B (so that it remains cost-neutral for both countries) and, therefore, rather than deal with the administrative costs of tariff collection, there would be incentive to eliminate this barrier completely and continuously decrease tariff rates when certain that this will be reciprocated by the country with the rules-based regime. However, it is possible that if it is done on a ‘revenue’ basis, then one country will always have incentive to maintain at least some tariff so there may need to be criteria aside from revenue. Nevertheless, if there was still positive revenue gained from the tariff, that country would still have incentive to eliminate it since the incidence of the tariff does (at least partially – the extent to which depending upon the price-elasticity of demand) reduce domestic social welfare by reducing consumer surplus.


Concluding Remarks


Various technologies could be used to streamline this process and I have sought to illustrate how a rules-based regime could actually provide greater incentive for freer trade (even if this does seem counter-intuitive at first and looks like a rules-based recipe for a trade war). The certainty that a rules-based trade policy regime entails could massively reduce the costs of trade since we currently experience largely discretionary regimes that are subject to the volatility of international relations and political sentiment. A similar logic can also be applied for international trading “standards” and licensure restrictions. Rather than countries subscribing to World Trade Organisation rules, they could independently operate their own rules-based trade policy regimes. The late, great Milton Friedman once suggested that the United States should lead the way in terms of enabling free trade by reducing tariffs and subsidies and that others will follow but this is, unfortunately, too idealistic for our times (nor is it politically feasible); we need to formulate and implement alternative mechanisms where countries have incentive to co-operate and foster freer trade relations.

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