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Who Pays the Tax on Imports from China?

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Who Pays the Tax on Imports from China?
Matthew Higgins, Thomas Klitgaard, and Michael Nattinger
Liberty Street Economics, NOVEMBER 25, 2019

 

 

 

 

Who Pays the Tax on Imports from China?
Matthew Higgins, Thomas Klitgaard, and Michael Nattinger

Tariffs are a form of taxation. Indeed, before the 1920s, tariffs (or customs duties) were typically the largest source of funding for the U.S. government. Of little interest for decades, tariffs are again becoming relevant, given the substantial increase in the rates charged on imports from China. U.S. businesses and consumers are shielded from the higher tariffs to the extent that Chinese firms lower the dollar prices they charge. U.S. import price data, however, indicate that prices on goods from China have so far not fallen. As a result, U.S. wholesalers, retailers, manufacturers, and consumers are left paying the tax.

Going Up
In August 2017, the Office of the U.S. Trade Representative (USTR) announced that it had launched an investigation to determine whether Chinese policies related to technology transfer and intellectual property were actionable under the Trade Act of 1974. In April 2018, USTR announced its finding that these policies “are unreasonable or discriminatory and burden or restrict U.S. commerce.” A number of trade actions against Chinese goods have now been announced. The first tariff increase came in July 2018, and was followed by a sequence of further hikes as the trade dispute continued. By June 2019, according to the USTR estimate, some $250 billion in Chinese goods faced an additional tariff of 25 percent. Another round of sharp increases was announced in August but these moves have been largely postponed. However, an estimated $120 billion in additional goods were hit with a tariff hike of 15 percent in September.

Tariffs are collected at the port of entry by the U.S. Customs, with the duty paid by the immediate U.S. purchaser of the good. In effect, the U.S. purchaser pays a sales tax to the Customs Service for the right to import the good.

No Clear Change in Import Prices
Who ends up bearing the burden of the higher tariffs? Chinese firms could lower the prices they charge to offset the tariff hikes in order to avoid losing market share in the United States. For example, a 25 percent tariff hike would need to be offset by a 20 percent price cut by the Chinese supplier to leave the total cost to the U.S. importer firm unchanged (1.25 x 0.80 = 1.0). Chinese firms will be more prone to lower prices to the extent that they believe U.S. purchasers can either do without their products or find alternatives from other suppliers.

A May 2019 Liberty Street Economics post noted that prices on imports from China have been stable in the face of higher tariffs. This stability has continued in the face of further tariff hikes. As seen in the chart below, prices on goods from China fell by only 2 percent in dollar terms between June 2018, just before the first tariffs were imposed, and September 2019. (These data refer to the prices charged by Chinese suppliers and do not include tariff expenses.) This drop is a small fraction of the amount required to offset the increase in tariff rates. Moreover, prices on goods purchased from Mexico and the so-called Newly Industrialized Economies (South Korea, Taiwan, Singapore, and Hong Kong) have fallen by roughly the same amount, suggesting that this small drop is the result of general market conditions rather than the increase in tariffs.

The same pattern is evident when we look at disaggregated import price data. The table below shows how much import prices for goods from China changed between June 2018 and September 2019 in several manufacturing sectors. The table also shows an estimate of the percentage point increase in the average tariff rate on Chinese goods over this period.

For these product categories, price changes for goods from China have been very small relative to the jump in tariff rates. Note that changes in tariff rates on electronics and computers had been modest as of September.

Why Haven’t Import Prices Fallen?
Policy efforts since World War II have been focused on lowering trade barriers. As a result, economists don’t have much data from which to glean insights into how firms respond to tariff hikes. Potential explanations for why import prices appear unaffected thus far include:

 

  • Narrow profit margins: Offsetting a large rise in tariffs by accepting lower profit margins isn’t possible if margins are already thin. Many of these firms may be dropping out of the U.S. market.
  • Few competitors: Chinese firms with few non-Chinese competitors will feel little pressure to adjust, leaving the tariff burden to the U.S. buyer. In textbook terms, these firms face a low price elasticity of demand.
  • Intra-firm imports: Affiliates of multinational corporations may be leaving reported import prices unchanged for accounting reasons. In doing so, the multinational would be letting higher tariffs reduce the reported profits of its U.S. operation (rather than those of its Chinese operation).
  • Price contagion: Lowering U.S. prices could cause customers in other countries to demand similar discounts.

 

The Role of Exchange Rates
Some observers have argued that the depreciation of China’s currency against the U.S. dollar is shielding U.S. businesses and consumers from the impact of the tariffs. In fact, the renminbi has fallen by about 10 percent versus the dollar since U.S. trade actions were first announced in April 2018.

The weaker Chinese currency provides scope for Chinese firms to lower their dollar prices. Each dollar of revenue is now worth more in local currency terms, and that matters since Chinese firms’ costs are predominantly in renminbi. But the facts we’ve reviewed show that Chinese firms have not used the change in exchange rates to regain some of the competiveness lost from tariffs by lowering their prices in dollar terms. Instead, they’ve accepted the loss in competitiveness in the U.S. market and have used the weaker currency to pad profits on each unit of sales.

What Happens if Import Prices Don’t Fall?
The continued stability of import prices for goods from China means U.S. firms and consumers have to pay the tariff tax. In annualized terms, U.S. tariff revenues were roughly $40 billion higher in the third quarter of 2019 relative to the second quarter of 2018, before the China-specific tariff hikes. This is considerably below what might have been expected. USTR estimates had a tariff hike of 25 percentage points on $250 billion of Chinese goods as of June, pointing to a $62 billion increase in annualized revenues. (The additional tariff hike imposed in September would push this figure higher.) The shortfall in duties is largely due to a steep drop in purchases of the affected goods. Detailed data show imports of goods hit by tariffs have declined by an annualized $75 billion since the second quarter of 2018, while imports of non-tariffed goods have been roughly stable.

Who pays the tariff tax depends on how it is split between lower profit margins (for wholesalers, retailers, and manufacturers) and higher prices for consumers. Estimating this split is difficult since the distribution of any tax increase on profit margins and prices depends on the details of market structure, such as the number and size of competing firms.

Regardless of whether consumers or businesses bear the burden, sustained high tariffs on Chinese goods will encourage a search for alternative suppliers. The chart below shows the change in China’s share of total U.S. imports by product category relative to 2017. China’s market share has already fallen by roughly 2 percentage points for machinery and electrical equipment and by close to 6 percentage points for electronics. A broader look at the trade data shows that China’s lost market share has gone largely to Europe and Japan for machinery and to Malaysia, South Korea, Taiwan, and Vietnam for electronics and electrical equipment.

To be sure, these figures will somewhat overstate the immediate hit to China’s economy. Trade data attribute all value added to the last country in a multi-country supply chain. Recent data from the OECD show that about 20 percent of the value of China’s manufacturing exports originates in other countries, principally other economies in the Pacific region. Moreover, companies may be shifting the final stages of production for Chinese products to third countries to avoid the tariffs.

Source: Liberty Street Economics

The post Who Pays the Tax on Imports from China? appeared first on The Big Picture.



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Cautionary Tales Ep 6 – How Britain Invented, Then Ignored, Blitzkrieg

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Blitzkrieg means “lightning war”, but despite the German name it was not a German invention. Back in 1917 a brilliant English officer developed a revolutionary way to use the latest development in military technology – the tank. The British army squandered the idea but two decades later later Hitler’s tanks thundered across Europe, achieving the kind of rapid victories that had been predicted back in 1917.

This is a common story: Sony invented the digital Walkman, Xerox the personal computer, and Kodak the digital camera. In each case they failed to capitalise on the idea. Why?

Featuring: Toby Stephens, Ed Gaughan and Rufus Wright.

Producers: Ryan Dilley and Marilyn Rust. Sound design/mix/musical composition: Pascal Wyse. Fact checking: Joseph Fridman. Editor: Julia Barton. Recording: Wardour Studios, London. GSI Studios, New York. PR: Christine Ragasa.

Thanks to the team at Pushkin Industries, Heather Fain, Mia Lobel, Carly Migliori, Jacob Weisberg, and of course, the mighty Malcolm Gladwell.

[Apple] [Spotify] [Stitcher]

 

Further reading

Mark Urban’s book The Generals has an excellent chapter on J.F.C. Fuller. Other sources on Fuller include Brian Holden Reid’s J.F.C. Fuller: Military Thinker and Harold Winton’s To Change An Army

Other sources on the development of the tank include Macksey and Batchelor’s TankNorman Dixon’s classic On The Psychology of Military Incompetence and Basil Liddell Hart’s The Tanks.

On modern corporate innovation try Gillian Tett’s excellent The Silo EffectCreation Myth” by Malcolm Gladwell, Clay Christensen’s Innovator’s Dilemma and The Disruption Dilemma by Joshua Gans.

 

The original paper on architectural innovation is:

Henderson, Rebecca M., and Kim B. Clark. “Architectural Innovation: The Reconfiguration of Existing Product Technologies and The Failure of Established Firms.” Administrative Science Quarterly 35, no. 1 (March 1990): 9–30

 

 

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The Fama Puzzle at 40

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Fama (JME, 1984) was published 35 years ago, but the earlier — perhaps the earliest — appearance of the Fama regression is in Tryon (1979). While the puzzle has largely persisted since then, it has seemingly disappeared since the global financial crisis.

Figure 1: Ex post one year depreciation of euro/dollar up to 2007M08 against one year offshore US-euro interest differential (up to 2006M08). 

Recall the puzzle: If the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations –- sometimes termed the unbiasedness hypothesis — held, then the slope of the regression lines (in red) would be indistinguishable from unity. In fact, they are significantly different from that value. This pattern of coefficient reversal holds up for other dollar-based exchange rates, as well as for other currency pairs (with a couple exceptions). The fact that the coefficient is positive in the post-global financial crisis period is what we term “the New Fama puzzle”.

Interestingly, after 2006, the relationship flips.

Figure 2: Ex post one year depreciation of eur/dollar up to 2019M06 against one year offshore US-euro area interest differential (up to 2018M06). 

In a revision to NBER working paper just released (No. 24342, posted 12/11), coauthored with Matthieu Bussière (Banque de France), Laurent Ferrara (SKEMA Business School), Jonas Heipertz (Paris School of Economics), we re-examine uncovered interest parity – the proposition that anticipated exchange rate changes should offset interest rate differentials, with data up to mid-2019.

This is one of the most central concepts in international finance. At the same time, empirical validation of this concept has proven elusive. In fact, the failure of the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations – sometimes termed the unbiasedness hypothesis – is one of the most robust empirical regularities in the literature, vigorously examined since Fama’s (1984) finding that interest rate differentials point in the wrong direction for subsequent ex-post changes in exchange rates.

The most commonplace explanations – such as the existence of an exchange risk premium, which drives a wedge between forward rates and expected future spot rates – have some empirical verification, albeit fragile.

One key development prompts this revisit. First and foremost, the last decade includes a period in which short rates have effectively hit the zero interest rate bound. This point is clearly illustrated in Figure 1 where we plot one-year interest rates for a set of eight selected economies and the US. This development affords us the opportunity to examine whether the Fama puzzle is a general phenomenon or one that is regime-dependent.

Figure 3: One year yields on Eurocurrency deposits.

As shown in Figure 3, more recently — and since the first version of this paper — short rates in the US have risen above the zero lower bound. This allows us to test to the robustness of our findings.

We obtain the following findings. First, Fama’s result is by and large replicated in regressions for the full sample, ranging from 1999 to June 2018 (for exchange rate changes ending in June 2019). However, the results change if the sample is truncated to apply to only the most recent decade, the period for which interest rates are essentially at zero. For that period, interest differentials correctly signal the right direction of subsequent exchange rate changes, but with a magnitude that is altogether not reconcilable with the arbitrage interpretation of UIP. In other words, we obtain positive coefficients at exactly a time of high risk when it would seem less likely that UIP would hold.

The use of survey based expectations — thereby dropping the rational expectations hypothesis — data provides the following insights. First, interest differentials and anticipated exchange rate changes are positively correlated, consistent with the proposition that investors tend to equalize at least partially expected returns expressed in common currency terms (see also Chinn and Frankel (2019) for results 1986-2017).

Second, the switch in the β coefficient at the one year horizon arises because the correlation of expectations errors (defined as expected minus actual) and interest differentials changes substantially between pre- and post-crisis periods. This is important, as can be seen by examining the probability limit of the β’ coefficient in a Fama regression:

s+1 – s = α’ + β'(i-i*) + error

so:

plim(β’) = 1 – [A] – [B] – [C]

Where

[A] ≡ cov(covered interest diff.,i-i*)/var(i-i*)
[B] ≡ cov(risk premium, i-i*)/var(i-i*)
[C] ≡ cov(forecast error, i-i*)/var(i-i*)

covered interest differential = – [(f – s) – (i-i*)]
risk premium = f – ε(s+1)
forecast error = ε(s+1) – s
f is the forward rate for period +1
s is the current spot exchange rate
ε(s+1) is subjective market expectations of the future spot exchange rate (proxied using Consensus Forecasts survey data).

The decomposition for the euro/dollar β’ is shown in the Figure 4 below, for the 2003M01-2018M06 period (defined by the survey data). The components are shown as theoretical β’ + [-A] + [-B] + [-C], so as to add up to the estimated β’.


Figure 4: Decomposition of euro/dollar β’. [A] is brown, [B] is blue, [C] is green; black square denotes estimated β’, line at 1 denotes theoretical β’ under unbiasedness hypothesis. Source: BCFH (2019).

Exchange risk comovement with the interest differential does not appear to be the primary reason why the Fama coefficient has been so large in recent years (although the altered behavior of exchange risk does play a role). Rather, how expectations errors comove with the interest differential appears of central importance — that is the [C] component. This correlation changes because in the pre-crisis period, the dollar depreciated more than anticipated, while that is no longer true post-crisis. The size of the swing is partly due to the fact that interest differentials are now less variable (the variance has shrunk).

So far the change has proved durable despite the liftoff of short rates — at least in the US, Canada and UK. Whether this will continue to be the case remains to be seen.

Ungated version of the paper, here.



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Bonus Quotation of the Day…

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… is from page 426 of the late Jan Tumlir’s January 1984 speech at the Cato Institute – a speech titled “Economic Policy for a Stable World Order” – as this speech is reprinted in Dollars, Deficits, & Trade (James A. Dorn and William A. Niskanen, eds., 1989):

Indeed the difficulty for the economist may now lie in explaining why the world economy still functions at all, however dissatisfied we may be with its functioning. The answer is, of course, that there is a lot of ruin in any economy with a modicum of freedom. I am sometimes unsure whether it is actually an advantage of the capitalist system that it can take such an enormous amount of beating. If it were in the habit of collapsing more frequently, we would perhaps govern ourselves more prudently (and more cheaply to boot).

DBx: Indeed.

I’ve long argued that the economist’s standard assertion that government intervenes into the economy first and foremost to correct market failures fails spectacularly as a positive theory of government intervention into the economy. It’s far closer to the truth to say that government intervention into the economy is fueled not by market failures (as understood by economists) but, rather by the market’s astonishing success and robustness.

The market’s success at raising people’s standards of living creates the expectation that wealth creation is easy and normal while poverty is out of the ordinary. But of course historically poverty is the norm – and poverty so deep, unrelenting, and overwhelming that few Americans today can begin to imagine a condition so crushing. Because the market makes wealth so abundant and its production appear to be normal and easy to the point of being practically automatic – and because nearly all of the massive number of details of the intricate processes at work at every moment to create wealth are hidden from view – the market’s ‘failure’ to create heaven on earth is believed by many to be an unanswerable indictment of the market.

On top of this ‘problem’ is the market’s mighty robustness: tax it, saddle it with diktats, poison it with easy money, accuse it of being run by and for demons and devils, and the market keeps motoring along, improving the lives even of those who most hate it and who do the most to harass it. The market works less well than it would absent these intrusions, of course, but it still works surprisingly well. As long as, and insofar as, prices and wages are allowed to adjust according to the forces of supply and demand, the market’s robustness is Herculean. (The market is not, however, indestructible. Harass it too much and it will quit working.)

If the market truly collapsed completely more often, giving people a taste of what life is like without it, the world would have in it not only far fewer communists and socialists, but also far fewer “Progressives” and “conservative nationalists.”

The market’s true failure, in short, lies is its incredible capacity to succeed and to keep on keeping on. The market fails to prevent people from taking it for granted.

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