Yes, tariffs can be too low

Tariffs have two effects. They distort production away from its most efficient pattern. Simple economics says that this efficiency cost is proportional to the square of the tariff.

So in reducing automotive tariffs from effective rates of more than 100 per cent in the mid 1980s to 10 per cent now, we’ve cut them by about 90 per cent. But we’ve got more than 99 per cent of the benefits of going to free trade. That’s right, we’ve got less than 1 per cent of those gains to go.

But as imports rise in response to tariff cuts, we export more to pay for the imports. And how do we increase exports? By cutting their price. Now most of our exports occupy relatively small shares of their global markets, so this “terms of trade effect” is small.

Then again, as the gains from tariff cuts become progressively attenuated, there’s a point at which cutting further does more harm than good. This is the “optimal tariff argument” which has a pedigree in economic orthodoxy going back at least to John Stuart Mill in the mid 19th century.

On July 15, 2008, Lateral Economics published (PDF 922KB) modelling funded by the Victorian Government. Free to come to our own independent conclusions, we asked Monash University to simulate a wide range of scenarios. The results indicate that reducing automotive tariffs to 5 per cent does more harm than good.

This isn’t special pleading for the industry. The harm to the industry is good news in our model allowing the economy to access cheaper motoring. The costs are transmitted through the export market. And we should still move to free trade if this gains us better access to export markets.

The Productivity Commission has never liked the optimal tariff argument.

In 2000 it argued that we should remove existing 5 per cent tariffs despite existing modelling indicating that this would harm the economy. It added a “cold shower” effect which had firms lifting their productivity in response to cheaper imports.

I’m all for this kind of improvising. But it has to be taken seriously. The Commission’s respecified model was hastily wheeled on stage - a deus ex machina. Alas, it recommended continuing beyond zero and replacing tariffs with import subsidies! It was then wheeled off stage and hasn’t reappeared.

The Commission has also suggested that we face such super-elastic export demand as to virtually eliminate the “terms of trade effect” - that a reduction in our export prices of less than 3.5 per cent would double export demand. Try telling that to an exporter selling coal, wool, iron ore, manufactures (sophisticated or otherwise), professional services, tourism, health or education.

We took all these moves seriously in our own modelling, including the cold shower effect, but we refined its specification to better reflect the limited evidence we have - which also avoids the ridiculous implication that import subsidies improve on free trade.

An extensive literature review gave us increasing comfort that, while export demand is highly responsive to price, it isn’t at the stratospheric levels mentioned above.

Having done all this and concluded that automotive tariffs are already around their optimum, we find we’ve been chasing shadows. The Commission’s new modelling is different. The cold shower effect remains missing in action. And the Commission has halved its preferred responsiveness of export demand. It chooses a figure that would normally generate an optimal tariff of around 11 per cent.

Now there’s a new deus ex machina. Cheaper cars lower the cost of investment and, in the Commission’s new modelling, tariff cuts induce an investment surge so big that it not only recovers the cost of undershooting the optimal tariff, it produces economy wide gains about the size of the revenue the tariff cuts forego.

If we believe all this we can get much more bang for our buck by lowering the cost of investment directly - by cutting company tax collections by the same amount.

But that’s a big “if”. This looks like another model in which we should forget free trade and just subsidise imports. Almost invariably modelling the overall economic effect of a half billion dollar switch in revenue collection from tariffs to some other tax will net out the transfers from losers to winners leaving a small fraction of that amount as the net economic cost or benefit.

But not here.

I suspect that if we investigate, we’ll find ourselves chasing more shadows.