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Additional Adverse Effects Although the tariff surcharge could help reduce the federal- budget deficit and the current-account deficit, it also would reduce U.S. exports because the tariff would promote a dollar appreciation and would reduce foreign income growth. The adverse repercussions on U.S. export industries would be especially serious if foreign governments retaliate. An attractive feature of an across-theboard tariff is that part of its burden falls on foreign producers, if they lower the prices of goods shipped to the U.S. market. This, however, is the most dangerous aspect of the proposal. If foreign governments view the tariff as a politically motivated attempt to shift the burden of financing U.S. budget deficits abroad, instead of incurring the domestic costs of trimming expenditures and raising taxes, they might retaliate by blocking the sale of U.S. exports in their markets. Many of our trading partners also have relatively large government budget deficits and could decide that if a tariff is an acceptable budget-trimming tool for the United States, Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, OH 44101 Address Correction Requested: Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101. it could work well in their countries. If retaliation were to result, the tariff jeopardizes the growth and continued development of some of our most efficient and rapidly growing industries, such as computers and aircraft. Moreover, retaliation would fall especially hard on already depressed U.S. agricultural exports, which are often a target of foreign protectionist measures. When talking about a tariff surcharge, we speak of imports as if they were a homogeneous group of products from a single foreign producer. In fact, we import myriad items from many different countries. It might not be in our best interest to tax all of these items according to the same rate. Some imports are important in the production process of domestic industries and lack domestic substitutes. Taxing such items could impair the ability of domestic industries that use imported materials to compete in world markets. It also might not be in our best interest to tax the exports of less-developed debtor nations. Despite the numerous financial arrangements lenders have provided to ease the burden of repaying international debts, debtor countries ultimately must run export surpluses if they are to repay their debts. Under International Monetary Fund austerity programs, these nations have greatly reduced their imports from the United States, but they cannot reduce their imports below the minimum level needed to support their economies. It is especially important, therefore, that these nations expand their export markets. Because the United States is the largest national market in the world, an across-the-board tariff would greatly handicap such efforts. The analysis presented in this Economic Commentary does not recommend the surcharge as an efficient policy option. Although such a tariff would help lower both the internal and external deficits, it would have adverse effects on dollarexchange rates and could easily invite foreign retaliation. Much of the burden of a tariff surcharge would settle on U.S. consumers and U. S. export industries. BULK RATE US. Postage Paid Cleveland, OH Permit No. 385 Federal Reserve Bank of Cleveland March 15, 1985 ISSN 0428-1276 ECONOMIC COMMENTARY The United States is currently experiencing the strongest economic recovery since the Korean War, with virtually no increase in the rate of inflation. Uncertainties associated with persistently large federalbudget deficits, and with internationalpayments imbalances, however, cloud the outlook for continued prosperity. The federal-budget deficit will equal approximately $210 billion in the current fiscal year, representing 5.4 percent of Gross National Product (GNP). In the absence of significant budget-cutting measures, the deficit will remain in the neighborhood of 4 percent to 5 percent of GNP throughout the decade. During the 1970s, the federal-budget deficit averaged slightly more than 2 percent of GNP; during the 1960s, a decade of rapid capital accumulation, the deficit averaged less than 1 percent of GNP. As the economy continues to expand, and as private credit demands continue to firm, hefty federal credit needs could place increasing pressure on interest rates and could threaten the continued growth of the interestsensitive sectors of the economy. Meanwhile, the current-account deficit reached a record $102 billion, or 3 percent of GNP, in 1984. The current-account balance measures our net international trade in goods and services plus U.S. unilateral transfer payments to foreigners. The authors are economists with the Federal Reserve Bank of Cleveland. They would like to thank Peter Isard for his helpful comments. The views stated herein are those of the authors and not necessarily those of the Board of Governors of the Federal Reserve System or of the Federal Reserve Bank of Cleveland. Many analysts regard the current-account surplus or deficit as the most useful summary statistic of the nation's gains or losses from international commerce. Throughout most of the post-World War II period, the United States has run a currentaccount surplus. Most observers expect the current-account deficit to remain in the neighborhood of 3 percent of GNP at least through 1987. The large currentaccount deficit bears witness to the substantial gains foreign competitors have made recently against U.S. firms in domestic and world markets. Recently, some policymakers have expressed interest in the possibility of using an across-the-board tax on imports to reduce the federal-budget and currentaccount deficits. Proponents of a tariff surcharge argue that the levy would reduce US. imports, thereby lowering the currentaccount deficit, while raising revenues to reduce the federal-budget deficit. In this Economic Commentary, we examine the possible effects of an across-the-board tariff and estimate its costs. The Current International Environment Economic theory and centuries of economic history have taught that nations engaged in international trade reap substantial benefits in terms of the quantity and diversity of products available for consumption. Trading nations have always prospered more than nations that have Will Taxing Imports Help? by Michael F. Bryan and Owen F. Humpage closed their borders. Recent experience has demonstrated, however, that the benefits of international trade are not always evenly distributed. The United States is currently experiencing a record current-account deficit, much of which is attributable to the 72 percent appreciation of the dollar since 1980. A dollar appreciation lowers the dollar-price of U.S. imports and raises the foreign-currency price of exports. A dollar appreciation benefits consumers and importers, but hurts US. industries that compete against imports and that sell goods in foreign markets. Many analysts cite the federal-budget deficit as one important factor contributing to the dollar's strength. The relationship between the federal-budget deficit and exchange rates is neither simple nor direct. It relies on the deficit's tendency to raise domestic interest rates and to attract foreign capital, which depends crucially on the behavior of private savings and investment both here and abroad. Heavy federal borrowing is consuming a record peacetime share of the private savings available to finance private credit needs in the United States, and is helping to keep U.S. interest rates above levels they otherwise would have attained. With credit demands relatively weak abroad, the attractive return on dollar-denominated assets has encouraged heavy net inflows The estimates also span two time frames. The decline in the quantity of imports also depends on how sensitive consumers The short run refers to a period of are to price changes in the import market. approximately three years. Some proposals If, for example, there are few domestically for a tariff surcharge would limit the tax produced substitutes for imports, U.S. to a period of three years. The long run consumers will be less sensitive to import- refers to a period longer than three years, in which consumers have adjusted more price increases than if substitute goods are readily available. Immediately following fully to the tariff. It is important to remember that our imposition of the tariff, the resulting price approach considers only the effects of the increases will elicit a relatively small The Effects of a Tariff tariff on imports. The tariff also will affect response from consumers. As consumers Tariffs, which are taxes on imports, raise the dollar prices of goods imported to the discover domestic substitutes for the higher exports through its influence on exchange rates and income levels both here and priced imports, however, their response United States. As prices rise, consumers to the levy will grow. Import sales will abroad. These effects on exports are buy fewer imports. The extent to which discussed in later sections of this Economic drop, and domestic sales will rise. a tariff alters the price and quantities of Commentary, but are not incorporated in imports depends on many things. Three In raising prices and lowering the the results presented in table 1. quantities of imports, the tariff has two important factors are the response of important effects on U.S. consumers. First, exchange rates to the tariff, the behavior The imposition of a 15 percent tariff of foreign prices following imposition of the tax transfers money away from U.S. by the United States would produce a consumers to the government. This money 4 percent to 6 percent appreciation of the the tariff, and the price-sensitivity of is a source of revenue for financing the U.S. consumers. dollar in the short run and a 7 percent federal-budget deficit. While certainly a The ultimate impact of the proposed to 9 percent appreciation in the long run, according to our models. Foreign producers tariff on U.S. consumer prices depends on cost to consumers, this transfer of purwould reduce their prices by approximately chasing power does not represent a net the resulting behavior of exchange rates. As U.S. residents buy fewer foreign goods loss to the country as a whole. The second 1 percent to 1.5 percent in the short run and 1.5 percent to 2 percent in the long because of the tariff, the amount of foreign effect does represent a net cost to the run. U.S. consumers would experience a currencies needed by U.S. consumers to country in the form of a misallocation of purchase those goods will decline, as will resources. Because of the tariff, consumers 7 percent to 10 percent rise in import the volume of dollars supplied to the shift some purchases away from low-cost prices in the short run and a 4.5 percent foreign-exchange market. Consequently, to 7 percent rise in import prices in the foreign producers to high-cost domestic long run. the dollar's exchange rates (the price of producers. The shift in production to a dollars relative to other currencies) will The tariff would raise approximately manufacturer that requires more resources tend to appreciate, making the dollar more to produce a given level of output represents $33 to 35 billion per year in the short expensive in terms of foreign currencies an efficiency loss. This loss is manifested run and $31 to $33 per year in the long and making foreign currencies less run. This revenue would be sufficient to in a lower level of world output and expensive in terms of dollars. The appreci- consumption. reduce the federal- budget deficit by an ation, therefore, tends to reduce the dollaramount equal to approximately 1 percent price of imports. In this way, the dollar's of GNP per year throughout the decade. The Effects on the Import Market appreciation partially offsets the price Of course, this assumes that the federal To consider the quantitative implications government enacts no additional spending effects of the tariff. of a comprehensive tariff, we estimated Tariffs reduce the competitive edge of programs or tax reductions. U.S. consumers the effects of a 15 percent tax levied on foreign products. As sales decline in the would pay most of the tax, but foreign United States, many foreign suppliers will all merchandise imports beginning in 1985. producers would pay roughly $3 to lower their prices. Some will reduce prices, Table 1 provides our results. We incorpo$6 billion in the short run and $6 to because the cost of production falls as rate into these estimates the offsetting $10 billion in the long run. the quantity produced for shipment to the influence of a dollar appreciation. The U.S. market declines. Others will cut prices exchange-rate effects were derived from a model that allows foreign prices to to protect market share in the United respond to the tariff and that assumes the States. As foreign producers lower their prices, they effectively pay part of the value of the dollar is determined solely by trade in goods and services.' Other tariff and help finance the U.S. federalfactors, such as expectations and interest budget deficit from their profits. rates, also influence exchange rates, especially in the short run. Because we are uncertain how the tariff will affect these factors, we could not include their influence in the exchange-rate model. of capital to the United States. These capital inflows have helped to keep the dollar strong in foreign-exchange markets. It might seem that measures to reduce the federal-budget deficit would promote a dollar depreciation, but this is not the case for a tariff, as we discuss below. 1. The exchange-rate model is found in Giorgio Basevi, "The Restrictive Effects of the U.S. Tariff and Its Welfare Value;' American Economic Review, vol. 58 (June 1968), pp. 840·52. environment, the tariff could cause greater Price Responses price increases than we normally might The tariff will tend to cause a one-time expect based on the current percentage of imports in the CPI. rise in the overall U.S. price level, the extent of which depends on many variables. As already discussed, the effect on Income Effects domestic prices depends on how foreign A large-scale tariff surely would have prices react to the tariff and on the resulting exchange-rate appreciation. We some effects on domestic and foreign have taken account of these factors in income levels, on real economic activity, making our estimates of the tariff's impact and on employment. Without a more on import prices. Weighting the increase in elaborate econometric model, we are unable import prices according to their importance to estimate the size of these effects, but in the consumer price index (CPI) suggests we can discuss the general direction of their influence. The tariff shifts consumers' that the tariff will add approximately expenditures away from imports to domestically produced goods. This should Table 1 Impacts of a 15 Percent Across-The- Board -Tariff' raise nominal domestic income growth, Long-run estimates Response Short-run estimates but the net impact on real economic $ 35.1 to $ 33.4 $ 32.8 to $ 31.4 Tariffrevenues (billions) activity and employment in the United $ 26.4 to $ 21.7 $ 31.8 to $ 27.8 Consumer burden States is quite uncertain. As we already $6.4 to $9.7 $3.3 to $5.6 Producer burden have indicated, the tariff will induce other $-38.4 to $-46.9 Change in import values $·24.7 to $-34.7 effects that will offset the boost to nominal (billions) income. The impact on real income also $1.3 to $1.3 $1.1 to $1.3 Efficiencylosses (billions) depends on how the tariff will affect prices. $1.0 to $1.1 $1.1 to $0.9 To United States In addition, as the tariff switches $0.2 to $0.4 To foreign producers $0.1 to $0.2 consumers' expenditures toward domes9.7 to 7.4 U.S. import price change (%) 6.6 to 4.5 tically produced goods, it will cause foreign -1.0 to -1.5 -1.6 to -2.0 Foreignprice change (%) income growth to slow. Foreigners Exchange rate change (%) 4.3 to 6.1 6.8 to 8.5 consequently will buy fewer of our exports. a. These estimates are average annual values and allow for exchange-rate feedbacks. The authors will provide Growth and employment among U.S. a description of the estimation technique upon request. export industries would decline. As already indicated, the tariff-induced appreciation of dollar exchange rates would lower According to our model, the efficiency 1 to 2 percentage points to the CPI, but further the growth of the export sector losses associated with the tariff would this estimate could be on the low side. and, as the tariff raised domestic prices, be fairly small, amounting to slightly more The speed and extent to which import it would erode further the export industries' price changes ripple through the economy than $1 billion per year. U. S. consumers ability to compete in world markets. We would incur nearly all of the efficiency depend importantly on the amounts of losses associated with the tariff. In total, unused resources and unused capacity in are unable to discern the net impact of the tariff on domestic growth and employment, the economy. A tariff works by switching U.S. consumers would incur costs associated with the transfer of purchasing consumer expenditures from foreign goods but these income considerations all suggest that the improvement in the to domestically produced goods. With power to the federal government and with current-account and federal-budget deficits the increased inefficiency resulting from unused resources in the economy, could be much smaller than our estimates domestic producers can accommodate this the tariff. suggest.' increase in demand largely through increased output. Prices under these circumstances will rise only modestly. When the economy reaches full employment and capacity limits, however, no additional output is possible; producers then will accommodate the increase in domestic demand through higher prices. The U.S. economy is showing strong and steady growth, as it enters its second year of expansion. GNP is currently above its trend value, suggesting that resources are becoming fully utilized and that price pressures could develop- In such an The model suggests that the U.S. trade deficit would decline approximately $25 to $35 billion in the short run and $38 to $47 billion in the long run. The tariff would be sufficient to reduce the U.S. current-account deficit to a level approximately equal to 2.5 percent of GNP through 1987. These figures consider only the effects of the tariff on imports, but the induced appreciation of the dollar will also raise the foreign -currency price of U.S. exports. Consequently, U.S. exports will also fall, and the resulting improvement in the trade balance will be smaller than our model suggests. 2. The GNP trend is the mid-expansion trend as defined by the Bureau of Economic Analysis, U.S. Department of Commerce. 3. Large-scale econometric model simulations suggest that an across-the-board tariff would reduce real economic activity and raise the unemployment rate moderately. See, for example, Christopher Caton, "The Effects of a Temporary Import Tariff;' Special Studies, Data Resources U.S. Review, March 1985, pp.13-20. The estimates also span two time frames. The decline in the quantity of imports also depends on how sensitive consumers The short run refers to a period of are to price changes in the import market. approximately three years. Some proposals If, for example, there are few domestically for a tariff surcharge would limit the tax produced substitutes for imports, U.S. to a period of three years. The long run consumers will be less sensitive to import- refers to a period longer than three years, in which consumers have adjusted more price increases than if substitute goods are readily available. Immediately following fully to the tariff. It is important to remember that our imposition of the tariff, the resulting price approach considers only the effects of the increases will elicit a relatively small The Effects of a Tariff tariff on imports. The tariff also will affect response from consumers. As consumers Tariffs, which are taxes on imports, raise the dollar prices of goods imported to the discover domestic substitutes for the higher exports through its influence on exchange rates and income levels both here and priced imports, however, their response United States. As prices rise, consumers to the levy will grow. Import sales will abroad. These effects on exports are buy fewer imports. The extent to which discussed in later sections of this Economic drop, and domestic sales will rise. a tariff alters the price and quantities of Commentary, but are not incorporated in imports depends on many things. Three In raising prices and lowering the the results presented in table 1. quantities of imports, the tariff has two important factors are the response of important effects on U.S. consumers. First, exchange rates to the tariff, the behavior The imposition of a 15 percent tariff of foreign prices following imposition of the tax transfers money away from U.S. by the United States would produce a consumers to the government. This money 4 percent to 6 percent appreciation of the the tariff, and the price-sensitivity of is a source of revenue for financing the U.S. consumers. dollar in the short run and a 7 percent federal-budget deficit. While certainly a The ultimate impact of the proposed to 9 percent appreciation in the long run, according to our models. Foreign producers tariff on U.S. consumer prices depends on cost to consumers, this transfer of purwould reduce their prices by approximately chasing power does not represent a net the resulting behavior of exchange rates. As U.S. residents buy fewer foreign goods loss to the country as a whole. The second 1 percent to 1.5 percent in the short run and 1.5 percent to 2 percent in the long because of the tariff, the amount of foreign effect does represent a net cost to the run. U.S. consumers would experience a currencies needed by U.S. consumers to country in the form of a misallocation of purchase those goods will decline, as will resources. Because of the tariff, consumers 7 percent to 10 percent rise in import the volume of dollars supplied to the shift some purchases away from low-cost prices in the short run and a 4.5 percent foreign-exchange market. Consequently, to 7 percent rise in import prices in the foreign producers to high-cost domestic long run. the dollar's exchange rates (the price of producers. The shift in production to a dollars relative to other currencies) will The tariff would raise approximately manufacturer that requires more resources tend to appreciate, making the dollar more to produce a given level of output represents $33 to 35 billion per year in the short expensive in terms of foreign currencies an efficiency loss. This loss is manifested run and $31 to $33 per year in the long and making foreign currencies less run. This revenue would be sufficient to in a lower level of world output and expensive in terms of dollars. The appreci- consumption. reduce the federal- budget deficit by an ation, therefore, tends to reduce the dollaramount equal to approximately 1 percent price of imports. In this way, the dollar's of GNP per year throughout the decade. The Effects on the Import Market appreciation partially offsets the price Of course, this assumes that the federal To consider the quantitative implications government enacts no additional spending effects of the tariff. of a comprehensive tariff, we estimated Tariffs reduce the competitive edge of programs or tax reductions. U.S. consumers the effects of a 15 percent tax levied on foreign products. As sales decline in the would pay most of the tax, but foreign United States, many foreign suppliers will all merchandise imports beginning in 1985. producers would pay roughly $3 to lower their prices. Some will reduce prices, Table 1 provides our results. We incorpo$6 billion in the short run and $6 to because the cost of production falls as rate into these estimates the offsetting $10 billion in the long run. the quantity produced for shipment to the influence of a dollar appreciation. The U.S. market declines. Others will cut prices exchange-rate effects were derived from a model that allows foreign prices to to protect market share in the United respond to the tariff and that assumes the States. As foreign producers lower their prices, they effectively pay part of the value of the dollar is determined solely by trade in goods and services.' Other tariff and help finance the U.S. federalfactors, such as expectations and interest budget deficit from their profits. rates, also influence exchange rates, especially in the short run. Because we are uncertain how the tariff will affect these factors, we could not include their influence in the exchange-rate model. of capital to the United States. These capital inflows have helped to keep the dollar strong in foreign-exchange markets. It might seem that measures to reduce the federal-budget deficit would promote a dollar depreciation, but this is not the case for a tariff, as we discuss below. 1. The exchange-rate model is found in Giorgio Basevi, "The Restrictive Effects of the U.S. Tariff and Its Welfare Value;' American Economic Review, vol. 58 (June 1968), pp. 840·52. environment, the tariff could cause greater Price Responses price increases than we normally might The tariff will tend to cause a one-time expect based on the current percentage of imports in the CPI. rise in the overall U.S. price level, the extent of which depends on many variables. As already discussed, the effect on Income Effects domestic prices depends on how foreign A large-scale tariff surely would have prices react to the tariff and on the resulting exchange-rate appreciation. We some effects on domestic and foreign have taken account of these factors in income levels, on real economic activity, making our estimates of the tariff's impact and on employment. Without a more on import prices. Weighting the increase in elaborate econometric model, we are unable import prices according to their importance to estimate the size of these effects, but in the consumer price index (CPI) suggests we can discuss the general direction of their influence. The tariff shifts consumers' that the tariff will add approximately expenditures away from imports to domestically produced goods. This should Table 1 Impacts of a 15 Percent Across-The- Board -Tariff' raise nominal domestic income growth, Long-run estimates Response Short-run estimates but the net impact on real economic $ 35.1 to $ 33.4 $ 32.8 to $ 31.4 Tariffrevenues (billions) activity and employment in the United $ 26.4 to $ 21.7 $ 31.8 to $ 27.8 Consumer burden States is quite uncertain. As we already $6.4 to $9.7 $3.3 to $5.6 Producer burden have indicated, the tariff will induce other $-38.4 to $-46.9 Change in import values $·24.7 to $-34.7 effects that will offset the boost to nominal (billions) income. The impact on real income also $1.3 to $1.3 $1.1 to $1.3 Efficiencylosses (billions) depends on how the tariff will affect prices. $1.0 to $1.1 $1.1 to $0.9 To United States In addition, as the tariff switches $0.2 to $0.4 To foreign producers $0.1 to $0.2 consumers' expenditures toward domes9.7 to 7.4 U.S. import price change (%) 6.6 to 4.5 tically produced goods, it will cause foreign -1.0 to -1.5 -1.6 to -2.0 Foreignprice change (%) income growth to slow. Foreigners Exchange rate change (%) 4.3 to 6.1 6.8 to 8.5 consequently will buy fewer of our exports. a. These estimates are average annual values and allow for exchange-rate feedbacks. The authors will provide Growth and employment among U.S. a description of the estimation technique upon request. export industries would decline. As already indicated, the tariff-induced appreciation of dollar exchange rates would lower According to our model, the efficiency 1 to 2 percentage points to the CPI, but further the growth of the export sector losses associated with the tariff would this estimate could be on the low side. and, as the tariff raised domestic prices, be fairly small, amounting to slightly more The speed and extent to which import it would erode further the export industries' price changes ripple through the economy than $1 billion per year. U. S. consumers ability to compete in world markets. We would incur nearly all of the efficiency depend importantly on the amounts of losses associated with the tariff. In total, unused resources and unused capacity in are unable to discern the net impact of the tariff on domestic growth and employment, the economy. A tariff works by switching U.S. consumers would incur costs associated with the transfer of purchasing consumer expenditures from foreign goods but these income considerations all suggest that the improvement in the to domestically produced goods. With power to the federal government and with current-account and federal-budget deficits the increased inefficiency resulting from unused resources in the economy, could be much smaller than our estimates domestic producers can accommodate this the tariff. suggest.' increase in demand largely through increased output. Prices under these circumstances will rise only modestly. When the economy reaches full employment and capacity limits, however, no additional output is possible; producers then will accommodate the increase in domestic demand through higher prices. The U.S. economy is showing strong and steady growth, as it enters its second year of expansion. GNP is currently above its trend value, suggesting that resources are becoming fully utilized and that price pressures could develop- In such an The model suggests that the U.S. trade deficit would decline approximately $25 to $35 billion in the short run and $38 to $47 billion in the long run. The tariff would be sufficient to reduce the U.S. current-account deficit to a level approximately equal to 2.5 percent of GNP through 1987. These figures consider only the effects of the tariff on imports, but the induced appreciation of the dollar will also raise the foreign -currency price of U.S. exports. Consequently, U.S. exports will also fall, and the resulting improvement in the trade balance will be smaller than our model suggests. 2. The GNP trend is the mid-expansion trend as defined by the Bureau of Economic Analysis, U.S. Department of Commerce. 3. Large-scale econometric model simulations suggest that an across-the-board tariff would reduce real economic activity and raise the unemployment rate moderately. See, for example, Christopher Caton, "The Effects of a Temporary Import Tariff;' Special Studies, Data Resources U.S. Review, March 1985, pp.13-20. Additional Adverse Effects Although the tariff surcharge could help reduce the federal- budget deficit and the current-account deficit, it also would reduce U.S. exports because the tariff would promote a dollar appreciation and would reduce foreign income growth. The adverse repercussions on U.S. export industries would be especially serious if foreign governments retaliate. An attractive feature of an across-theboard tariff is that part of its burden falls on foreign producers, if they lower the prices of goods shipped to the U.S. market. This, however, is the most dangerous aspect of the proposal. If foreign governments view the tariff as a politically motivated attempt to shift the burden of financing U.S. budget deficits abroad, instead of incurring the domestic costs of trimming expenditures and raising taxes, they might retaliate by blocking the sale of U.S. exports in their markets. Many of our trading partners also have relatively large government budget deficits and could decide that if a tariff is an acceptable budget-trimming tool for the United States, Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, OH 44101 Address Correction Requested: Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101. it could work well in their countries. If retaliation were to result, the tariff jeopardizes the growth and continued development of some of our most efficient and rapidly growing industries, such as computers and aircraft. Moreover, retaliation would fall especially hard on already depressed U.S. agricultural exports, which are often a target of foreign protectionist measures. When talking about a tariff surcharge, we speak of imports as if they were a homogeneous group of products from a single foreign producer. In fact, we import myriad items from many different countries. It might not be in our best interest to tax all of these items according to the same rate. Some imports are important in the production process of domestic industries and lack domestic substitutes. Taxing such items could impair the ability of domestic industries that use imported materials to compete in world markets. It also might not be in our best interest to tax the exports of less-developed debtor nations. Despite the numerous financial arrangements lenders have provided to ease the burden of repaying international debts, debtor countries ultimately must run export surpluses if they are to repay their debts. Under International Monetary Fund austerity programs, these nations have greatly reduced their imports from the United States, but they cannot reduce their imports below the minimum level needed to support their economies. It is especially important, therefore, that these nations expand their export markets. Because the United States is the largest national market in the world, an across-the-board tariff would greatly handicap such efforts. The analysis presented in this Economic Commentary does not recommend the surcharge as an efficient policy option. Although such a tariff would help lower both the internal and external deficits, it would have adverse effects on dollarexchange rates and could easily invite foreign retaliation. Much of the burden of a tariff surcharge would settle on U.S. consumers and U. S. export industries. BULK RATE US. Postage Paid Cleveland, OH Permit No. 385 Federal Reserve Bank of Cleveland March 15, 1985 ISSN 0428-1276 ECONOMIC COMMENTARY The United States is currently experiencing the strongest economic recovery since the Korean War, with virtually no increase in the rate of inflation. Uncertainties associated with persistently large federalbudget deficits, and with internationalpayments imbalances, however, cloud the outlook for continued prosperity. The federal-budget deficit will equal approximately $210 billion in the current fiscal year, representing 5.4 percent of Gross National Product (GNP). In the absence of significant budget-cutting measures, the deficit will remain in the neighborhood of 4 percent to 5 percent of GNP throughout the decade. During the 1970s, the federal-budget deficit averaged slightly more than 2 percent of GNP; during the 1960s, a decade of rapid capital accumulation, the deficit averaged less than 1 percent of GNP. As the economy continues to expand, and as private credit demands continue to firm, hefty federal credit needs could place increasing pressure on interest rates and could threaten the continued growth of the interestsensitive sectors of the economy. Meanwhile, the current-account deficit reached a record $102 billion, or 3 percent of GNP, in 1984. The current-account balance measures our net international trade in goods and services plus U.S. unilateral transfer payments to foreigners. The authors are economists with the Federal Reserve Bank of Cleveland. They would like to thank Peter Isard for his helpful comments. The views stated herein are those of the authors and not necessarily those of the Board of Governors of the Federal Reserve System or of the Federal Reserve Bank of Cleveland. Many analysts regard the current-account surplus or deficit as the most useful summary statistic of the nation's gains or losses from international commerce. Throughout most of the post-World War II period, the United States has run a currentaccount surplus. Most observers expect the current-account deficit to remain in the neighborhood of 3 percent of GNP at least through 1987. The large currentaccount deficit bears witness to the substantial gains foreign competitors have made recently against U.S. firms in domestic and world markets. Recently, some policymakers have expressed interest in the possibility of using an across-the-board tax on imports to reduce the federal-budget and currentaccount deficits. Proponents of a tariff surcharge argue that the levy would reduce US. imports, thereby lowering the currentaccount deficit, while raising revenues to reduce the federal-budget deficit. In this Economic Commentary, we examine the possible effects of an across-the-board tariff and estimate its costs. The Current International Environment Economic theory and centuries of economic history have taught that nations engaged in international trade reap substantial benefits in terms of the quantity and diversity of products available for consumption. Trading nations have always prospered more than nations that have Will Taxing Imports Help? by Michael F. Bryan and Owen F. Humpage closed their borders. Recent experience has demonstrated, however, that the benefits of international trade are not always evenly distributed. The United States is currently experiencing a record current-account deficit, much of which is attributable to the 72 percent appreciation of the dollar since 1980. A dollar appreciation lowers the dollar-price of U.S. imports and raises the foreign-currency price of exports. A dollar appreciation benefits consumers and importers, but hurts US. industries that compete against imports and that sell goods in foreign markets. Many analysts cite the federal-budget deficit as one important factor contributing to the dollar's strength. The relationship between the federal-budget deficit and exchange rates is neither simple nor direct. It relies on the deficit's tendency to raise domestic interest rates and to attract foreign capital, which depends crucially on the behavior of private savings and investment both here and abroad. Heavy federal borrowing is consuming a record peacetime share of the private savings available to finance private credit needs in the United States, and is helping to keep U.S. interest rates above levels they otherwise would have attained. With credit demands relatively weak abroad, the attractive return on dollar-denominated assets has encouraged heavy net inflows