The Physiocratic Platform: Tariffs

A Return to the American System of Taxation

If taxation is to be morally legitimate, then (a) it must be in service of a morally legitimate government; (b) it must be imposed in a manner that is reasonably related to the government’s services; and (c) its cost should be born, not by “the poor” or “the rich” per se, but rather by those who benefit from its services.

The first principle dictates the type of governments that can legitimately impose taxes; the second principle dictates what types of taxes those governments can rightfully use; and the third principle dictates who can be charged those taxes and how much they can be charged. The physiocratic theory is effectively neutral about whether a tax should be “progressive” “flat” or “regressive.”

If we follow the American tradition that men establish governments in order to secure their rights, then any morally legitimate government must provide services related to securing those rights. It seems to me that the services of such a government can be reduced (at a bare minimum) to four:

1. Maintaining peaceful transfer of power over time;

2. Protecting the person and property of citizens of the state from violation;

3. Securing the state’s borders from incursion and invasion; and

4. Upholding the legitimate contracts made by the state’s citizens.

Obviously a government surely can do other things, and most governments do many other things, but a government that cannot do what’s necessary to provide these four services will be a government that fails its necessary purpose.

If these are the necessary purposes of government, and if taxation must be reasonably related to these purposes, then the scope of taxation is necessarily limited. Working from this core of four services, I have identified four taxes that can be imposed in a manner that is reasonably related to those services and paid by those who benefit from them. These four taxes are:

• Poll taxes

• Land-value taxes

• Tariffs

• Transaction taxes

In last week’s essay (the first installment in this series), we discussed poll taxes. Now we will turn our attention to tariffs.

Tariffs

The physiocratic platform entails a 30% tariff on all imported goods levied at the border. This would apply uniformly across all countries and industries, without exceptions or loopholes. In order to avoid “shocking the system,” it could be implemented over a 5-year period, with a 6% tariff in the first year, a 12% tariff in the third year, and so on.

In the physiocratic platform, tariffs are intended to fund the government’s efforts to secure the borders from incursion and invasion. Therefore, the revenue would be earmarked specifically for the Department of Defense, Department of Homeland Security, and other agencies responsible for national security.

Historical Precedent

Historically, tariffs were one of the primary ways the U.S. government funded its operations, as well as one of the primary policy tools the U.S. government deployed to build the nation.

During the heyday of the American School of Economics in the mid-to-late 19th century, the United States operated what it called the American System, which maintained relatively high tariffs to protect domestic industries and promote economic development. This period, particularly under the leadership of figures like Henry Clay and Abraham Lincoln, saw tariffs as a crucial tool. The most notable tariffs during this time were:

1. Tariff of 1828: This tariff had duties as high as 45% on imported goods, particularly targeting British manufactured goods, to protect nascent American industries, especially in the North. The Tariff of 1828 was a cornerstone of the American System, which fostered industrial development in the nascent nation.

2. Morrill Tariff of 1861: This tariff significantly increased duties on imported goods, raising them from an average of 20% to between 35-48%. It was enacted just before the Civil War and was designed to protect Northern industries, which were crucial to the Union's war effort. After the war, this protective stance continued as a means to promote industrialization.

3. McKinley Tariff of 1890: Named after Congressman William McKinley, this tariff further increased rates to nearly 50% on some imports, maintaining the protectionist stance well into the late 19th century. The rationale was to support domestic manufacturers and workers, keeping foreign competition at bay.

Overall, during the height of the American School, U.S. tariffs averaged between 25% and 50%, depending on the period and the types of goods. The tariff was both the chief source of revenue and the centerpiece of the country's industrial policy until the early 20th century, at which time the income tax was introduced and free trade policies were implemented.

The United States was not the only country to industrialize under a protectionist tariff. In fact, every manufacturing powerhouse in history has utilized tariffs:

• United Kingdom: Although the UK is often seen as the birthplace of free trade, this was only after it had developed a global manufacturing supremacy. During the 18th century, the UK heavily protected its industries through Navigation Acts and other mercantilist policies. Only once Britain became the "workshop of the world," did it begin to advocate for free trade, thereby opening up markets for its manufactured goods while importing cheap raw materials.¹

• Germany: In the late 19th century, under Otto von Bismarck, Germany adopted protectionist tariffs to foster its industrial development. This protection helped Germany quickly catch up to Britain in industrial power, focusing on sectors such as steel and chemicals.

• Japan: After the Meiji Restoration (1868), Japan used tariffs and other forms of protectionism to nurture its industries. Japan kept out foreign competition until it had built a strong industrial base, particularly in shipbuilding, steel, and textiles. Post-World War II, Japan has maintained informal protectionist measures to allow its industries to dominate global markets.

• South Korea and Taiwan: These countries followed a similar path during the latter half of the 20th century. They employed tariffs and other protectionist policies to develop domestic industries such as electronics and automobiles. South Korea, in particular, restricted imports and focused on export-led growth, all the while protecting and nurturing key industries.

• China: Beginning in the late 20th century, China used a mix of state planning and tariff protections to develop its industrial sectors. While China joined the World Trade Organization (WTO) in 2001 and has since embraced aspects of free trade, it initially relied on tariffs and other protective measures to foster domestic industries like electronics, steel, and consumer goods.

Why does this matter? Because virtually every mainstream economist today insists that tariffs are destructive and that their implementation will destroy the United States. The historical evidence completely discredits that claim. Not only have great powers survived high tariffs, they have flourished under them.

Funding Required

For the most recent fiscal year 2024, the budgets for the Department of Defense and Department of Homeland Security are as follows:

1. Department of Defense: The total budget for the DoD is approximately $842 billion for FY 2024. This includes funding for personnel, operations and maintenance, procurement, research and development, and other defense-related activities.

2. Department of Homeland Security (DHS): The budget for the DHS is approximately $103 billion for FY 2024. This budget covers various agencies under DHS, including Customs and Border Protection (CBP), Immigration and Customs Enforcement (ICE), the Transportation Security Administration (TSA), FEMA, and the Coast Guard, among others.

In total, the combined budget for the Department of Defense and Department of Homeland Security is roughly $945 billion annually. While that is only a fraction of the Federal Government’s total spending, it’s the only portion we’ll be paying for with the tariff.

Initial Revenue Estimate

According to the Bureau of Economic Analysis, in 2023 the total value of U.S. imports was approximately $3.11 trillion for goods and $714.5 billion for services, bringing the total to around $3.83 trillion.

If the U.S. continued to import $3.83 trillion worth of goods and services annually, a 25% tariff would generate $950 billion in revenue. This would be more than sufficient to cover the $945 billion annual budget of the DOD and DHS and be less than our planned 30%.

OK, good job everyone. Essay’s over.

I kid, I kid. It’s not so simple. It’s not at all clear that the U.S. actually would continue to import $3.83 trillion in goods and services if there were a 25% tariff. If not, what would actually happen if we returned to our historical tariffs on imports? And who exactly would pay for the tariffs?

Economic Implications of the Tariff

As with all things economic, the implications of a policy decision are multi-factorial, with second-order, third order, nth-order implications that are neither obvious nor intuitive. Economists of every school would agree on the likely first order effects, but beyond that, opinions begin to diverge sharply. A Neoclassical economist would anticipate third- and fourth-order implications that were highly destructive, while an American School economist would expect productive and constructive effects.

It would require another essay, or even a book, to explain why the American School is right and the Neoclassical school is wrong on tariffs. Fortunately, I’ve already written that essay and Ian Fletcher has already written that book. If you are unfamiliar with the American School of Economics and the American System that transformed us into an industrial powerhouse, or in general are not familiar with the robust arguments against neoliberal free trade, I refer you to my article Against Free Trade, which includes my own thoughts and references to Mr. Fletcher’s book.

For now let’s set aside the theoretical debate and simply review it mathematically.

Tariff Pass-Through

Critics of tariffs often make a simplistic analysis in which a 25% tariff means that consumer prices on imported goods increase by 25%. That is not the case. Only a portion of the price increase from the tariff is passed through to importers and only a portion of that price increase is passed on to consumers. The exact percentage is known as the pass-through rate.

Unfortunately, experts do not agree at all on what the pass-through rate actually is. I’ve read estimates that range from 0% to 100%! To help us understand, let’s (as usual) build a toy model.

Imagine that Shandong Iron & Steel Ltd. is selling steel to Ford Motor Company at a market price of $700 per ton. Ford, in turn, uses that steel to manufacture automobiles. Let’s say that Ford’s cost to manufacture is $12,000 per automobile. Of this cost, 15% is the cost of steel, or $1,800. Ford then sells its to car dealers for $20,000, who in turn sell the car for $22,000.

Now imagine that the U.S. imposes a 25% tariff. A tariff is (legally speaking) paid for by the importer, not the exporter. Thus, when Ford purchases Shandong steel for $700, it will have to also pay ($700 x 25%) = $175 in customs duties to the U.S. government. Ford’s price for Shandong steel is thus effectively $875. In other words, Ford’s cost for steel increases 25%.

The cost of steel per car increases by 25% from $1,800 to $2,250. Ford’s cost of goods rises by 3.07% to $12,450. To maintain its markup, it sells to the car dealers for $20.750. They, in turn, mark up 10% to $22,825. So the consumer pays 3.75% more.

But it needn’t necessarily happen that way. Imagine that Ford’s rivals all source their steel from domestic manufacturers, so their cost of goods hasn’t gone up. Ford, in that case, cannot just raise prices on its cars, because it will lose market share to its lower-priced competitors. In this case, Ford might simply reduce its margins by $450.

But if Ford’s rivals are able to buy domestic steel, Ford might be able to buy domestic steel, too! In that case, Ford might demand that Shandong reduce its price or sell its steel DDP (Delivered Duty Paid). In this case, Ford would still pay $700 per ton, while Shandong would pay the $175 tariff out of its margins.

Thus even from this toy model, you can see why the pass-through rate might range from 0% to 100% of the tariff rate!

What generally happens in the real economy is a combination of all of the above. Importers pay the tariff partly by raising prices to consumers, partly by securing lower prices from exporters, and partly by accepting lower profits on imported goods. Both consumers and importers also seek out domestic substitutes to avoid the burden of the tariffs.

A study by the New York Fed found that across all industries, a 10% input tariff (that is, a tariff on the intermediate inputs to manufacture a good) raised overall consumer prices by 2.3%, for a 23% pass-through rate. However, for purposes of this article, we will assume a 100% pass-through rate.

Increase in Costs

Over the last decade the value of U.S. imports has been about 15% of total GDP every year except 2020 (when it dropped to 13%). However, a substantial portion of US GDP is in non-importable services such as healthcare (18% of GDP), housing (16% of GDP), and education (7% of GDP).

Therefore personal consumption expenditure on apparel, food, personal care products, recreational goods and services, and transportation account for around $7.5 - $8 trillion or 30% - 33% of our $24 trillion GDP. That, in turn, means that the value of imports ($3.83 trillion) is actually around 50% of personal consumption expenditures!

In other words, we import about half of everything we eat, wear, and use.

Let’s assume that the pass-through rate on the tariff is the absolute worst case 100%, such that every 1% increase in the tariff is a direct 1% increase in consumer prices. How much will the cost of living increase overall?

Well, personal consumption expenditures excluding healthcare, housing, and education account for approximately 40% of U.S. household expenditure. The impact of a 25% tariff at 100% pass-through would thus be to increase the cost of living by (40% of expenditure) x (50% imported) x (25% tariff) x (100% pass-through) = 5% overall. This effects would occur almost immediately.

While a 5% increase in cost of living is substantial, it is far less than the cost of living increase that Americans have endured under the Biden Administration’s inflationary policies. And it would come with a broad reduction in overall household taxation. Thus, even absent the beneficial effects predicted by the American School of economics, the tariff’s cost of living surcharge could be absorbed by American households simply by virtue of the decrease in taxes they would pay on payroll, income, property, and more.

Remember — this is worst case. If the pass-through rate were only 50%, then the increase in cost of living would be 2.5%. If it were only 23% (as above), then the cost of living increase would not even be 1.25%.²

Decrease in Imports

When the price of imports increases, the demand for imports decreases. Remember our toy model - Ford switched from Chinese steel to American steel to avoid paying a 25% tariff on the imports. But by how much do tariffs decrease the volume of trade? This value, known as the elasticity of trade, is the subject of substantial debate.

Prior to the 2018 Trump tariffs, some mainstream economists asserted that elasticity ranged from 2 to 5, such that a 1% increase in tariffs would lead to a 2% to 5% decrease in the volume of imports. These neoliberal scaremongers argued that e.g. a 10% tariffs on $10 billion in imports would reduce imports down to between $5 and 8 billion. Obviously, if the elasticity of trade were that severe, a tariff would be incredibly destructive to volume of trade.

However, empirical data from Trump’s 2018 tariffs now proves otherwise. For Chinese products subject a 7.5% tariff, imports dropped by only 3%. For Chinese products subject to a 25% tariff, imports dropped by 22%. This suggests an elasticity of trade of less than 1! If elasticity of trade is just 0.4 to 0.88, then even a substantial tariff still leaves a substantial volume of trade.

A similar outcome is observed in the steel industry. After a 25% tariff was enacted on foreign steel, overall steel imports declined from 34.5 tons in 2017 to 26.3 million tons in 2019. That’s a 23% reduction, for an elasticity of trade of 0.92.

The elasticity of trade of a broad tariff, like the one imposed by physiocracy, is likely to be much less. Why? Let’s think it through. If a tariff only applies to China, then importers can just import from e.g. Vietnam instead; the tariff will appear to have a substantial effect on the volume of imports, but all that has actually happened is that Vietnamese imports have replaced Chinese imports. (The study of the Trump tariffs proves just this.) Likewise, if a tariff only applies to imported coffee, then as coffee prices rise and consumer demand goes down, imports will switch to importing tea instead, and the tariff will appear to have a substantially impacted trade volume when in fact it has just changed it.

A broad study by the New York Fed to calculate average import tariffs by averaging across countries and Harmonized Tariff Schedule (HTS) product codes using 2017 import weights, found that average tariffs had increased from an average of 1.6 percent to 3.3 percent. During this time, the total volume of imports decreased by just 0.4%. Thus a 1.6% percent increase in tariff caused a 0.4% decrease in volume, for an elasticity of trade of just 0.25.

For our purposes, we will assume an elasticity of trade of 0.5, such that a 1% increase in tariffs reduces the total value of imports by 0.5%.

Increase in Wages

According to mainstream economists, tariffs reduce the gains of trade, ultimately reducing production, productivity, wages, and GDP. Virtually no neoliberal will ever support any type of protectionist or revenue-generating tariff.

The problem with the neoliberal narrative, however, is that it assumes Ricardian free trade, where gains from trade are derived by comparative advantage. In the absence of Ricardian free trade, manufacturers (indeed, all companies) are incentivized to engage in international arbitrage, whereby capital is sent overseas to exploit cheap labor .³

That capital has been sent overseas to exploit cheap labor is at this point undeniable; the U.S. has grossly deindustrialized, with its once-proud manufacturing leadership now a decades-gone memory. However, neoliberal economists would assert that the cause was not free trade but rather, e.g. over-regulation of U.S. industry, unjustifiably high U.S. wages, and so on. What such answers boil down is that the U.S. could have remained competitive with third-world labor if our workers were willing to be paid like third-world labor.

The American School economists see the situation quite differently. They reject the idea that protection reduces productivity and growth. Tariffs, by protecting domestic manufacturing, tend to increase productivity, wages, and GDP. In The Harmony of Interests, the American School economist Henry Carey summarizes the American view:

Two systems are before the world… One looks to the continuance of that bastard freedom of trade which denies the principle of protection… the other to extending the area of legitimate free trade by the establishment of perfect protection… One looks to underworking the Hindoo, and sinking the rest of the world to his level; the other to raising the standard of man throughout the world to our level. One looks to increasing the necessity of commerce; the other to increasing the power to maintain it. One looks to pauperism, ignorance, depopulation, and barbarism; the other to increasing wealth, comfort, intelligence, combination of action, and civilization… One is the English system; the other we may be proud to call the American system.

For purposes of this article, we will assume that the impact of the tariff is neither as good as the American School might hope nor as bad as the neoliberal economists might fear, and ignore this effect from our analysis.

Decrease in Exports

Free trade is, at least in neoliberal theory, a bilateral relationship, in which Country A and Country B eliminate obstacles to trade and thereby unlock the positive-sum gains of trade arising from comparative advantage. Thus, when the U.S. imposes tariffs on imported goods, neoliberal theory predicts that other countries may retaliate by imposing tariffs on U.S. goods.

In this case, neoliberal theory is right — tariffs are generally met by counter-tariffs in retaliation. However, this is an issue of little concern to us, relatively speaking. Because of the massive size of the United States, its huge population, its abundant resources, and its consumer-driven economy, exports play a relatively small role in our economy. US exports currently stand at just $2.0 trillion, with the top export being fossil fuels (16% of total or $323 billion).

This is not to trivialize the matter, only to assert that the cost of a trade war for the United States is far less than the cost is to a country whose economy is built on exportation rather than domestic consumption.

So where does that leave us?

Revised Revenue Estimate

If the U.S. import $3.83 trillion worth of goods and services at 0% annually, and the elasticity of trade is 0.5, then a 25% tariff would reduce imports by 12.5% ($0.48 trillion) down to $3.35 trillion. That in turn would reduce the income of the tariff to $837.5 billion - not enough to cover the $945 billion annual budget of the Department of Defense and could also fund Homeland Security and related functions.

Therefore, for the physiocratic tariff to meet its goal, it needs to be higher. The 30% tariff would reduce imports by 15% ($0.58 trillion) down to $3.25 trillion. From $3.25 trillion, the 30% tariff would then generate $975 billion in revenue - and that is enough to cover the budget.

With $3.35 trillion of imports against personal consumption expenditure of $7.5 trillion, imports would now account for 48% of personal consumption expenditures. Since we assume 100% passthrough, the entire cost of the tariffs would be passed through to consumers. The impact of the 30% tariff at 100% pass-through would thus be to increase the cost of living by (40% of expenditure) x (48% imported) x (30% tariff) x (100% pass-through) = 5.76% overall.

In last week’s essay, we calculated that the median taxpayer pays (directly and indirectly) between 33% and $40% of their income in taxes.⁴ The 30% tariff would be (effectively) a 5.76% tax on total income. The poll tax we introduced last week imposed an effective 2.1% tax. Thus the total tax so far is 9.86% of median household income.

What about bottom quartile taxpayers? These households pay somewhere between 15% and 24% of their income to the government, either directly or indirectly.⁵ The 30% tariff would be (effectively) a 5.76% tax on total income. The poll tax we introduced last week imposed an effective 7.6% tax. Thus the total tax so far is 13.36% of bottom quartile income.

The remaining two taxes (land value tax and transaction tax) will fall most heavily on high-income taxpayers. We seem to be on track to a tax system that considerably lightens the taxpayer burden for middle-class households while paying for all essential government services.

1. To understand British policy in this regard, remember that Ricardian free trade theory assumes that capital (investment) and labor (manpower) is fixed. Each country’s economic actors can choose where to invest their capital and where to allocate their labor, and (per Ricardo) ought to do so in those sectors where their country has comparative advantage over other countries. Britain, by being the first to industrialize, had comparative advantage in manufacturing; being a small and resource-poor island, it had comparative disadvantage in securing natural resources. If Great Britain had managed to convince the rest of the world to adopt Ricardian free trade, then all the other countries would (by the law of comparative advantage) have specialized in exporting Britain their resources, while Britain would have stayed specialized in exporting manufactured goods - a trade that was guaranteed to maintain Britain’s industrial supremacy.

But Great Britain did not succeed in promulgating free trade theory. It is because the US and Germany did not fall for this trap in the 19th century that they superseded the UK in industry in the 20th. After Great Britain declined in power, America became the world’s chief proponent of free trade theory, and for the same reason; and, again, it is because China did not fall for this trap in the 20th century that it superseded America in the 21st.

2. As an aside, the fact that so much of the American household’s income is consumed by housing, healthcare, and education is of course a gross misallocation caused by governmental dysregulation, debt-based financial capitalism, and so on. A healthier economy would allow Americans to enjoy much more discretionary income on goods and services they want, rather than goods and services they need just to survive.

3. It is extremely important to understand that the labor arbitrage that occurs under contemporary globalism is not what Ricardian free trade theory predicts. Ricardian free trade theory assumes that labor and capital are fixed, such that each nation directs its domestica capital and domestic labor into those industries where it has comparative advantage. Under contemporary conditions, neither labor nor capital are fixed, and free trade causes massive migration of capital and labor to conditions of absolute advantage.

4. For median (middle-income) taxpayers, with a household income of $74,580 per year, the federal income tax rate is around 12% - 15%. Payroll taxes are another 7.65%. State income taxes are another 5% - 7%, sales taxes about 5%, property taxes about 2% - 3%, and excise taxes about 1% - 2%.

5. For bottom-quartile taxpayers, with a household income of $20,000 per year, the federal income tax rate is between 0% and 5%. Payroll taxes are 7.65%, sales taxes are about 5% - 7% of income, property taxes (paid indirectly to the landlord) about 1% - 2%, and excise taxes about 1% - 2%.