Why a trade war with China would hurt the U.S. and its allies, too

U.S. President Donald Trump, flanked by ?Commerce Secretary Wilbur Ross, U.S. Trade Representative Robert Lighthizer, White House Homeland Security Advisor Tom Bossert, Assistant to the President Peter Navarro and Deputy Assistant to the President for International Economic Affairs Everett Eissenstat, delivers remarks before signing a memorandum on intellectual property tariffs on high-tech goods from China, at the White House in Washington, U.S. March 22, 2018. REUTERS/Jonathan Ernst - RC153113ADA0

Two-thirds of world trade now occurs through global value chains that cross at least one border during the production process, and often many borders. As a result, the typical “Chinese product” that the United States imports has a lot of value-added from countries other than China. It often has value-added from U.S. firms with operations in China, as well as from parts suppliers in Japan, South Korea, and Taiwan. Hence, in any trade war between the United States and China, there will be collateral damage on third countries.

The United States has published its list of products from China that would be hit with 25 percent tariffs in response to the investigation under Section 301 of the 1974 U.S. Trade Act, which authorizes the president to respond (including via retaliation) to a foreign government action that violates an international trade agreement and that burdens or restricts U.S. commerce. There will now be a 60-day comment period before any tariffs go into effect.

The 301 investigation examined China’s unfair trading practices and, in particular, issues of intellectual property theft and forced technology transfer for U.S. companies operating in China. In choosing which imports to punish, Washington faces a dilemma. On the face of it, it would make sense to target high-tech industries that benefit from technology transfer. However, these tend to be the industries in which Chinese value-added has the lowest share. In the case of computers and electronic equipment, for example, less than half the value added in Chinese exports comes from China. The rest is value-added imported from other countries, including the United States. It should also be noted that these industry classifications are quite broad. Within computers and electronic equipment, there is a vast array of different products. Some of the products exported from China have very little domestic value-added, less than 10 percent.

Furthermore, in computers and electronics, more than half of China’s exports come from multinational firms operating in China. This is a separate issue from domestic versus foreign value-added. The operations of multinationals in China will count as Chinese domestic value-added. But the firms earn substantial profits from these operations, and that is a benefit for U.S. and other foreign owners. China’s industrial policies are often aimed at building up China’s state-owned enterprises (SOEs). But these firms hardly export at all. In 1995, SOEs accounted for almost half of China’s exports; by 2015 that figure had dropped to low single digits.

There are some sectors in which China’s exports consist primarily of domestic value-added. These tend to be old industrial sectors. In textiles, for example, 75 percent of value added is really “made in China.” If Washington wants to limit collateral damage on its own firms and third countries, then it makes sense to go after an old sector like textiles.

U.S. firms are also involved in production chains. Thirty-seven percent of U.S. imports from China are intermediate products used by American firms to make themselves more competitive. Putting tariffs on intermediate products is shooting oneself in the foot. The list of targeted products posted by the United States includes some intermediates, such as aircraft propellers.

Many of the targeted products are consumer goods such as televisions and dishwashers. When a large country such as the United States imposes tariffs, the pain is shared between consumers who pay higher prices and producing firms abroad who have to absorb lower profit margins.

What all this means is that tariffs are a very poor instrument for punishing China for any unfair trading practices. Some of the cost will be borne by American consumers; some by American firms that either produce in China or use intermediate products from China; some by firms in countries (mostly U.S. allies) that supply China; and some by Chinese firms (mostly private ones).

If the United States proceeds with the 301 tariffs, China can be expected to retaliate based on its past behavior. In fact, it quickly published its own list, including penalizing U.S. soybean and aircraft exports. The same analysis can be applied to Chinese retaliatory tariffs. Chinese consumers will pay more for soybeans and products like pork that rely on soybeans. Chinese airlines will be less productive if they cannot buy American aircraft. It happens that these U.S. exports have mostly domestic content, so that most of the pain felt by producers will be within the United States, not in third countries.

Overall, tariffs are the wrong instrument to address the U.S.-China trade issues. Tariffs will cause a lot of unnecessary pain for consumers and third countries, not to mention American firms caught in the crossfire.