Reciprocal Tariffs Should India Respond?

As of yesterday, the Office of the United States Trade Representative (USTR) has published the formula by which the change in US tariffs (and hence reciprocal tariffs, RT) are to be calculated. At the same time, the New York Times has published what the formula implies for tariffs ranging from 34 percent (average) for China to 26 percent for India and 20 percent for the EU and so on. These are 50 percent of what the RT should actually be and indicates “magnanimity” on the part of Trump. From all indications, these represent the percentage by which US tariffs must increase to balance bilateral trade. Israel has already responded (though it is excluded from the RT calculations) by unilaterally eliminating all tariffs on US imports. On the other hand, it is not clear how countries likely to face much higher tariffs should respond. Should one retaliate? Should one do nothing? How should India respond? These are some of the questions I will take up here.

But first some other issues should be clear. Keep in mind that the proposed tariffs are on commodity trade. As I have argued extensively (see Mint, Jan 20) the US does not today have the impact on trade it had even 20 years ago. In simple terms, US import demand today constitutes only about 13 percent of world demand for commodities. Even if one adds the fact that some countries like China and the EU have routed their exports via Mexico and these would also fall with the RTs, the total US (direct and indirect) share of world imports would not go above 15 percent. This is a far cry from the direct US share in world imports of about 20 percent in 1990. And a still further cry from the US share in 1950 of about 60 percent. Historically two things have happened. One, rising wage costs have led to a decline in the developed world’s production of manufactured goods (as trade theory rightly predicts) with production shifting to low wage countries. The resulting decline in import prices has led to a rising standard of living in these countries particularly in those (like the USA) which have kept their import duties low. This is precisely why the US has the highest standard of living today as compared to other OECD countries: their import duties on manufactures are the lowest. The new pattern of production led to the high trade between China and the US: China assembled products with low wage costs with inputs from East and Southeast Asia and shipped them to the US and other OECD countries. This “assembly pattern” of world production has been highly beneficial to the US in particular.

Second, the structure of production in the developed world has shifted to services in response to higher wages. Today the service sector is far less labour using than the manufacturing sector. The digital technological revolution since about 2000 has meant that unskilled labour (the Trump constituency) can be substituted by technical increases in productivity. This has also been an economic response to declining fertility rates in all developed countries leading to a decline in their labour force.

So here is the conundrum. For one, the US just doesn’t have the economic clout to enforce submission by other countries as it did in say in the 1950s. This I had discussed in detail (see, Mint, 18 April). In any case, as the above discussion shows, any US success would result in persistent higher inflation as the economic factors leading to a change in the pattern of production and trade in the USA was not caused by protectionism but by long-term structural change. Since countries like the EU, Japan, China etc. are likely to retaliate, the harm to US consumers and companies may well be irreversible.

What about the USTR formula? As indicated in the NYT, the RT calculation is simple. Dividing the trade deficit by the value of imports gives you the US tariff. Half that gives what the increase in US tariff should be. Sounds extremely simplistic since there is no reference to import price response to tariffs or import demand elasticities. A closer look at the derivation of the formula used by the USTR reveals the truth: if one assumes (as has been done) the right values for both, these elasticities become irrelevant, and a simple division gives you the proposed tariff. To look at the values taken, for the two elasticities, assume the first is 0.25 and the second is 4, then the product is 1! So they disappear from the calculations and we get the change in tariff as deficit divided by the import values!

Bottom line? A retaliation will certainly lead to some disruption as in the 1930s but the consequences will be nowhere as severe given the emergence of new trading blocs and the diminished US clout in world commodity trade. What should India do? First suggestion is to do nothing. The USTR formula suggests a 26 percent tariff increase. Since this implies an average increase, it’s best to wait for the trade agreement to figure out how the average can be worked out and still protect some political interests. Suitable choice of averages can still protect political interests.

Bottom line? This is one war only the USA can lose.

Manoj Pant
Visiting Professor, Shiv Nadar University