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We are extremely grateful to Lorenzo Caliendo for sharing some of his codes and for many insightful conversations, and to Nigel Chalk, Rupa Duttagupta, Martin Kaufman, Daniel Leigh and Brad McDonald for extensive discussions. We would also like to thank Helge Berger, James Daniel, Ben Hunt, Florence Jaumotte, Koshy Mathai, Susanna Mursula, Jay Peiris, Roberto Piazza, Rafael Portillo, Marika Santoro and various IMF seminar participants for constructive comments. All errors are ours.
CRC present a number of quantitative trade models, the most complex of them having the same features as CFRT: firm heterogeneity, imperfect competition, and intermediate-input trade.
See footnote 11 and eq. (10) in CFRT; see also Section 5 of the online Appendix in CRC. CRC argue for the simpler approach of modeling tariffs as cost shifters given lack of evidence of whether tariffs affect revenues or costs (see footnote 30 in CRC). Clearly, ad-valorem tariffs apply to the final price of goods, so that having them as revenue shifters appears to be the only realistic modeling approach (except for the case of perfect-competition models, in which price equals marginal cost and this modeling choice is therefore irrelevant).
The fact that economies of scale may generate specialization is well known. What is problematic is that this result (a) appears to be non-generic, as it vanishes once an elasticity of substitution between home and foreign goods is just above unity, and (b) shows up under relatively mild changes in trade policy. For example, in a 28-sector and 15-country application of the monopolistic competition models by CRC using standard elasticity estimates, a 25 percent increase in U.S. auto tariffs leads to a 100-percent drop in total Canadian auto exports. These results are available from the authors upon request.
Indeed, simulations based on macro models suggest that trade-policy-uncertainty and confidence effects can be significant relative to the direct effects of increase tariffs. See IMF (2018a).
Within the model we use, we are also reassured by the fact that countries’ terms of trade do not exhibit large swings in any of the scenarios considered below. As argued by Ossa (2016), the customary assumption of fixed trade balances can produce “[…] extreme general equilibrium adjustments for high tariffs as the model then tries to reconcile falling trade volumes with constant aggregate trade deficits and cannot hold at all in the limit as tariffs approach infinity.” Given our estimated price changes, the assumption of fixed overall deficits appears to be adequate for the changes in tariffs considered.
Detailed estimates across all three samples are available upon request.
USMCA side-letters would exempt Canada and Mexico from U.S. auto tariffs up to certain quotas. The potential effect of such exemptions is analyzed in more detail in the next section.
Box 1 explores the effects on U.S. states of an alternative, ‘selective’ form of retaliation which targets specific U.S. sectors.
The first consideration – that sectors with higher elasticities of substitution experience smaller tariff changes – has two key advantages, over and above offering a seemingly nondiscretionary way of handling the many degrees of freedom involved in modeling such a transactional deal. First, it helps avoid unreasonable changes in quantities that can emerge if large tariff changes are assumed for highly-elastic sectors. Second, by relating tariff changes to inverse elasticities as in Ramsey’s optimal taxation framework, the calibration helps put a lower bound on how distortive such a deal can be in practice.
Export restraints were used by Japan to limit its automobile exports to the U.S. before the creation of the WTO, and were part of the Multi Fibre Arrangement that limited developing countries’ textile exports to developed countries. More recently, Korea agreed to voluntarily reduce its exports of steel and aluminum to the U.S. A WTO dispute settlement panel related to this issue has been recently established.
See Appendix A for details on how we modified the model in CFRT to include export tariffs.
As with scenario 2, the escalation scenario may in practice involve changes in policies that the model we use cannot quantify, such as e.g. restrictions on FDI or on technology-transfer policies.
This general result is fairly robust to different specifications and varying assumptions, as will be shown in subsequent sections.
This parameter measuring the degree of substitutability is an important driver of the magnitude of the effects in all trade scenarios. This point is explored in more detail in Section IV.
Our database breaks down economic activity into 17 sectors for each of the 50 states and the District of Columbia.
This type of “selective retaliation” follows the spirit of the tariff retaliation that was envisaged by some of the U.S. main trading partners (e.g. Canada, the European Union, and Mexico) following the introduction of tariffs by the U.S. on imports of steel and aluminum products in March 2018.
In fact, USMCA quotas are already binding for current levels of U.S. vehicle imports from Mexico.
Alternatively, both countries could limit their exports of vehicles to the U.S. to remain within the USMCA quotas, and thus still not fully benefitting relative to a counterfactual where all their auto exports to the U.S. were the only ones exempted.
To avoid the non-generic case that leads to corner solutions (see discussion in Section II.A), we set foreign-domestic elasticities to be equal to foreign-domestic elasticities divided by 1.01.
We only report results of this robustness check for the cases where China introduces export restraints and in the U.S.-China escalation scenario. We were unable to find a solution with higher foreign-domestic elasticities in the case of the auto tariff scenario.