Free Trade and the Political Milieu

Free trade is like virtue – it is widely approved, but hard to practice.  Carrier Corporation’s recent announcement that it is moving manufacturing operations from Indiana to Mexico illustrates this tension.

Carrier, a subsidiary of United Technologies, manufactures heating and cooling systems and related products.  It also claims the mantle of an environmental steward: “Whether it’s reducing our greenhouse gas impact, leading the phase-out of ozone-depleting refrigerants, or introducting many of the world’s most energy efficient building solutions, at Carrier, we incorporate sustainability in all that we do. To us, it’s only natural.”

But like all manufacturers, sustainability commitments require economic profitability.  Apparently, the company found that significant wage savings could be realized by moving some manufacturing operations to a lower-wage environment. Mexican workers, who would accept lower wages than their U.S. counterparts, are winners from this transaction. But this would mean that 1400 workers in Indianapolis and another 700 in Huntington would lose their jobs.

Mexican workers, who reportedly will earn about $3/hour vs. $20/hour for the U.S. workers, gain an opportunity to raise their standard of living.  The company’s labor cost savings will likely translate either to lower costs for purchasers of Carrier products, or higher profits for shareholders of Carrier’s corporate parent, United Technologies. (Incidentally, UTX shares have increased by more than 10 percent following this announcement – though other confounding variables may explain this change. )

The distribution of those profits and/or cost savings is likely to be diffused throughout the economy. The consumer who pays less for the air conditioner may be able to afford new blinds, or maybe she will outsource her tax return preparation, landscaping, or hair styling services, thereby benefitting others in the economy. The same may be true for the UTX shareholder, who may be depending on investment income to support her retirement. But it seems that the costs are focused in the particular locales of the U.S. workers. And many of us are sympathetic to their plight. We know that it takes money to raise a family, and that requires good jobs and skills.

What can the government do? It could provide tax incentives to keep manufacturing in the U.S.  The federal government has actually done this. Examples include IRC § 199, which allows an additional deduction of up to nine percent of wages attributed to qualified domestic production activities against taxable income. This provision does incentivize domestic production, but its effect is muted. If the taxpayer is eligible for the full nine percent deduction, this translates into roughly a three percent tax savings (assuming, for ease of computation, a 33% marginal tax rate).  But that kind of reduction cannot overcome the labor cost savings that could be achieved by outsourcing production.

State and local governments also provide incentives, which can reduce state and local taxes. But since these are often small in relation to labor costs, the impact of those provisions may not be sufficient. Moreover, those incentives create local disparities, as small businesses often do not receive these incentives, while larger ones do. Is it really fair to tax the mom and pop shop at a higher rate than a large business?

Notably, Carrier also reportedly received a federal tax credit under IRC § 48C, which was designed to help finance manufacturing through advance tax credits associated with investments in so-called “green” production. This may confer a significant tax benefit, but it does not contain any clear rules about what happens if the facility stops production.  (If I get to invest, keep the tax credit, and then move on when a better deal arrives, it is kind of like crossing your fingers at a wedding ceremony – sorry, honey, but a better mate just came along.)

There is also the prospect of imposing a tariff on goods imported back into the U.S. from the foreign facility. That could sting, particularly if the U.S. is a major market for the good. It could unwind the prospect of labor cost savings, as well as lower costs for consumers or higher profits for shareholders by channeling these amounts to the government. It sounds like a magic solution. If it was effective — and one of the candidates on the campaign trail suggests it would be – those good folks in Indiana would not be losing their jobs. It all sounds so sensible. And it makes political sense, too, since those who care about the Indiana workers will buy into it and may support the candidate, while those who are worried about costs and profits are probably not thinking much about their lost economic benefits, which are diffused and often hidden.

But of course, that is not the end of the story.  Mexico may respond by imposing a tariff on U.S. corn. That will be bad for the corn farmers, and for all their suppliers and employees. They will see the effects on their profits, and they will call their Senators and complain about the lack of free trade. And then there are the spillover effects of higher costs and lower profits caused by free trade –  consumers will pay more, and they will not outsource their tax return, landscaping, and hairstyling. Those who might have provided those services will wonder why business is slow, but they may not realize it is caused by the resulting restrictions on trade.  The workers in the Indiana plants will be OK, though, for the time being,  as long as their production is economically viable.   But can that last if the costs are not competitive in a global marketplace?  The government may also get to collect some tariffs, but do you think they will redistribute these funds as effectively as the accountant, the landscaper, and the hairstylist?

In many ways, the free trade argument resembles the argument that Ernie Goss and I have made about casino gambling. In our book, Governing Fortune (U. Mich. 2006), we argued that casino proliferation is the product of a political bargain in which costs are diffused and hidden, and benefits are apparent and concentrated. Trade restrictions may share these features, in that they deliver political benefits to those who might lose jobs, but they impose costs that are diffused throughout the economic landscape.

Moreover, trade restrictions  achieve these results through empowering government as the intermediary who can raise and lower prices at will. Will such power be exercised prudently and for the common good? Really? I guess it depends upon your understanding about human nature. If you think that some humans may seek out self-interest over the common good, do you think that this condition changes when your employer becomes the government, instead of the private sector?   Free trade is not a utopian solution. It produces winners and losers, but they are chosen in an impersonal manner through market forces, not by government minders.