Join the new world

I’m fairly new to this game and still learning. Like my real life namesake I have a keen interest in economics, so when I saw a very brief article about VAT and Import Taxes it got me thinking. Not really being able to make head or tail of the argument I decided to do a little reading and find out how taxation worked.

The premise of the article seemed to be that whatever level of VAT is set the import tax should be higher to protect local businesses from competition.

In real life the arguments for protectionism have been rightfully mocked and relegated to the status of quaint historical fairy tale. Protectionism temporarily protects the hip pockets of investors and workers in inefficient industries, and sends the bill to consumers by way of higher prices. All that capital and labour is then a sunk cost in a dead-end industry rather than invested in sectors where a country has some natural advantage.

But it’s different here, right? Productivity has nothing to do with the education and training of workers, good management practices or natural advantage, and everything to do with resource bonuses. Any country with more resource bonuses than us will be able to produce more per worker. So at face value, an argument for protectionism via higher import taxes? Probably not, there’s more to this story.

Firstly if I understand correctly the article has it wrong. The relative difference (or equality) of import tax and VAT means absolutely nothing because they are combined on selling price and not charged differentially. For example with our current 15% VAT and 15% Import tax on weapons, a non-citizen making an offer on our market will have BOTH taxes subtracted from the sale price, i.e. if they sell a weapon for $10 they will receive $7, with $3 going to tax revenue ($1.50 for VAT and $1.50 for Import Tax). So the relative rates of VAT and Import Tax are in no way relevant and should be ignored entirely. Australian weapons producers enjoy a 15% price advantage over importers regardless of VAT.

So what happens if we increase import taxes as the article suggests? In the short term importers will be less competitive and will either increase prices or leave the market creating room for local producers to raise prices and increase production. Price increases are obviously not much good for consumers, but will make local producers more profitable. Demand for workers will be higher, and in a full-employment market like eRepublik that will mean wages will rise to lure workers away from less profitable industries. Eventually the wage rises will balance out the profitability increase and producers will be no more profitable than they were prior to the tax increase. Wage rises will also balance out the price increase, so consumers should be no worse off. Price rises will once again allow importers to be competitive and re-enter the market. We have returned to the status quo though we’ve seen wage and price inflation to get us there.

So what happens if we drop import tax entirely? Presumably importers will be able to sell cheaper and still turn a profit. Prices will drop, consumers will be happy but local manufacturers will start losing money (assuming they aren’t making super profits already). Naturally local producers will have to reduce wages, so workers will earn less. In real life this would lead to unemployment, but not in a game like this where full employment is virtually guaranteed. In the long run, prices will drop, wages will drop and we’ll return to the status quo after deflation.

To sum up the previous 2 paragraphs,import tax as a means of protecting domestic industry is ineffective because with a full employment economy wages and prices will always adjust to neutralise the effect of the change.

This argument only holds true if the import tax is not extreme, e.g. a lot of countries seem to set import tax at 99%, effectively a ban on imports. This may work for a country that can supply all of its needs even in extreme circumstances, though would most likely lead to highly exaggerated price fluctuations and product shortages as demand peaks/subsides in response to wars and encourage a large black market thereby depriving government of any tax revenue.

I would therefore argue that in the absence of any budget shortfall there is no compelling reason to significantly change our current import tax rate. It provides some revenue to government without being so high that it encourages major black market trading, while in the long run any changes in either direction will be absorbed by price and wage changes.

Disclaimer: It is an oversimplification to say that changes in import tax rates are long-term neutral as there will be marginal changes in black market activity and government revenue, however the basic premise of the argument holds true from a consumer/producer perspective.