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Investor-State Dispute Settlement: Who Uses It?

Investor-State Dispute Settlement: Who Uses It?

Foreign investment is an important driver of the global economy, and the United States has been the number one destination for foreign investors. Foreign direct investment coming into the United States adds around $870 billion in value to the US economy as of 2014, and foreign investors employ some 6.4 million American workers. Foreign direct investment also drives more than one quarter of US trade.

How about US investments outside the United States? The common gripe about US investments overseas is that companies appear to be wholly offshoring their production. But foreign investment is generally complementary to a firm’s investments in the home market, not a substitute exports or domestic production. In some cases, foreign direct investment is required to do business elsewhere. For example, Citibank might better serve its customers by opening a branch in Shanghai. The branch didn’t displace a branch in Idaho – it’s there to serve another customer, the one who lives in Shanghai. It’s a way of growing sales by being present in another market, or of tapping into physical resources that are located outside of the United States.

Enforceable rights

While the overwhelming majority of US investors never utilize the specific investor-state dispute settlement provisions (ISDS), they benefit every day from the substantive obligations of US international investment agreements (IIA), which are made stronger because of their enforceability.

US investment agreements include a commitment to provide “national treatment” with respect to establishment, acquisition, and expansion prior to the investment being made, which is a powerful market access tool. Basically, it affords US investors the same opportunities as domestic firms. Once the investment is made, investment agreements provide a guarantee from the host government to provide reasonable and fair treatment, including:

Prohibitions on certain performance requirements, such as technology transfer requirements, domestic content requirements or limitations on imports.

The right to transfer funds related to an investment-interest, dividends, repatriated profits, etc. — into and out of the host country-allowing the investor to deploy capital in the most efficient and timely manner.

Guarantees that the host government will provide “fair and equitable treatment,” as well as “full protection and security” for their investments. Further, they agree not to engage in “arbitrary” or “discriminatory” measures.

Prohibitions from expropriating an investment — directly or indirectly — without prompt, adequate and effective compensation, consistent with rights under the US Constitution that all investors here possess.

These obligations reflect core US legal principles, and are intended to provide US investors abroad the same treatment all firms, foreign or domestic, receive in the United States.

How often has ISDS been used?

Given the large number of international investment agreements in force, it’s a challenge to find a comprehensive overview of their application and usage. Fortunately, the United Nations Conference on Trade and Development (UNCTAD) has developed an excellent web-based tool, the Investment Policy Hub. On the investment dispute settlement page, the site shows a running total of all known investment arbitrations, as well as the results of concluded arbitral proceedings. Readers can surf to their heart’s content, but here are some observations of the cumulative data.

First, with a total of 817 known ISDS arbitrations and over 2500 IIAs in force, it’s safe to say that the majority of IIAs have operated without a single dispute.

Second, of the 528 concluded arbitrations, governments win more often than investors: about 27 percent of disputes are settled before arbitrators reach a decision; governments prevail in 37 percent of disputes, while investors succeed in 24 percent of arbitrations; around 11 percent are discontinued after the appointment of arbitrators, and a few cases result in a decision by the panel but no damages are awarded.

Third, governments have wide-ranging experience in the number of arbitration cases. For example, the United States has been a respondent in 16 arbitrations, while US investors have entered 152 arbitration claims. Canada has been the respondent in 26 disputes; Canadian investors have been claimants in 45 disputes.

ISDS is used more by the little guy

Susan D. Franck, professor of law at American University, has done extensive research into ISDS outcomes, costs, and operations. One interesting conclusion from Dr. Franck’s work is the predominance of small enterprises as users of ISDS. Roughly two-thirds of the US investors who have filed with for investment arbitrations with the International Center for the Settlement of Investment Disputes (ICSID) would be classified by the Commerce Department as small or medium-sized businesses.

Why so few cases?

Individual disputes are highly fact-intensive, in the manner of complex civil litigation. Consequently, it’s difficult to generalize about firm decision-making regarding ISDS. Overall, however, we can say that investment disputes are (from an investor’s standpoint) expensive to file, time-consuming, and difficult to win.

Add to these drawbacks the risk of alienating the host government, and it’s not surprising that in a world of ever-growing international investment, ISDS appears to be used by investors as a last resort.

Scott Miller is a senior adviser at CSIS. Previously, Miller was director for global trade policy at Procter & Gamble. 

This article originally appeared on Used with permission.

Trump has imposed tariffs on Chinese shipments of export cargo and import cargo in international trade.

Where Will a Trade War Be Fought?

President Trump and his administration often express their concern about trade with China by referring to the size of the US trade deficit with China, which has been growing since 1985 and totaled $375 billion in 2017. Last year, we wrote that bilateral trade deficits are not a good way to keep score on trade policy. The numbers obscure where value is added to products and only really count where the product last made a transformation.

Something Made in China could have more than 70 percent of its value created by Americans in the United States, as with the popular example of the iPhone. There’s another reason to avoid hanging importance on the deficit: many US firms do business through affiliates in China rather than rely solely on exports.

American phones and cars (and many other products) sell well in China. According to the Internet Society of China industry association, there were 310 million active iPhones in China in 2016, amounting to one out of six smartphone users. US-headquartered Apple generated $48 billion in revenue from China in 2016, mostly in iPhones. But these iPhones cannot be found in US-China bilateral trade data because, regardless of the high level of US content in the form of design, engineering, software, and high-value components, iPhones sold worldwide are assembled in China. A product sold where it is assembled is considered domestic, and counts neither as an export nor an import. Apple records the revenue associated with iPhone sales and service, with no effect on the US-China trade balance.

General Motors’ 2017 annual report shows that the company sold 3.6 million cars in the United States and 4 million cars in China. Yes, you read that correctly. In the same year, only 1.2 million cars were imported to China from any firm or exporting country. General Motor’s entire manufacturing and distribution network in China is, for the most part, absent from trade statistics.

Conversely, how popular are Chinese brands in the United States? Answer: not very.

The iPhone is ubiquitous in China, yet Chinese-brand smartphones are rarely found in the United States. Same for cars: the streets of Shanghai are filled with Buicks, yet Americans have only seen Chinese-nameplate cars in the United States at auto shows. What’s going on here? Why, if we have such a large trade deficit, is the presence of US brands in China so much more prominent than Chinese brands here?

The US Department of Commerce’s Bureau of Economic Analysis (BEA) conducts surveys on US enterprises with global operations. Companies are asked to report key statistics on the operation of their foreign affiliates, such as sales and exports/imports. The BEA survey reports that, in 2017, US subsidiaries sold $223 billion worth of goods and services in China, and those sales have grown at an annualized rate of 18 percent since 2009.

For many firms, sales by the foreign subsidiary are more important than exports. US goods exports to China were $101 billion, while US affiliates sold $172 billion of goods in China. Bottom line, goods exports are only one way of reaching consumers, and looking only at exports gives an incomplete picture of a commercial relationship.

Unfortunately, the government of China does not collect data on the operation of Chinese subsidiaries in the United States, so we cannot do a direct comparison. But it is known that Chinese direct investment in the United States is small compared to US direct investment in China, and Chinese affiliates have limited presence in the United States.

Many firms operate subsidiaries in foreign markets as a complement to their export operations, as the foreign operation provides distribution and after-sales service support. For others, the foreign affiliate is an essential link in their business plan, such as an express package delivery service firm’s distribution center. “Operating close to the consumer” is a maxim followed by firms large and small, in no small part because local knowledge is a key to success. The Chinese affiliates of US firms use a combination of local and importer goods, and local and imported talent, to achieve success in the marketplace.

The US-China commercial relationship is more than just bilateral trade in goods. How will the Trump administration’s restrictions on Chinese imports, and China’s likely response, affect the larger relationship? While President Trump believes China’s large trade surplus shifts the balance of power in a tariff war to the United States, China can respond by punishing US affiliates, who are sitting ducks in a trade war.

Scott Miller is a senior adviser at CSIS. Previously, Miller was director for global trade policy at Procter & Gamble. 

This article originally appeared on Used with permission.

New NAFTA would govern North American shipments of export cargo and import cargo in international trade.

Investor-State Dispute Settlement

First included in a treaty in 1959, investor protections became embedded routinely in free-standing investment treaties and bilateral trade agreements through the mid-1990s. The commitments were designed to promote the rule of law in developing and emerging economies, which would in turn help developing economies attract more capital.

In 1995, a member governments of the Organization for Economic Cooperation and Development (OECD) launched an effort to create a multilateral framework for international investment that would both open markets to foreign investment and include a form of investor-state dispute settlement (ISDS), effectively creating a common template for ISDS.

At a time when anti-business NGOs were ramping up protests against globalization and the institutions that advance it, the OECD talks attracted the attention of these vocal critics, who saw ISDS as a way for foreign investors to challenge the legal systems in the countries where they invest or to invest irresponsibly.

Negotiations were discontinued in 1998 when governments determined that there was too little “on the table” to proceed further. Critics, emboldened by the collapse, maintained their challenge to investment treaties and the ISDS commitments in them. At the same time, many governments myopically focused on responses in specific ISDS disputes – i.e., cases where investors had sued them—and failed to provide a robust argument in favor of bilateral investment treaties (BITs) and the ISDS provisions in them. Over the ensuing 20 years, the public debate was fueled by vocal critics of investment disputes, but met with silence from the governments that entered into the treaties on behalf of its investors. The OECD experience from the 1990s, wherein NGOs mounted significant pressure on the governments involved, seemed to have the lingering effect of chilling any public defense of the liberalization agenda.

All Politics are Local

Vague and speculative criticism of the OECD negotiation effort took on more specific shape and importance in the American debate over ISDS through our experience with investor-state disputes under NAFTA. The US government had become a respondent in disputes brought by Canadian investors using NAFTA’s Chapter 11 procedures. US policymakers accepted the idea that investment agreements gave foreign investors access to a unique process (ISDS), but worried that investment treaties gave foreign investors substantive protections beyond those found in US law and practice.

In 2001, US officials along with trade ministers of Canada and Mexico, clarified the definition of “minimum standard of treatment” when dealing with foreign nationals and their property so that it more closely adhered to US legal standards. Congress took a similar stance in the Trade Act of 2002, directing the administration to ensure that commitments in trade agreements not confer to foreign investors “greater substantive rights” than are conferred to US persons.

The Attempt at a Model BIT

Before US trade negotiators sit at the negotiating table with foreign governments, they develop their positions through interagency discussions, interactions with Congress, and public stakeholder engagement. On particularly sensitive topics, like provisions in investment treaties, and because the US government was negotiating a series of bilateral investment treaties with foreign governments, negotiators developed a so-called model text to arrive at the US preferred set of commitments that could be pursued consistently with foreign government counterparts.

Direction from Congress in the 2002 Trade Act prompted the Administration to undertake a major review of the 1984 Model BIT, a process that resulted in the 2004 Model BIT. As often happens, the model text grew (from 10 pages to 40). But, it also achieved the objective set by Congress while seeking to advance a broader reform agenda. Among the changes to the model BIT were improved transparency to ISDS tribunals.

When President Obama took office in 2009, his advisors remained concerned about BITs, launching another review that produced the 2012 Model BIT. The 2012 version closely mirrored both the substantive obligations and the dispute settlement process of 2004. Most recently, during the Senate debate on the Trade Priorities Act of 2015, Senator Warren (D-MA) proposed to amend the negotiating objectives to prevent the usage of ISDS in future agreements. The amendment failed 39-60, an expression of bipartisan support for investor-state dispute settlement, but the current NAFTA negotiations have revived the debate.

Can ISDS survive?

As recently as 2015, it was reasonable to believe that, in the United States, ISDS was “better than its press clippings.” Presidents of both parties, from Reagan to Obama, supported treaty-based investment arbitration and found ways to refine and improve the process rather than discarding it. In Europe, however, ISDS has been subject to intense opposition lately, including 1990s-style protests like those surrounding the failed OECD effort. Despite Europe being a major capital exporter and party to over 1,300 member-state BITs, EU policy on ISDS became a major stumbling-block in the now-dormant Transatlantic Partnership negotiations between Europe and the United States.

More recently, current US Trade Representative Robert Lighthizer has called investor protections “political risk insurance for outsourcing, paid for by the US government.” In response, over 100 members of Congress, including the key committee chairmen, recently tied their support for a new NAFTA to the inclusion of ISDS, but the matter remains unsettled as NAFTA negotiations continue.

The United States has a long history of advancing the rules-based order and, as a practical matter, has never lost a dispute arising from one of its many investment agreements. But if the United States cannot maintain political support for ISDS, or decides from the executive branch that it does not want to keep ISDS, it’s hard to see how ISDS has a future as a legitimate tool of statecraft.

Scott Miller is a senior adviser at CSIS. He previously was director for global trade policy at Procter & Gamble. This article originally appeared here.

Safeguards limit competitors' shipments of export cargo and import cargo in international trade.

Safeguards: The Dirty Laundry of Trade Policy

US consumers love choices. According to CNET, there may be as many as 150 different models of washing machine you could buy in the US market. Some are front-loading versus top-loading. They hold different sized loads and use different amounts of water. Some take longer per load than others. Some have auto soap dispensers and some are even “smart” enough to let you tell Amazon’s Alexa to “start the wash.”

It’s competitive, but what happens when some competitors want relief from competition from fairly traded products in their segment? They can turn to a little-used trade remedy called a “safeguard.”

Safeguards are designed to help domestic producers adjust to competition, but there at least four reasons they don’t help the American consumer. We are about see how the current administration will approach this crossroads.

Two high profile Section 201 investigations are active now: earlier this year, Whirlpool filed a petition on large residential washing machines, and Suniva, Inc. filed a petition on solar panels. By early 2018, the administration will make some decisions on a course of action in each case.

Political Response to Private Agitation

For 70 years, the US and other economies have made major reductions in barriers to trade. Liberalized trade has been an engine for global economic growth and a boon to consumers, in part because open markets intensify competition. But increased competition can lead to political backlash.

The US Congress created the safeguard in Section 201 of the Trade Act of 1974, in order to mitigate the economic disruption associated with greater foreign competition. Section 201 authorizes the president to implement temporary import barriers — for example, raising the tariff on imported goods — on products that are threatened or injured by increased imports. The idea is to offer some relief by making it harder for imported goods to compete, while the domestic industry or aggrieved firm makes a “positive adjustment” to better cope with competition.

Front Loading Protection

Safeguards are permitted under WTO rules, but they are in tension with its core disciplines, which seek to maintain agreed-upon levels of market openness. As Christopher Hitchens once said of hypocrisy, safeguards are “the compliment vice pays to virtue.” Safeguards are a political remedy not justified by economic principles and the broader consumer benefits of market openness.

If fact, no Section 201 investigations have been pursued since 2003. From 1975 through 2002, the US International Trade Commission handled 73 investigations (roughly three per year), and recommended action in 34 of those cases.

Why did Section 201 safeguards fall out of favor? Since 1994, six US safeguards were challenged in the WTO’s dispute settlement body, and all six were ruled inconsistent with our GATT 1994 obligations. Bottom line, current US law appears in need of reform before safeguard remedies can withstand challenges from trading partners.

Coming Clean – Four Ways Consumers Could Lose

Mixed Load. Firms protected by safeguards may benefit, but many other domestic interests can suffer harm under that safeguard. Take solar panels. Low-cost (fairly-traded) imported panels expanded the market and created the need for many more installers. The industry now employs 260,000 Americans, 85 percent of whom are not in manufacturing. If safeguard tariffs make panels more expensive, there will be less demand for installation and fewer installers.

Spin. The imports in safeguard cases are fairly traded. If a similar “injury” was a result of domestic competition, no government remedy would be available at all. Korean washing machine producers Samsung and LG have been investing in US-based production. With regard to the current Section 201 case, LG issued a public statement saying, “Soon, competition in the washer market will not be about domestic vs. foreign production. It will be about competition among washers made in the United States, in Ohio, Kentucky, Tennessee and South Carolina.”

Delicates. There is scant evidence that domestic firms that receive safeguard protection make sufficient changes to alter their competitive position. In the three most recent completed actions—on lamb meat, wheat gluten, and steel line pipe—all three industries continued to decline in the years after the safeguard was terminated. Meanwhile, safeguard actions can strain international relations. The 1999 action on lamb alienated two key US allies, Australia and New Zealand, after their producers invested massive amounts of time, energy, and capital into developing the US consumer market for lamb.

Soak. Reliance on the safeguard mechanism can open the door to pure protectionism. Considering the two investigations in progress, if the president acts on the petitioners’ behalf, how long will it be before other firms who are facing tough but fair competition will ask for similar remedies? Then, how likely is it that other economies will refrain from using similar measures? No one knows for sure, but it could end badly for consumers, other firms in the supply chain, and the trading system itself.

Scott Miller is holds the William M. Scholl Chair in International Business at the Center for Strategic and International Studies. 

This article originally appeared on Used with permission.

NAFTA governs North American shipments of export cargo and import cargo in international trade.

NAFTA 2.0 and the Art of the Deal

During the‭ ‬2016‭ ‬campaign,‭ ‬Donald Trump repeatedly and harshly criticized the‭ ‬23-year old North American Free Trade Agreement‭ (‬NAFTA‭)‬.‭ ‬Last month,‭ ‬the Washington Post reported that President Trump was set to announce withdrawal from the agreement.‭ ‬Members of Congress,‭ ‬his own cabinet officers,‭ ‬and leaders from agriculture and business urged him not to do so.‭ ‬Ultimately,‭ ‬the President decided to renegotiate,‭ ‬not terminate,‭ ‬NAFTA.

Is renegotiating NAFTA a good idea‭? ‬It depends what you are trying to accomplish.‭ ‬No agreement is perfect,‭ ‬and commerce has changed markedly since‭ ‬1994‭—‬for example,‭ ‬when NAFTA entered into force,‭ ‬there was no commercial use of the internet.‭ ‬Modernizing and updating the agreement is a worthwhile objective.‭ ‬Yet trade agreements are typically effect,‭ ‬not cause:‭ ‬nations make agreements because existing commercial relationships are important,‭ ‬not the other way around.‭ ‬Overall,‭ ‬NAFTA has helped to triple merchandise trade among the three economies in nominal terms,‭ ‬from‭ ‬$306‭ ‬billion in‭ ‬1993‭ ‬to just over‭ ‬$1‭ ‬trillion in‭ ‬2015.‭ ‬But it’s important to remember that Canada and Mexico were the United States‭’ ‬number‭ ‬1‭ ‬and number‭ ‬3‭ ‬trading partners respectively before NAFTA,‭ ‬and they hold the same rank today.

Protect the Downside
As the President engages with Congress and the public on a renegotiated NAFTA,‭ ‬he may find it useful to consider some advice he once provided to others.‭ ‬In‭ ‬1987,‭ ‬Mr.‭ ‬Trump and Tony Schwartz produced Trump:‭ ‬The Art of the Deal,‭ ‬a business advice book which reached number‭ ‬1‭ ‬on the New York Times best seller list.‭ ‬The book contains an‭ ‬11-step formula for success.‭ ‬Step‭ ‬2‭ ‬has particular relevance in this case:‭ “‬protect the downside,‭ ‬and the upside will take care of itself.‭”

Why is this step so important in the context of NAFTA‭? ‬Because for more than two decades,‭ ‬businesses large and small have organized themselves according to the NAFTA rules.‭ ‬Discarding the existing rules could upend these networks and disrupt patterns of voluntary,‭ ‬mutually beneficial exchange.‭ ‬Businesses would be forced to pull back from longtime partners and scramble to find new workers,‭ ‬new suppliers,‭ ‬and new markets.‭ ‬The degree of disruption from re-introducing trade restrictions would be substantial,‭ ‬and the loss of stability and predictability would raise costs and stifle investment.‭ ‬These kinds of results are not in line with a principle of‭ “‬protecting the downside.‭”

North America is a Commercial Ecosystem
North America is an enterprise,‭ ‬a commercial ecosystem that spontaneously organized over many business cycles by millions of actors and assisted by stable rules.‭ ‬Destroying these rules would be the economic equivalent of a forest fire.‭ ‬Maybe we would be better off if we stop thinking of NAFTA as a trade agreement—which leads us to consider how much we sell to each other—and instead see it as a production agreement.‭ ‬North America is a place where‭ ‬460‭ ‬million people make things together,‭ ‬which we then sell to each other and the rest of the world.‭ ‬Consider the electric power grid—a sector not covered by NAFTA,‭ ‬yet one where national boundaries are irrelevant.‭ ‬Or,‭ ‬imagine the automobile industry viewed from space:‭ ‬it would be easy to find Interstate‭ ‬75‭ ‬and Canada’s Highway‭ ‬401,‭ ‬but not a national border.‭ ‬That’s the real NAFTA,‭ ‬and the downside risks associated with disruption definitely need to be managed.

Agree to Agree
Is there a way to improve NAFTA without setting fire to the ecosystem‭? ‬Yes.‭ ‬NAFTA itself provides for just such a process in its Article‭ ‬2202,‭ ‬which states:

1.‭ ‬The parties may agree on any modification of or addition to this Agreement.

2.‭ ‬When so agreed,‭ ‬and approved in accordance with the applicable legal procedures of each Party,‭ ‬a modification or addition shall constitute an integral part of this Agreement.

Leaders of the three economies should make it explicit that they are invoking Article‭ ‬2202‭ ‬to improve the agreement.‭ ‬This would send a clear signal that the NAFTA as implemented would remain in force until such a time when the parties complete negotiations and,‭ ‬in the case of the United States,‭ ‬when the Congress adopts implementing legislation.‭ ‬This approach offers a clear path toward acting on the Art of the Deal’s rule number two,‭ ‬and provides the stability North American businesses,‭ ‬farmers,‭ ‬and workers count on today.‭ ‬With this assurance,‭ ‬the president and his team should work to build public support for his negotiating agenda.

Scott Miller is a senior adviser and holds the William M.‭ ‬Scholl Chair in International Business at CSIS.‭ ‬Previously,‭ ‬Miller was director for global trade policy at Procter‭ & ‬Gamble.

Jobs are supported by more shipments of export cargo and import cargo in international trade.

Don’t Use the Trade Deficit to Keep Score

Americans like to play to win. When it comes to international trade, however, we shouldn’t use the size and trend of the national trade deficit as a way of scoring trade policy. It’s like using the size of players’ salaries to evaluate whether you had a winning season.

To start with, the way we talk about the deficit throws us off our game. Renowned economist Thomas Sowell insists that the language around economic principles should serve to clarify, not obfuscate. He thinks the trade deficit is perennially misunderstood owing both to the language we use to describe it and to the political rhetoric used to decry it.

Sowell explains:

The basic facts about international trade are not difficult to understand. What is difficult to untangle are all the misconceptions and jargon which so often clutter up the discussion. The great US Supreme Court Justice Oliver Wendell Holmes said, “we need to think things instead of words.” Nowhere is that more important than when discussing international trade, where there are so many misleading and emotional words used to describe and confuse things that are not very difficult to understand in themselves.

For example, the terminology used to describe an export surplus as a “favorable” balance of trade and an import surplus as an “unfavorable” balance of trade goes back for centuries. At one time, it was widely believed that importing more than was exported impoverished a nation because the difference between imports and exports had to be paid in gold, and the loss of gold was seen as a loss of national wealth. However, as early as 1776, Adam Smith’s classic The Wealth of Nations argued that the real wealth of a nation consists of its goods and services, not its gold supply.

Too many people have yet to grasp the full implications of that, even in the twenty-first century. If the goods and services available to the American people are greater as a result of international trade, then Americans are wealthier, not poorer, regardless of whether there is a “deficit” or “surplus” in the international balance of trade.

– Thomas Sowell, 2015. Basic Economics, 5th Edition, p. 476-477

It’s Just an Accounting Convention
The balance of trade is not a good way to measure the effectiveness of trade policy. Here’s why: it confuses accounting theory with economic theory. To understand the accounting, start with double-entry bookkeeping where both sides of the ledger must be equal.

The trade balance is typically the largest component of the “current account.” For an economy like the United States, the current account is always in balance with the “capital account.” The total amount of dollars bought for foreign currency must equal the total amount of dollars sold. If dollars bought are used to buy stocks, bonds, or property, they cannot be used to buy goods for export. A so-called “surplus” in the capital account must be balanced by a so-called “deficit” in the current account.

The current account is a bookkeeping device which records trade in goods and services and net earnings on foreign investments, while the capital account records the international investments themselves. Because buyers must match sellers for the foreign exchange markets to clear, exchange rates and interest rates adjust to ensure capital flows match trade flows.

All Trade is Free Exchange – You Only Do It if You Stand to Gain
Confusing accounting theory for trade theory generates two misunderstandings. First, it obscures the essence of free exchange. The nature of trade is that each party will make the exchange only if the good received is of greater value to the trader than the good surrendered. Said another way, trade is always a positive-sum event; each party gains from the transaction.

Second, focusing on the trade deficit alone presumes that dollars that do not return to the United States in the current account do not return at all. But this can only be the case if one ignores the existence of the capital account. Trade balances are determined by the balance between savings and investment.

The Deficit Doesn’t Correspond with Unemployment
The conventional rhetoric is that trade deficits subtract from GDP and therefore must result in lost jobs. But this argument is entirely inconsistent with actual experience of the US economy.

Thanks in part to the Smoot-Hawley Tariff Act of 1930, the United States ran large trade surpluses from 1930 to 1935 and again from 1937 through 1941, while unemployment frequently exceeded 25 percent. Fewer imports did not bring economic success.

In contrast, beginning in 1975, the United States began running trade deficits every year. During those four decades, the US economy tripled in real terms, manufacturing value added quadrupled, and the number of jobs in the economy more than doubled.

For the last 40 years, an increasing trade deficit has correlated with lower rates of unemployment. Faster economic growth increases demand for both labor and material inputs (domestically-produced as well as imported inputs). Growth in demand pushes up the trade deficit while it pushes down unemployment.

So Is The Trade Deficit A Good Thing?
A growing trade deficit seems to be associated with good economic results—why is this? Dan Ikenson explains it this way. “Rather than weakness or …foreign malfeasance, the trade deficit is a global endorsement of the relative strength of the US economy.” Because of the strength and stability of our economy, and because the dollar became the predominant reserve currency after the gold standard was eliminated, the demand for dollar-denominated assets grew steadily (leading to a surplus in the capital account). Our economy was attractive to investors.

On the flip side, a declining trade deficit usually is a sign of recession. The deficit fell substantially in 2009 versus the previous year, as the downturn caused by the financial crisis reduced aggregate demand for goods, services and labor.

A Solution in Search of a Problem
The critics of trade deficits have failed to produce a factual, convincing argument that the trade deficit is an economic problem which needs a solution. The reason is simple—it’s an accounting identity, not a scorecard for trade policy.

After over 200 years, Adam Smith’s advice is still sound; focus on consumer welfare and growth, and let the current account measure what it measures.

Scott Miller is a senior adviser and holds the William M. Scholl Chair in International Business at the Center for Strategic and International Studies. Previously, Miller was director for global trade policy at Procter & Gamble and advised the US government on trade policy.

Shipments of export cargo and import cargo are equally important to international trade.

Imports: Part of America’s Secret Sauce

What’s the most positive word uttered by politicians on trade? Exports. What’s the most negative? Deficit.

More specifically, when many politicians talk about trade, they often promote exports as an inherently good thing, and decry the US trade deficit as evidence that other countries are taking advantage of us.

But that characterization leads the general public to suspect that imports are a problem, and somehow Americans would be better off if we were to import fewer goods and services from abroad. Before we rush to a conclusion, let’s take a look at what we import.

We import products we need to make other products
Half of the goods we import are orders from US companies (that is, manufacturers) as the inputs they need to operate their own production processes in the form of intermediate components or raw materials.

The US Department of Commerce provides a useful way to look at imports by classifying them by their end use. In 2015, 48 percent of US imports consisted of capital goods (machinery and machine tools, semiconductors, parts, equipment, etc.) and industrial supplies (chemicals, fuels, lumber, plastics, metals, etc.). More than half of imports fall into these two categories if we include imported auto parts and engines (i.e., not finished vehicles) to the capital goods total.

Firm decisions
In each transaction, firms must determine the most appropriate inputs, ingredients, and other supplies to make their products, taking into account form, quality, price and a dozen other criteria their suppliers must meet. There may be a variety of reasons they choose to import those supplies. The material or equipment they need might not be readily available from a domestic source, or perhaps it’s not available in sufficient quantity, or isn’t made exactly to the right specification.

Because the firm (which employs US workers in US factories) has access to their choice of inputs, its finished products are a better value for consumers and that usually translates to greater sales and more secure jobs for the firm’s employees.

Imports support jobs
That’s something you don’t hear politicians say. Increased demand for industrial inputs – whether imported or not – is a sign of economic strength, even if it leads to an increase in the trade deficit.

Because small and large producers alike can make appropriate choices about their inputs – and use imported inputs as needed – they are more competitive in world markets. Conversely, if imported goods became artificially more expensive because of a tariff, firms risk being made less competitive; they would sell fewer finished products, and ultimately employ fewer workers.

Imports support US lifestyles
There is a lot to like about the other half of what we import, too. Imported consumer goods, from electronics to clothing to jewelry, give us greater buying power and a broader array from which to choose. And don’t forget imported food, which means fresh avocados for your big-game guacamole as well as delicacies from around the world at your local store.

Sure, it’s good when American companies export goods and services to the world. But imports make many American-made products more competitive as well as enriching our lives as consumers – they are part of the secret sauce of what makes our economy work so well.

Scott Miller is a senior adviser and holds the William M. Scholl Chair in International Business at the Center for Strategic and International Studies. Previously, he was director for global trade policy at Procter & Gamble.

Proposals to change US corporate tsax system would impacy shipments of export cargo and import cargo in international trade.

On the Menu: Tax Policy with a Side of Trade Controversy

The US Congress and the Trump Administration agree that the US corporate tax system is a drag on the competitiveness of American companies and the American economy. Tax reform is therefore a top priority for 2017.

Under current law, corporations are taxed on their income earned worldwide and the U.S. top rate of 35 percent is the highest among advanced economies.

But the United States is the only industrial economy to maintain a worldwide system, which encourages American corporations to move their headquarters operations out of the country (inversions), and discourages them from bringing their foreign-earned profits home for re-investment.

Previous reform proposals pushed for a territorial system, taxing income where it is earned. Territorial systems commonly used by major economies are more efficient and eliminate the incentives to move legal headquarters. Territorial taxation can, however, be subject to attempts to shift profits to low-tax jurisdictions, known as “base erosion.” Consequently, such proposals are usually accompanied by rules that attempt to limit profit-shifting activities.

Shifting to Destination-Based Taxation

House Republicans have developed a tax blueprint called a “Better Way” that would enact a destination-based tax on cash flow.

Instead of taxing worldwide income (the current law) or taxing income in the jurisdiction where it is earned (a territorial system), the House plan would tax companies’ cash flow where their goods and services are sold, regardless of where production, management, or income is located.

Further, the destination-based system proposed is border-adjustable. In simplest terms, the destination-based cash flow tax would impose a flat 20 percent tax rate on earnings from sales of output consumed within the United States.

How does this affect companies? Since the tax falls only on output consumed in the U.S., the cost of imported materials would no longer be deducted from taxable income (as part of the cost of goods sold), while all revenue from exports would be deducted and therefore not subject to federal tax.

It’s All About That Base

Why are House Republicans proposing this change? First, this approach eliminates the distortions of a worldwide system without needing new rules on base erosion.

Second, and probably more important, the cash flow tax broadens the tax base dramatically. Because the U.S. currently runs a trade deficit of about $500 billion per year, border adjustment would generate nearly $1 trillion in additional revenue over a ten-year period.

Broadening the base is critical to achieving lower tax rates, from 35 percent to 20 percent, (and a range of other pro-growth reforms like expensing of capital spending) while staying close to revenue neutral. A conventional tax on income does not offer enough base-broadening measures to deliver a large rate reduction.

The House “Better Way” proposal is likely the starting point for a debate on tax reform, and a change of this magnitude may or may not survive the legislative process.

Back to Trade Policy

Individual firms will do their own assessment of the effects on their business. Exporters will probably find a cash flow tax beneficial. Importers including retailers, oil refiners, or apparel companies will probably see the proposal as a major tax hike.

The fact that differently-situated companies will face different effects may divide the business community, cutting into the nearly unanimous support for pro-growth tax reform.

Moving away from income taxation to something closer to (but not precisely) a tax on consumption is clearly a substantial policy change. It’s also one that is big enough to affect trade flows, and therefore likely to spark trade controversy.

Is an Adjustable Border Tax Protectionist?

Proponents say, “no,” that the tax is neutrally applied based on where the good or service is consumed.

But there would be an incentive to import less. Also, in the near term, the change may boost inflation, as importers raise their prices to suppliers and consumers to maintain margins.

Medium-term, currency exchange rates will likely adjust to absorb some of the impact, which would lead to an even stronger U.S. dollar.

Does an Adjustable Border Tax Square with US Trade Obligations?

WTO rules permit border adjustments for indirect taxes, such as credit-invoice value-added taxes (VATs). But the House plan operates like a direct tax, and it’s a near certainty that it would be challenged by trading partners.

Many of us recall the 2002 WTO case in which a US provision regarding tax treatment for Foreign Sales Corporations was found contrary to trade rules, leading to a change in U.S. tax law. The United States could be vulnerable to losing a WTO case on border tax adjustability. The Trump administration and Congress would have to make some decisions that could include repealing border adjustability, or turn the cash flow tax into a subtraction-method VAT, or ignore the WTO ruling altogether, which would give other nations the right to retaliate.

Stay closely tuned to forthcoming policy debate. The plan raises important issues about tax competitiveness, but also broader U.S. economic engagement with the world.

Scott Miller is a senior adviser and holds the William M. Scholl Chair in International Business at the Center for Strategic and International Studies. Miller was previously the director for global trade policy at Procter & Gamble.