Terms-of-Trade Gains, Tariff Changes, and Productivity Growth

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The magnitude of [the] acceleration [in U.S. productivity growth between 1995 and 2006] has been overstated, with a sizable share of the gains actually being accounted for by the benefits of international trade.

Productivity growth in the United States appears to have accelerated dramatically since 1995. Some research has attributed that growth to declining prices for information technology (IT) products. In Effects of Terms of Trade Gains and Tariff Changes on the Measurement of U.S. Productivity Growth (NBER Working Paper No. 15592), authors Robert Feenstra, Benjamin Mandel, Marshall Reinsdorf, and Matthew Slaughter argue that part of this apparent speed-up in productivity actually represents gains in the terms of trade and tariff reductions, especially for these IT products. They demonstrate how unmeasured gains in the terms of trade and declines in tariffs can cause conventionally measured growth in real output and productivity to be overstated.

Many factors have contributed to the increasing globalization of the IT industry, including the creation and spread of global production networks. However, the global engagement of the U.S. IT industry deepened after 1995, around the time that the Information Technology Agreement (ITA) - a comprehensive free-trade agreement that eliminated all world tariffs on hundreds of IT products - was ratified. This timing suggests that the ITA may have played an important role in the post-1995 trend in IT prices.

The evidence suggests that even small reductions in tariffs under the ITA have a considerable impact on both prices and variety. The authors attribute the effect on prices to the fact that the ITA was a multilateral tariff reduction, with U.S. tariff cuts matched by those abroad. Since imports are being processed in multiple countries, their prices can easily fall by more than the drop in U.S. tariffs.

Moreover, improvements in import variety have contributed substantially towards improving the terms of trade: without that effect, the increase in the terms of trade would be only one third of its actual level. This supports the hypothesis that entry of lower priced varieties from new sources of supply has caused a substantial drop in import prices that the standard methods used to construct official indexes may omit.

In addition, since 1995-at precisely the time that productivity growth picked up-U.S. terms of trade reversed and began rising, with a string of solid gains from 1995 through 2006. That suggests a connection between the terms of trade and productivity. In fact, the authors find that unmeasured changes in the terms of trade have a first-order impact on conventionally measured productivity growth. In particular, if the reduction in import prices is understated, then conventionally measured productivity growth will be correspondingly overstated. Correcting for three different measurement errors, they find that the actual U.S. terms of trade were rising much faster than officially reported.

In the past decade, the U.S. economy clearly enjoyed faster productivity growth than in previous time periods. The authors suggest that the magnitude of this acceleration has been overstated, with a sizable share of the gains actually being accounted for by the benefits of international trade. Their findings indicate that from 1995 through 2006, the actual average growth rates of the price indexes for U.S. imports are 1.5 percent per year lower than the growth rate of price indexes calculated using official methods. Thus, properly measured terms-of-trade gains can account for close to 0.2 percentage points per year, or about 20 percent, of the apparent increase in productivity growth for the U.S. economy over this period.

-- Claire Brunel