Feedback taxes are those which have rates that change according to some condition, and could be used to drive that condition to some chosen value. They cannot be constructed without some thought, as improperly designed feedback taxes can have undesirable effects, such as instability or abuse. Here we will discuss the construction of one example, a tax on trade, which is assumed to be done for the purpose of driving trade between two nations into a balance, at least in some types of goods.
For an example, take the situation where one country wants to establish a trade balance with another country in manufactured goods. Exactly what constitutes manufactured goods has already defined by the customs laws of the first country, so there is no question as to what they are. Exactly what constitutes manufactured goods from the first country is also well defined by customs law, so the task remaining is to try and construct some taxation rule, perhaps with subsidies, that uses feedback to accomplish this task.
What is not desired is to have this balance be achieved by a ban on trade between the first country and the second country. While this would accomplish the stated goal of the tax, to balance the trade in manufactured goods between the two countries, it causes two problems, at least, or one problem with two aspects. This might be called the Adam Smith problem. In his famous book, The Wealth of Nations, Smith discussed how two nations might improve the welfare of both by each manufacturing what they did best, meaning for lowest cost, and then trading their individual products. This maximizes the total goods produced and the total consumption in each nation. Of course, this type of trade does not exist today, and it is replaced by a situation where one country manufactures all goods, trades them to the other in return for debt, which is gradually turned into ownership of property in that first country. Smith did not deal with unbalanced trade, and to take advantage of his insight into how to mutually benefit, it might be possible to construct a tax in such a way that it does not eliminate trade between the two countries, but brings it into balance in the sense that Smith envisaged it.
One aspect of the Adam Smith problem is that trade could be driven to zero by taxes that were too high. The other aspect of the Adam Smith problem is that some item, chosen by the first country as its desired manufactured good, would be produced at low quality, so to take advantage of the benefits of the tax law. The second country, in order to maintain some trade, might simply buy goods of low quality or with other flaws. This defeats the purpose of Adam Smith’s insights. In order to function, the tax would have to affect all manufacturers equally, to the same degree, so that competition would ensue between them. Competition would eliminate low quality production in favor of goods, by manufacturers in the first country, which were higher in benefit to cost ratio that others. So one guideline for constructing a tax is that it cannot be too specific, but must equally cover all manufacturing.
Specific item taxes are designed to benefit some individual manufacturers or some group of manufacturers, and do not conform with what Adam Smith proclaimed as a means for improving production in a mutual way. Protection such a tax might provide would serve other purposes, such as ensuring that some vital product was always internally available, and could not be cut off in an embargo by other nations. This does not necessarily improve the economic situation of a pair of countries that are affected by such a specific item tax, as would be the intention of a tax designed to utilize the benefits Smith deduced.
A flat level tax, such as 50% of value, has major disadvantages relative to one which has feedback built into it. When such a tax is imposed, it comes as a shock to the economic arrangements of those manufacturers involved. If the tax is across the board on manufactured goods, the shock is universal. Companies typically do not have such flexibility, unless they are extremely profitable, and can stand to work with substantially reduced profit. On the other side, imposition of a flat tax provides a shock to the consumers of such products, as the amount available would be reduced abruptly, as manufacturers cut back in response to less revenue.
There would be some adaptation within the trading market after the imposition of a flat tax. It might take considerable time for the market to adjust to this tax, as some manufacturers go out of business and others reduce production. Prices would also have to be adjusted, as there might be negative income when the tax is imposed. A new point where supply and demand balance has to be found. This point is not necessarily where productivity is maximized or the total benefit of both countries added together is maximized. Because the tax level chosen is arbitrary, it is very unlikely that it would happen to be chosen just where productivity was maximized. On the other hand, if the tax were adjusted frequently, this introduces such instability into the market that production would certainly fall. Uncertainty has costs, and these costs can undermine the profitability of even an efficient manufacturing firm.
One way to mitigate the economic shock of taxation is to introduce it gradually. A small tax to start, with annual increases, allows the manufacturers and consumers of the manufactured products traded between these two nations to know what their additional costs will be, and to therefore plan on this basis. This reduces the uncertainty. It does insist on changes in trade levels, with each gradual change in the tax rate. This cannot be eliminated as the entire goal of the tax is to change trade levels. Whether a single abrupt change can be tolerated is a question; slow gradual changes allow businesses to change what they manufacture, change customers, or make production changes that affect costs.
One way to approach more closely the Adam Smith ideal of each country manufacturing what they can most efficiently produce is to have a universal tax on manufacturing trade, with a gradual change, but one which is automatically adjusted in amount. The adjustment rules can be tailored to both produce balance in trade volume and be slow in changes to allow business planning to be maximized. Such a combination might look like this: an increase of 5% in each successive year until the trade imbalance drops below some threshold amount, then an increase of 1% in each year until the trade imbalance drops below a second threshold amount, followed by a change of 0.1% in whatever direction the trade imbalance indicates. In this final phase of the tax situation, if the trade from country two to country one is positive but small, the tax would increase by 0.1% each year until that reverses. If the trade from country two to country one is negative but small, the tax would decrease by 0.1% each year until it reverses. At the end of this process, the tax level would be fluctuating by a small amount each year, not enough to cause any significant disruption of business on either side of the trade exchange, but only affecting marginal users and producers.
The feedback trade tax is also resilient to changes in costs. If one of the two countries invents some novel transformation of the manufacturing process for some particular item, the trade would shift to take advantage of this transformation. If the transformation were done for a particular good which was highly traded, the trade imbalance might slip out of the final band and enter the second band, where incremental changes are larger. These incremental changes would accumulate until the entire spectrum of manufactured goods was adjusted, leading again to a balance of trade, but in a different allocation of products. Thus, the procedure is robust against any type of change.
If both countries adopted such a feedback trade tax, would there be any possibly different results? The problem with feedback taxes occurs if the steps taken are large. In this case there could be instabilities, resulting in taxes swinging wildly year to year. When both countries are introducing changes, this is more likely. The clear barrier against it is to have the incremental changes in both countries be small, so that if it happened that they both aligned, the changes would not be too abrupt.
The advantages of such a tax comes from its components. A gradual change allows business planning. A target value of zero net manufacturing trade allows the Adam Smith efficiency gains to be fully experienced. Tapering changes allows a stable state to be approached. Automated changes in tax levels allows changes in manufacturing efficiency to be accommodated in the most efficient way possible.
One way to gracefully accelerate the change to a balanced trade situation would be to take the tax collected and distribute it as a subsidy to those manufacturers in the first country who are exporting to the second. This subsidy would speed up the change to manufacturing larger quantities. Another way to make worldwide trade more efficient would be to apply a tax in the first country to all countries which trades with it. This would allow a more efficient distribution of manufacturing around the world, instead of only in the two countries in the example.