11 minute read 23 Sep 2021
Red truck running over the bridge

Why pandemic-induced trade protectionism will affect tax for years

By EY Global

Multidisciplinary professional services organization

11 minute read 23 Sep 2021
Related topics Tax Global trade

The COVID-19 pandemic has increased protectionism. But to what extent is this the latest episode in an ongoing and entrenched global trend?

In brief
  • The pandemic was responsible for a once-in-a-lifetime hiatus in global trade, as calls for self-sufficiency were paired with aggressive trade controls.
  • While COVID-19 vaccination programs are making a big impact in many countries, trade protectionism is likely to remain, especially as infections continue to spike in different regions. 

Pandemics don’t pay any heed to borders, but human responses to them clearly have. The global spread of the COVID-19 pandemic was rapid and relentless, and left much of the world sharing a collective experience of trauma, disruption, isolation and uncertainty.

As governments scrambled to contain the COVID-19 pandemic’s spread, their policies had an immediate impact on borders – and trade. Open trade policies, already under pressure in key markets before the pandemic, quickly gave way to restrictive changes aimed at protecting their citizens and interests. The result?  Calls in many countries for increased national self-sufficiency, near-shoring of supply chains and increasing talk of permanent shifts to hedge against similar disruptions in the future.

Globalization is an elemental economic force of modern times and has faced crises before. But can it emerge unscathed from the reflexive trade protectionism related to the pandemic or is a more fundamental shift underway?

Existential threat

The trade response to the  COVID-19 pandemic’s sudden, existential threat took several forms. These included tariffs, regulation and “vaccine nationalism,” where, in the words of the International Trade Centre, governments established “temporary trade measures that aim to restrict exports of vital medical supplies.” Immediate restrictions applied to core components, medical ingredients, PPE and ventilators.

But the influence of the authorities stretched further than imports and exports. The pandemic also served to highlight perceived limitations in the global supply chain, and the vulnerability of just-in-time inventory to black swan events. Governments began taking a more hands-on role in protecting critical supply chains.

This was the thinking behind the EU’s joint declaration on processors and semiconductor technology1, released in June 2021, which aims to create synergies among EU members’ research and investment initiatives.

That same month US President Joe Biden, having already extended many of the protectionist measures introduced by his predecessor – including trade tariffs on metal imports, and Buy American legislation – signed an executive order on supply chains, addressing short-term discontinuities.

According to Doug Bell, EY Global Trade Policy Leader, such measures mark a fundamental shift. “China has always had a vibrant planned economy, but the EU and US traditionally took a different approach,” he says. “With the pandemic, issues of economic security quickly became issues of national security, and the role of the state in the economy increased. When you have the three largest trading bloc economies moving in that protectionist direction, that impacts everyone else. And that suggests a longer-term prospect.”

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Chapter 1

Trade protectionism before the COVID-19 pandemic

Protectionism in trade was already a trend before COVID-19 but the pandemic has accelerated it.

To be sure, the COVID-19 pandemic itself didn’t usher in a protectionist era –  countries had already begun to prioritize looking after their own before the days of social distancing.

The movement toward trade protectionism actually dates to the global financial crisis of 2008 and reflects a number of factors, including increasing levels of economic nationalism, rising disappointment with the effects of globalization, and the increasing role of populism in politics. Which all suggests that a return to more liberal trade may be no simple prospect. “It would be misleading to say the pandemic sparked this trend and that the end of the pandemic might change it,” says Sally Jones, EY UK Trade Strategy and Brexit Leader. “The whole model is moving more and more toward protectionism, and has been for 10 to 15 years.”

Jones points to a variety of sources, including the OECD’s Services Trade Restrictiveness Index1 and the IMF’s World Uncertainty Index2, which show a steady increase in state interventions since 2008.

According to the state interventions per year index3, between 2009 and 2021, the US implemented 399 liberalizing interventions, but 2,647 restrictive ones. Jones says this pattern is replicated across the board; China brought in 2,957 restrictive  interventions; Germany: 1,993; Italy: 891.

“Every country you look at has put in more interventions restrictive to global trade than liberal ones,” Jones explains.

Out of the bag

Protectionism could be here to stay, at least for a while. Governments around the world are facing a catalog of urgent challenges, including, but certainly not limited to, climate change and the drive to raise revenue to pay for the pandemic recovery. So they may not rush to put these protectionist tools, tariffs and regulations, back in the box.

“Politicians now have this hammer, and they may start looking for nails,” says Marc Bunch, EY UK Global Trade Leader. “Actions such as prohibiting exports are understandable when used in a public health crisis for a very specific, temporary reason, or for other valid reasons like sustainability. But they may also seek to use them for some old-school mercantilism, to prevent specific exports or imports. You’ll certainly see it in the agri-food sector, bringing in rules around product origins. And that will spark retaliatory behavior.”

Indeed, the issue here is that trade tends to be tied inextricably to geopolitics. Trade is triggering geopolitical incidents, as with the US-China trade dispute that escalated under former President Trump, with the unilateral Section 301 tariffs placed on China. Trade is also used as a counter measure when a geopolitical issue flares up independently – as when China put substantial tariffs on Australian beef and wine after Australia criticized certain domestic Chinese policies.5

Such matters can influence the shape of globalization.

“With Trump, you saw a change in China’s behavior, for the first time in many years,” says Bunch. “His actions appeared successful, at least in the short-term, in winning some of these trade disputes. And that may lead other policymakers to look at it and rethink their actions.”

 

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Chapter 2

Pockets of free-trade activity

Regional free trade agreements are happening in some places as the undercurrents of globalization remain strong.

Globalization and protectionism aren’t facing off against each other in a zero-sum game. While the long-term trend is toward protectionism and a more difficult trade environment, there is a natural push and pull.

And there are indications that a spirit of cooperation is alive in some places. Take free trade agreements (FTAs), which promote open trade in certain defined areas (albeit at the implicit expense of others). While questions remain over the true effectiveness of FTAs, the Regional Comprehensive Economic Partnership (RCEP), signed in late 2020, was a clear step toward liberalization in Asia.

Meanwhile, the newly ratified African Continental Free Trade Area (AfCFTA) aims to bring together 1.3 billion people in a $3.4 trillion economic bloc – the largest free trade area since the establishment of the World Trade Organization.7 In the wake of Brexit, meanwhile, the UK has just agreed the broad terms for an FTA with Australia, the first trade agreement negotiated from scratch by the UK since it left the EU, the world’s largest trading bloc.8 It has also begun negotiations to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, strengthening trade links with 11 countries across Asia-Pacific. Meanwhile there has also been a notable uptick in regional trade agreements. As of 15 June 2021, there were 349 in force globally.9

The fundamentals of globalization, meanwhile, remain sound. Trade tends to find and follow the path of least resistance. Demand breeds supply, and business isn’t about to forgo the opportunity to access the maximum number of customers in the broadest range of territories. It will find ways to overcome new issues, to absorb costs, and to harness innovation, improving supply chains and optimizing production.

From 1990 to 2019, the three biggest international trade indicators (licensing royalties, world exports and FDI flows) grew at a faster rate than average GDP.10 This underlines the rationale for cross-border commerce and the unique role played by multinationals. Inequalities still exist between nation states in everything from incomes and education systems to laws and R&D capabilities, creating the opportunity for these companies to generate wealth, through aggregation and trade arbitrage.

It’s fair to say that the protectionist shift we’re seeing now is not so much the end of globalization; instead it’s an attempt by governments to wrestle its runaway force under some semblance of control.

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Chapter 3

The zoom effect

Technology is emerging as a new flashpoint in trade, as tools make it easier for work to be performed remotely.

This points to technology, which is one of the future flash points of tension between globalization and this increasingly potent protectionism. Technology has the potential to enable greater flow of goods. It also offers multinational businesses large and small the chance to make huge gains and efficiencies through the free flow of data. But governments are increasingly taking steps to regulate data flows and tax revenue. Meanwhile, the lines between free-market and state-controlled technology are blurring, creating further geopolitical flashpoints.

Technology is fueling further potential protectionist tension by enabling the “Zoom effect.” Thanks to advances in ever-cheaper technology, service industries are increasingly offshoring headcount and talent, confident that roles can be fulfilled remotely and at a lower labor cost elsewhere. But gone are the days when outsourcing meant low-skilled work. It’s now moving into fields like telemedicine. With the rise of collaboration technology, there’s no reason white-collar roles can’t be outsourced from the West to offshore locations.

“Today, the governments are fighting the tech companies,” says Bunch. “Tomorrow, the new trade front will be around where the work is being done and the value generated. You can see a lot of hollowing out of white-collar jobs in Western countries, all shifting to offshore locations in South Asia. It will be painful, and governments will need to manage it, but it’s an inevitability that governments can’t control. As the tech moves on, services will be accelerated.”

The changing face of the trade function

Tax departments are already experiencing the shift to this fluid, dynamic operating environment.

Transfer pricing is a key challenge because it involves the allocation of company profits across the business and  the tech-enabled flow of skilled services work across borders.

“Increased transparency regarding transfer pricing data, an evolving tax policy landscape and tax authorities’ asking for more data means companies need to be diligent about connecting with the business and assessing alignment with the business. Given the amount of regulatory, transaction related and organic business change,  the potential for double taxation on transfer pricing matters is increasing and companies will need to improve real time processes and adopt technologies to help monitor, analyze and defend the flexibility and resilience of their structures,” says Tracee Fultz, EY Global Transfer Pricing Leader.   

They will also need to get a handle on a shifting income tax picture, a key current focus of the G7. In addition, there are new and complex indirect taxes emerging, including in nascent areas such as sustainability, all of which are being applied in different ways by these increasingly protectionist governments.

“We can expect more tax liabilities in the protectionist world,” says J. Michael Heldebrand, EY Americas and US Global Trade Leader. “As these governments are increasingly strapped for money, they need to fund the reopening of markets, and they’ll do that through taxation. In the US, for example, that’s happening on a local, state, even federal level.”

In this new environment, tax needs to assume a new role, becoming an integral part of decision-making as the business works out how to manage its taxes, and how to comply with the increasingly robust regulations.

“It will be increasingly important for the tax function to be at the table,” says Bell. “It will need to be part of these operational and strategic decisions, not least in how to factor all these different tariffs and trade agreements into operations.” 

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Chapter 4

The new look of globalization

Tax and trade functions should remain agile to operate effectively in the new environment.

With all the forces conspiring to reshape globalization as they know it, tax departments need to become more agile, integrated and tech-enhanced, and to take a more strategic role in the business.

But globalization isn’t finished just yet. There are lots of compelling reasons why globalization has taken the path it has, in terms of efficiencies and lower costs. And those economic drivers aren’t going away. The competitive advantage may change, in response to the price of carbon or the role of technology, for example. But there will still be an underlying economic impetus to seek comparative advantage, and a compelling argument to serve other markets and to do this through trade.

“State intervention and policy developments may affect the outcome, but it won’t be a binary choice between globalization and protectionism,” says Bell. “The shape of trade will reflect many millions of individual decisions, arriving at a more stable new equilibrium for the movement of goods and services across borders.

“So, globalization will still be there; it will just be different.”

Summary

It would be easy to suggest that the COVID-19 pandemic has helped usher in a new era of trade protectionism, but with more considered analysis, it is clear governments began to check the march of globalization as early as the global financial crisis of 2008. Post pandemic, both globalization and trade protectionism will continue to be forces to be reckoned with, however it is likely trade protectionism will be in the ascendant.

About this article

By EY Global

Multidisciplinary professional services organization

Related topics Tax Global trade