For more than two decades Chile has been a laboratory for successful free-market reforms. In 1980, it became the first country in the world to create a fully funded private pension system based on savings and investment rather than taxing and spending. Now the country is doing it again, this time with bold trade liberalization. The two reforms are not unrelated.
Chile's 10% tariff rate is low compared to the rates of most countries and, more importantly, with the possible exception of four agricultural products, it is applied equally to all imports. But Chile isn't resting on past success. Two months ago Chilean Finance Minister Eduardo Aninat proposed--and lawmakers approved--a bill that will cut the tariff automatically by one percentage point per year, bringing it down to a flat 6% by 2003. From there to zero should be a small step for Chile but a historic leap for free trade.
The mere possibility of zero import tariffs is stunning in an economy that in the 1960s was one of the most protectionist in the world. In those days, Chile was a devoted follower of the misguided import-substitution proposals of the Santiago-based United Nations Economic Commission for Latin America. But in the mid 1970s, the country's trade policy turned around. Not only did Chile completely dismantle the system of quotas and other trade barriers, but under the courageous leadership of Finance Ministers Jorge Cauas and Sergio De Castro, the uniform tariff policy was adopted; by 1979 that tariff was down to 10%. Unfortunately, Latin America's 1982-83 economic crisis prompted a retreat, and by 1990 the rate was 15%. Still, lessons had been learned and free trade had momentum.
While the nation was consolidating its free-trade strategy, it was also establishing a revolutionary system of individual private retirement accounts. The connection between the two is important. In most of the world, trade liberalization is cast as a battle between capitalists and employees, between "global elites" and the "common man." In Chile, however, market-invested retirement funds mean that every employee is a capitalist and has a visible stake in an internationally competitive economy.
A vast majority of Chileans benefit from free trade not just as consumers but also as owners of the productive assets of the economy through their retirement accounts. Free trade is good for the economy, and what's good for the economy is good for investors. Thus there is a virtuous cycle of trade liberalization that has so far thrived regardless of the political party in power. For 13 years, under three different governments, economic growth has averaged 7% per year.
Of course, Chile still has major reforms to implement, and progress can't be taken for granted. But the country's future as a free-trade nation is already secure.
Following the peaceful transition to democracy in 1990, free-market supporters worried that beneficial economic reforms might be undone by the incoming center-left government of Patricio Aylwin, given that many in his coalition had initially opposed reform. Particularly disheartening was the fact that the new finance minister--economist Alejandro Foxley--had for years been an academic supporter of protectionism and differentiated tariffs.
To his great credit, however, once in office Mr. Foxley embraced and maintained the principle of a flat tariff rate, and even secured approval for a further reduction. It is likely that the success of Chile's private pension system influenced the new government's policy choices. By the time Mr. Aylwin's government took office, Chilean employees wanted an open, wealth-producing economy in which business, and thus individual pension accounts, could flourish.
But whatever the reason, the flat tariff decision was critical. A differentiated tariff not only creates economic distortions that slow economic growth, but continually generates special interest pressures and opportunities for corruption. With a flat rate, a politician can't be bought on trade issues because he has nothing to sell.
Contrast that with the situation in Washington, where so many members of Congress, with notable exceptions, cling tenaciously to protection for favored industries. True, the United States maintains an average tariff rate of around 5%, but that figure masks the real cost of byzantine trade barriers. U.S. rates range anywhere from zero (for politically unsupported products) to over 30% for many textiles and even 125% for peanuts sold over the quota. Differentiated tariffs create huge variations in what is called "effective protection" rates. This is a recipe not only for lobbying, as wealth is bestowed by government, but also for resource misallocation and inefficiency.
The complex U.S. tariff code is also costly to administer and breeds absurd conflicts. Indeed, the U.S.'s harmonized tariff schedule fills an astounding 3,825 pages. It requires an army of administrators and a detailed classification system that has spawned metaphysical debates over the nature of a minivan (car or truck?) and, more recently, over the taxonomy of Halloween costumes. Such debates are increasingly meaningless as technological progress blurs the boundaries between products and even industries.
Simplifying and lowering U.S. tariffs has become progressively more difficult because uneven rates give special interests an incentive to fight for their pieces of the protectionist pie, and consumers typically don't organize to fight for free trade. In Chile, however, a move from a 6% tariff rate to a zero rate over a period of several years would be positive for businesses, increasing market capitalization and benefiting both employees and shareholders.
Of course, Chile still has major reforms to implement, and progress can't be taken for granted. But the country's future as a free-trade nation is already secure. One recent proposal would achieve a zero tariff by the bicentennial in 2010; a reduction of only a single percentage point would be needed each year after 2003. If that happens, Chile will be the first sovereign state to recognize fully the right of its citizens to transact freely with anyone in the world. It's about time; after all, countries work that way internally. With political borders losing their economic relevance in the new world of globalization and cyberspace, such a unilateral move would be both pioneering and visionary.
The Chilean experience provides a powerful lesson for U.S. free traders. Liberalization does not take place in a vacuum; the proper economic climate and culture are essential. A flat tariff rate and Social Security reform leading to private individual accounts should be top priorities, not only for those who are pro-choice on employees' retirements, but also for everyone who defends the right of Americans to trade freely.