Understanding the Estimated Gains from Trade Pacts

In a previous blog post, I discussed the results—and also some limitations—of our estimates of the economic impact of the Trans-Pacific Partnership (TPP) through “computable general equilibrium” modeling. We do not estimate large gains early on but show that the TPP will generate benefits that matter over time. These benefits would increase especially sharply in the long run if the rules pioneered by the TPP were extended to other large economies in Europe and Asia. This is because over the long term, the trade and investment liberalization that accompanies trade agreements moves workers and resources toward the most productive firms and industries, while increasing worker’s wages and reducing the costs of what people buy.

For the United States, we estimate that implementation of the TPP by 2025 would mean an additional $77 billion per year in real incomes and an additional $124 billion per year in exports (see table 1). These estimates represent permanent jumps in US spending and exports. Thus, real incomes would be greater by $77 billion in 2025 and by a similar percentage every year thereafter. However, this is distinct from additions to US growth. In other words, the gains will not increase from $77 billion the first year to $154 billion the second, and so on. (US growth will increase slightly, to the extent that each year’s gains are partly reinvested.) Some economists do argue for a significant permanent growth effect, but we did not include that possibility since it is rather speculative.

The income gain associated with trade policy can be thought of as technological progress: It allows more spending on goods and services but requires no new borrowing or resources beyond the workers and capital that the United States already has. In technical terms, it's an "equivalent variations" measure of how much more income it would take, absent the TPP, to get the economic benefits provided by the TPP.

The Specification of Income Gains

In addition to the estimates we have published, we have posted many detailed results on our website. This information allows observers to dig into country and sectoral detail on varied dimensions of the agreement. Many have welcomed this level of transparency. Unfortunately, some have used it to search out results that can be used to suggest that the benefits will be smaller than those highlighted in our publications. Such arguments are typically made by citing a single component of the gains, which is necessarily smaller than the total. The following notes will hopefully clear up misinterpretations.

The $77 billion of gains to the US economy is an estimate of the total additional real income expected from the TPP, in other words, the annual, extra money, in 2007 dollars, that Americans could spend on some combination of consumption, investment, and government spending.

This overall income gain reflects both trade effects and foreign direct investment (FDI) effects, including investments by the United States abroad and by other countries in the United States. As explained in Petri, Plummer, and Zhai (2012), investment effects are estimated using a side-model that does not have as much detail as our trade model. This means that some detailed sectoral results on our website refer only to the trade portion of the analysis.

The overall income gain is equivalent to several other measures of economic benefits. For example, it is very similar to real wage, profit and tax revenue gains—commonly known as purchasing power increases. In the case of trade effects, where we do have wage and profit detail, the changes are similar to those in incomes. That is, in the case of the United States each would rise by the same percentage rate as income overall. While there is no significant bias toward capital or labor, there is some bias toward skilled labor versus unskilled labor.

Income gains are also similar to gains in the real value of output, since that's what enables firms to pay higher real wages, profits and taxes. The real value of output goes up when we produce more (trade tends to increase productivity) and when the prices of what we sell abroad (exports) go up relative to what we buy from abroad (imports)—what are called “terms of trade” effects. (Price changes for goods both produced and sold domestically wash out from a national viewpoint and won't affect the real value of US output.)

However, the real output (GDP) measure reported in our spreadsheets does not equal income gains for several reasons noted below, including especially that it measures only trade and not FDI-related effects. But it is important to remember that income gains are what matter, not the amount of physical output that goes into getting them. For example, one can say that Russia is a lot worse off after the fall in oil prices even if it pumps more barrels.

Income gains and real output differ for three technical reasons. First, as with the case of Russian oil, real output changes don't measure changes in the value of that output, which also depends on terms-of-trade effects. Second, our real output measure uses 2007 relative prices (set up to track output growth over time), and not the estimated 2025 relative prices when the TPP effects really happen. Third, our GDP measure does not capture FDI effects, for reasons already mentioned above. These last effects are fairly large for the United States in the TPP because a good part of income gains (some 40 percent) comes from increased FDI between Japan and the United States. The benefits associated with FDI include not only higher profits for multinationals but also productivity gains in the host country, and in added employment at headquarters in the investing country. Unfortunately, our FDI specification is not sophisticated enough to calculate the allocation of FDI gains.

Gains beyond the TPP

As we noted, estimates of early gains associated with the TPP are not large compared with the US economy. This is partly because the agreement will be implemented in steps, with some taking as many as 10 years. Gradual implementation is desirable since it will make any economic dislocations far more manageable than they would be under sudden policy changes.

At the same time, our results suggest that the ultimate benefits of the TPP will be much greater than short-term benefits. The TPP was always envisioned as a pioneering agreement—as a new template for global trade rules last updated by the Uruguay Round agreements in 1994. Major economic changes have occurred since, including the rise of global value chains, the digital economy, and powerful new exporters. TPP rules address these developments. But to make difficult negotiations feasible, the TPP brought together “like-minded” partners that often already have good trade agreements with each other. Because of prior agreements, the added benefits from adopting TPP rules are smaller among these partners than they would have been with randomly selected economies.

This implies that benefits would grow sharply if the TPP template were adopted more widely, with other trading partners. That may well happen due to competitive liberalization: Additional economies will want to join the TPP or other similar agreements in order to avoid falling behind reforms elsewhere. Indeed, our calculations show that extending TPP-style rules across Asian economies that are not yet TPP members would alone triple the benefits. More large gains would follow from agreements with Europe, and ultimately from making some TPP provisions part of the global rule book through plurilateral agreements in the World Trade Organization.