In the modern global economy, final goods are typically produced by combining domestic and foreign value added via global supply chains. Foreign value added accounts for 20 percent of the value of final manufacturing output in many countries, and more than 50 percent in some countries and sectors. In turn, imported final goods contain substantial domestic value added, as exported intermediate inputs return home embodied in foreign-made final goods.

These global supply chain linkages alter the conventional calculus of import protection. First, taxing imports hurts those upstream domestic firms that supply inputs to foreign producers, because import barriers depress the value of foreign goods produced and hence revenue accruing to domestic input suppliers. This mechanism dampens governments’ incentives to impose import protection. Second, when domestic final goods firms use foreign value added in production, some of the benefits of an import tariff are passed back through the supply chain to foreign input suppliers. This too discourages import protection.

Despite these observations, global supply chains are absent in most theoretical and empirical analysis of trade policy. This omission is conspicuous in light of the growing importance of global supply chains as conduits of trade. It is also out of step with ongoing discussions among trade policymakers, in which supply chain concerns are front and center.<sup>1</sup> In this paper, we introduce cross-border supply chain linkages into a workhorse terms-oftrade model of trade policy. We use the model to characterize how government objectives over final goods tariffs depend on the nationality of the value-added content embodied in home and foreign final goods. Using newly assembled data on bilateral applied tariffs, temporary trade barriers (TTBs), and value-added contents, we then test the predictions of the model for 14 major economies over the 1995-2009 period. We find strong support for the empirical predictions of the model: by erasing the distinction between final goods made at home versus made abroad, global supply chains are reshaping trade policy.

Our framework and results contribute to both the theoretical and empirical trade policy literatures. The first theoretical contribution is to extend the canonical terms-of-trade theory to include cross-border supply chain linkages. In our model, final goods are produced by combining domestic and foreign value added (equivalently, home and foreign primary factors). The use of foreign value added in production drives a wedge between national income and the value of final goods production in each country: some revenue from domestic final goods production ultimately accrues to foreigners, while some foreign final goods revenue is paid to home residents. This re-conceptualization of the production process changes the mapping from prices to income, and hence welfare, relative to standard models. As a result, global supply chains alter government incentives to apply import protection.

> 1On the role of supply chains in policy discussions, see the WTO’s Made in the World Initiative and the 2014 World Trade Report [WTO (2014)]. See also Baldwin (2012) and Hoekman (2014).

1