The Truth About Tariffs

Council on Foreign Relations (CFR)

Newswise — Tariffs have long been used to prop up homegrown industries by getting locals to buy goods produced domestically. For most of the past century, however, tariffs have fallen out of favor because they often lead to reduced trade, higher prices for consumers in tariff-wielding countries, and retaliation from abroad. With tariffs once again rising under U.S. President Donald J. Trump and global trade slowing, many experts fear companies could soon face higher costs and the world economy could suffer.

What is a tariff?

A tariff is a tax imposed on goods imported from a foreign country. Tariffs are paid by an importing business to its home country’s government, most commonly as a fixed percentage of the value of the imports.

Tariffs can serve several goals. Like all taxes, they provide a modest source of government revenue. Several countries have also used tariffs to help their infant industries at home, hoping to shelter local firms from foreign competitors. Some tariffs are also meant to address unfair practices that other countries have used to make their exports artificially cheap.

Who uses tariffs?

Almost every country imposes some tariffs. Exceptions include Hong Kong, which as a “free port” never imposes tariffs. In general, wealthy countries maintain low tariffs compared to developing countries. There are several reasons why: developing countries might have more fragile industries that they wish to protect, or they might have fewer sources of government revenue. The United States, for instance, maintained high tariffs for many years, until income taxes supplanted tariffs as the most important source of revenue. After World War II, tariffs continued to decline as the United States emphasized trade expansion as a central plank of its global strategy.

Median tariff rates for countries, grouped by income level

Who authorizes tariffs in the United States?

The U.S. Constitution grants Congress the power “to regulate commerce with foreign nations, and among the several states,” which it used for more than a century to impose tariffs. Perhaps most infamous, Congress raised close to nine hundred separate tariffs with the 1930 Smoot-Hawley Tariff Act, driving the economy deeper into the Great Depression. But over the past ninety years, Congress has delegated more and more trade authority to the executive branch, in part a response to its mistakes in Smoot-Hawley

Several pieces of legislation underline this trend. Among them, the Trade Expansion Act of 1962 [PDF] granted President John F. Kennedy the authority to negotiate tariff reductions of up to 80 percent, and the Trade Act of 1974[PDF] allowed the president to negotiate some trade agreements with foreign countries, which were then presented to Congress for an unamendable up-or-down vote. Both Democratic and Republican presidents have used this authority to shrink tariffs, create the World Trade Organization (WTO), and enter into a range of trade agreements.

US Average Tariff Rates since 1890

What are the various aims of tariffs?

In a narrow sense, tariffs are intended to protect local industries by making imports more expensive and driving consumers to domestic producers. In the United States, several industries benefit from such tariffs: sugar producers have been protected by tariffs since 1789, and the auto industry has benefited from the so-called chicken tax since 1964, which places 25 percent tariffs on some pickup trucks.

 

Other tariffs are meant to counteract specific measures taken by foreign countries or firms. For instance, the United States applies countervailing duties when another country subsidizes a domestic industry—allowing its exporters to sell products at a lower price than they would otherwise be able to in a free market—undercutting U.S. producers. Antidumping tariffs are applied when a U.S. firm proves that a foreign firm is selling products in the United States at lower prices than they charge in their home market, often in an attempt to drive competitors out of an industry before raising prices.

In both of these cases, tariffs are meant as a penalty that allows domestic producers to compete as if the market had not been distorted. Critics, however, claim that even these tariffs are often disguised protectionist policies.

In some strategic industries, often for goods with military uses, tariffs can be used to ensure a country does not rely on trade for its supply of a good. Section 232 of the Trade Expansion Act of 1962, for example, allows the president to raise tariffs on certain goods for national security reasons. President Trump used this law to raise tariffs on steel and aluminum imports from China, as well as from allies including Canada and the European Union, leading to accusations that national security was being used as a pretext for protectionism.

Many economists challenge the logic behind tariffs and suggest they hurt more industries than they help, but some economists favor tariffs. Robert E. Scott of the Economic Policy Institute, a pro-labor think tank, found that as of late 2018 hundreds of jobs had been created in the steel and aluminum sector and that there was “no evidence of the negative downstream effects” many economists had forecast. Others point out that U.S. taxpayers have subsidized those jobs, with cost estimates ranging from $300,000 to $2.3 million per job created.

Others have made arguments rooted in grand strategy. Alexander Hamilton asserted that tariffs were necessary at least temporarily to help “infant industries” in the United States until they grew strong enough to compete abroad, at which point tariffs could be removed.

Still others support tariffs for purely geopolitical reasons, ceding any economic argument. According to them, tariffs might not help the home country, but wielding such a powerful weapon can hurt adversaries abroad and force them to make political concessions. Several of President Trump’s trade advisors have advanced this notion, framing recent U.S. tariffs on China as a negotiating tactic that has gotten Beijing’s attention. They have pointed to the fact that the threat of tariffs against U.S. ally South Korea led it to quickly institute quotas on steel exports to the United States.

President Trump has often noted that tariffs reduce trade and, if the United States has a bilateral trade deficit with a country, less trade will shrink that deficit. Reducing bilateral deficits has been one of the president’s avowed goals despite a near consensus among economists that bilateral trade balances matter far less than other trade indicators, and that trade deficits aren’t a function of a country’s tariffs. Around the world, many high-tariff countries run substantial trade deficits.

Who pays?

Importers pay tariffs to their home government. Most economists find that the bulk of tariff costs are passed on to consumers. This is particularly true for industries, such as retail or grocery stores, with small profit margins. “I don’t think there are an awful lot of retailers or businesses out there whose margins are so huge that they can just swallow a 25 percent cost increase,” said Philip Levy, an economist in the George W. Bush administration. A study by researchers from the Federal Reserve and the University of Chicago found that consumers bore between 125 and 225 percent of the costs of washing machine tariffs, indicating that appliance retailers charged even more than the tariffs had cost them.

Other studies have pointed to different costs for consumers: with tariffs on their foreign competitors, domestic producers can raise their prices. In May 2019, Goldman Sachs told clients that it found that the effects of U.S. tariffs applied to Chinese goods “spilled over noticeably to the prices charged by U.S. producers competing with goods affected by the levies.” Ultimately, consumers share the burden with importers. At the same time, exporters can cut prices to hold on to their market share. Most empirical research on recent U.S. tariffs suggests this has not occurred, but economists agree it is a possibility.

What is the impact on countries targeted with tariffs?

Tariffs hurt exporters by making their products more expensive. They could struggle to maintain their sales, which could cause profits to fall and, potentially, the country’s economy to shrink. Alternatively, exporters could decide to cut their prices to maintain sales, but this too could shrink their profits.

The effect is particularly worrisome for countries whose economies are export-driven. The Asian Tigers—Hong Kong, Singapore, South Korea, and Taiwan—relied on exports to maintain annual growth above 7 percent for much of the postwar era, though their growth has slowed more recently. Other countries, especially in Asia, have attempted to replicate this. China became the world’s largest exporter in 2009, and Vietnam has become a hub for low-cost manufacturing exports.  More recently, many high-income countries, such as Germany, have turned to exports to support their growth.

Countries that depend on exports for growth can lose many of their consumers when they face tariffs, resulting in strong economic headwinds. Economists forecast that Chinese economic growth will take a 0.8 percent hit when U.S. tariffs announced in May 2019 take effect.

What is the impact on tariff-wielding countries?

Tariffs also act as an economic drag in the countries using them. When consumers bear the brunt of tariff costs, it makes them effectively poorer because prices are higher. Many economists agree that this has been the result of the wave of U.S. tariffs implemented in 2018. One study [PDF] by economists from the Federal Reserve Bank of New York, Princeton University, and Columbia University found that the entire burden of those tariffs fell “on domestic consumers, with a reduction in U.S. real income of $1.4 billion per month by the end of 2018.”

Firms that use domestic products as inputs also see their purchasing power shrink, as tariffs allow domestic producers to raise prices. For example, as automakers pay more for steel, economists suggest they are likely to shed more workers than steel mills will hire. One study by the Peterson Institute for International Economics found that U.S. jobs in steel-using industries outnumbered jobs in steel-producing industries by an eighty-to-one ratio. Separately, CFR’s Benn Steil found that steel tariffs alone could cause forty thousand American autoworkers to get laid off.

Advocates hope that tariffs will force firms in the tariff-wielding country to produce more. China has long maintained a high auto tariff, leading both domestic and foreign firms to open automotive plants in China as they sought to tap into the world’s largest auto market. Such examples show tariffs don’t always hurt domestic production, though there is still a drop in overall trade and countries miss out on the economic gains it can bring.

Perhaps most important, tariffs often lead to retaliatory tariffs. These place the country that first levied tariffs on the other side of the equation and ensure that both its consumers and its export industries will be hit.

What can countries do to mitigate the effects of tariffs?

The most common way for countries to fight back against tariffs—aside from levying retaliatory tariffs—is to subsidize the domestic industries that have been hit. The Trump administration has countered tariffs on agricultural products by providing farmers with $12 billion in aid to make up for lost exports. Trump has considered another $20 billion in assistance as wheat and soybean exports continue to shrink.

Many economists have criticized these strategies as counterproductive and wasteful. Some fear that recipients come to rely on such spending programs, making them difficult to end. Others point out that unilaterally imposing tariffs or retaliatory tariffs could violate WTO rules, though this has not stopped some countries in recent trade disputes.

Some experts, including CFR’s Brad W. Setser, have suggested that export-dependent countries could let their currencies depreciate in the face of tariffs. “Letting the yuan weaken has always been, in my view, the logical asymmetric Chinese response to a trade war,” Setser writes. This would effectively cheapen exports and make them competitive despite tariffs. But it would also make consumers in that country poorer, as the local currency would have less purchasing power.

Another remedy is to find alternative markets for imports and exports. Trump has encouraged this, suggesting that companies facing tariffs on imports from China turn to Vietnam. 

Many companies’ greatest fear is that changes in trading patterns from tariffs will become entrenched. If tariffs lead trading partners to find new buyers and sellers, those new relationships may endure. Chinese importers, for instance, have reacted to their own country’s retaliatory tariffs on U.S. soybeans and liquefied natural gas by shifting to buying from Brazil and Australia. This leaves American suppliers unsure whether lowering tariffs would be enough to bring Chinese importers back.




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