A Primer on Tariffs

Understanding Tariffs

What is a tariff? What is the impact of a tariff on the economy? These are questions that economists have studied for a long time and have also come front and center in the political discourse.

How do tariffs work?

At its core, a tariff is a tax on consumption, like a state sales tax: the price of goods and services taxed are increased by the proportional amount of the tax. Where a tariff becomes different from a generic sales tax is how it can be customized. Not only can a tariff be selective on which goods and services to tax, say taxing washing machines as opposed to clothes dryers, but it can also be made conditional on where the product is produced, say washing machines made in China versus those made in the USA. This differentiation also has implications for the mechanics of the tax. A sales tax is levied on the consumer, and a tariff is levied on the importer of the goods in a country. This means the tariff on washing machines from China is paid by the American importer, not the Chinese exporter.

Why do governments impose tariffs?

Governments use taxes to achieve two primary goals: raising revenue and influencing economic behavior. Tariffs, like other taxes, can generate revenue, but more importantly, they are designed to push consumers and businesses away from foreign goods and services and toward domestic alternatives.

Balancing Trade-offs: The Policymaker’s Dilemma

We live in a globalized world. The amount of trade that takes place has systematically outpaced the growth of the global economy for decades. Trade allows firms to source materials and parts from around the world, enhancing efficiency. Trade is also a key driver of increases in the cost of living (not only does growth in trade help drive growth in the economy, but trade-driven increases in the available variety of goods and services also contribute to the well-being of consumers). With this in mind, it might seem puzzling that a government might intentionally limit its ability to trade. Henry George in the 19th century famously said, “In time of peace, we do to ourselves by tariffs what we do to our enemy in time of war.” This sentiment is shared by many economists today.

Are tariffs an effective tool for job creation?

The challenge with trade is that while it creates widespread prosperity, it also imposes concentrated costs on certain workers and firms. Let’s go back to our example of washing machines mentioned above. In 2018, during the first Trump administration, tariffs on washing machines from China were about 20%, significantly raising the cost of these foreign goods. The goal of this trade policy was to protect American appliance manufacturers that had progressively become less competitive relative to their Chinese and South Korean counterparts. As documented by several economists,^1,2 domestic manufacturers were indeed able to retain and expand their workforce. However, domestic manufacturers also increased prices to match the price of foreign products that were raised due to the tariff. In the end, almost the entirety of the cost of the tariff was paid by US consumers in the form of higher prices (this finding is particularly concerning as we have just experienced a period of heightened inflation). The question remains, however, whether retaining and expanding the manufacturing workforce was worth the rise in prices. Economists have estimated that each additional job created by imposing tariffs has cost consumers more than $800,000,¹ an unsustainable amount for long-term growth and stability.

Tariffs: What’s the verdict?

Is there any scope for tariffs? Economists are skeptical about tariffs being a useful tool for job creation. A potential benefit is that tariffs may be used to nudge the reshoring of strategically important goods crucial for national defense. For these products, the simple cost-benefit analysis hinted above does not apply as we now should also account for the “what ifs” of international cooperation.

While tariffs can protect specific industries and jobs, they often come at a high cost to consumers and the broader economy. Policymakers must carefully weigh these trade-offs and consider the long-term implications of trade policies.

1. Flaaen, Aaron, Ali Hortaçsu, and Felix Tintelnot. 2020. “The Production Relocation and Price Effects of US Trade Policy: The Case of Washing Machines.” American Economic Review, 110 (7): 2103–27.

2. Amiti, Mary, Stephen J. Redding, and David E. Weinstein. 2019. “The Impact of the 2018 Tariffs on Prices and Welfare.” Journal of Economic Perspectives, 33 (4): 187–210.