Despite was the US President says, tariff is – at least among economists – far from the most beautiful word in the English language. But it’s certainly the word of the week, and has been resurrected from the doldrums of interest in seemingly no time (writes Fraser of Allander Institute’s JOAO SOUSA).
What even is a tariff?
What we usually call a tariff is a tax on the importation of a good into a jurisdiction. The tax itself is called a customs duty in the National Accounts, and can be levied either as a specific (certain amount per unit) or ad valorem (that is, as a percentage of the price). The duty is payable on clearing customs and therefore payable on entering a territory legally for consumption, final or intermediate, and depends on two things: the good in question and its provenance.
A trade tariff is also the name of the overall regime: for example, see this link for the UK’s set of tariffs for each good from each jurisdiction.
What do economists know about tariffs?
Generally, tariffs are by themselves quite bad for the whole of the economy and for consumers. International trade allows countries to focus on what they have comparative advantage in, which means they can sell those goods (and services) abroad and import other countries’ goods that are produced more efficiently than otherwise would be the case.
Importantly, this is true even if a country is more efficient at producing all goods than others. This was the important contribution of David Ricardo in the 1810s, and focusses on the fact that not focussing on those more productive goods and services has an opportunity cost. So the system as a whole produces more and allows for higher consumption in all countries if they focus on their respective relative strengths.
Of course, the world is a lot more complicated than Ricardo’s original two-factor model. But even now – over two hundred years after On the Principles of Political Economy and Taxation – there is broad agreement that countries tend towards specialising in their comparative advantages and that in turns results in higher living standards.
Even some of the more nuanced views of the effects of globalisation and trade which have emerged in the last decade and a half, such as David Autor’s, is unequivocal about both the overall positive effect of trade on global welfare and on the US as a whole. His argument about the ripple effects on the US of China’s rise and entry into the global trade focusses on both the sectoral and geographical concentration of negative effects.
Who wins and who loses?
Imposing tariffs or increasing them has the opposite effect of trade liberalisation. It will increase prices somewhat to consumers: the extent to which it does will depend on how responsive consumers are to price and how much domestic production can satisfy any pent-up demand.
But most consumer goods which are imported are likely to see significant price rises, especially because of how large the increase in tariffs is. So US consumers as a whole will lose out.
Domestic firms producing goods in competition to those normally imported are the main winners in the short-run, at the expense of consumers, as they will pick up some of the lost international activity.
But the extent to which they gain will be tempered by their ability to source factors of productions, particularly intermediate goods, many of which will come from abroad and be therefore subject to tariffs. Their costs might well go up, which could negate many of their potential gains.
The US federal government will also gain some direct revenue, although imports will likely decline significantly, undercutting some of that increased revenue. The increase in prices is likely to slow economic growth in the US, both because of the hit to real household income and because the Federal Reserve will likely act to curb inflation. It’s possible that overall tax revenues will fall, even if tariff revenues increase.
Across the world, trade will slow down, especially with news of retaliatory tariffs. A general slowdown in trade is bad news for economic growth, and that is the overwhelming channel through which the shock will propagate worldwide. In the long run, slower growth far outweighs any other effect, and means that the world is less efficient at producing goods and services, leading to lower living standards across the globe.
Are there any sensible reasons for increasing tariffs?
The US President’s rationale for imposing trade restrictions is based on the fact that the US runs a trade deficit, and therefore is being taken advantage of.
This obviously makes no economic sense. A nation is not a firm, and so any analogy is misguided. Imports allow US consumers to benefit from more and cheaper goods, and enhances their living standards.
There is no macroeconomic reason to aim for a trade balance or surplus. This is a mercantilist idea that became discredited in the 18th century.
That is to say nothing of the complete fallacy of division being implied by the Trump Administration, which appears to believe that the not only should the US run a trade surplus as a whole, but that it should do so with every country.
This is a preposterous idea, based on no coherent economic theory. It wouldn’t make sense even if one thought a trade surplus made sense to aim for. Which, to reiterate, it doesn’t. People derive utility from consuming goods and services, not from selling them.
The current account – which includes the trade deficit, but also other flows of funds such as investment – can and does matter. But it matters especially for smaller countries which cannot borrow in their own currency and may need hard currency. In those cases, tariffs can be an emergency measure to discourage imports.
Of course, this doesn’t apply to the US in any sense. The US dollar is the anchor currency of the world system, and that has allowed it to run large current account deficits for decades.
Tariffs have historically been used to protect nascent domestic industries from foreign competition. The history of their success is patchy, but the rationale is understandable if a sector is building up its capacity and would be initially inefficient, but could serve as a way of increasing innovation and growth in the future if it gets enough scale.
While this is an oft-cited reason, the dynamic problems are easy to see. Protection from foreign competition disincentivises domestic efficiency, and so the policy might fail as a way to drive competitiveness in the long run. There is also a danger of enhancing the power of firms benefitting from it, who will have a strong incentive to lobby for tariffs to be maintained – therefore improving their position at the expense of consumers.
Targeted tariffs can also be used as anti-dumping measures. The idea is that countries might try to subsidise their exporters – either for economic or other reasons, such as geopolitics – to drive out other countries’ manufacturers from the market.
This is essentially an argument against excessive market power, especially when it comes from countries with state-subsidised or controlled monopolies, and interacts with strategically important sectors such as military supplies.
For example, the European Union and the US have often used these against Chinese steel, arguing that there is an interest in maintaining domestic capability for security reasons. In the long run, however, it’s doubtful whether these tariffs are effective at achieving their aims if the difference in production costs is too large.
There’s also an argument that they could have been useful as a temporary tool to ease the transition to a world where China was entering the global trade system. In this view, tariffs could have slowed down exposure to cheaply made goods that almost overnight made whole industries uncompetitive in certain places in the US and across the Western world. But even if we think this might have been a good idea – and as we’ll explore later – it’s hard to see doing it now being enough to reverse what has happened.
How big an increase in tariffs is this, and what precedent is there?
It’s pretty big. The Yale Budget Lab calculates that the effective tariff rate will now be around 22.5%, up from 2.6% in 2023.
That would mean an 857% increase in the level of tariffs. The actual figures might be somewhat different because there might be some substitution towards lower tariff countries, but make no mistake: this is the largest relative increase in tariffs in a single year in the history of the United States, and will likely bring tariffs to levels not seen since Teddy Roosevelt’s presidency – higher, for example, than in the aftermath of the Smoot-Hawley tariffs of the early 1930s.
Chart: Effective tariff rates for the United States over its history
Source: US Bureau of the Census, US Bureau of Economic Analysis, Yale Budget Lab, FAI analysis
The US might be seen as a bastion of free trade, but that’s only true relatively recently. Tariffs were the main source of government revenue before the federal income tax was introduced in the 1910s, and as such were both a vehicle for trade policy and an important source of funds for military emergencies.
The War of 1812 in particular stands out as a time when it served that dual purpose, raising revenues to fight the UK and acting as a punitive measure for UK-originated goods. With the effective rate reaching over 60% of all imported goods (excluding gold and silver), it is still the high watermark for tariffs in US history.
The following decades saw a see-saw of trade policy. The Northeast of the US was much more protectionist, as it had a larger manufacturing base; Southerners, which sold so much of their cotton (produced using slave labour) to the UK, were much keener on lower tariffs to maintain good relationships with Britain.
After the American Civil War – when tariffs were hiked to provide revenue – the US protected many of its growing industries by maintaining tariffs high. This was followed by a further hike in 1890 by the newly Republican-dominated US Congress, which no longer used the fig-leaf of nascent industry protection – it was straight up shielding of industry from foreign competition.
After a gradual decline in tariffs under Woodrow Wilson, the US reacted back with the unmitigated disaster of the Smoot-Hawley tariffs of 1930. It was meant to shield the US from the worst of the Great Depression, but it did nothing of the sort. It increased unemployment, propagated the banking crisis and unleashed protectionism across the world and ensured the crisis was deeper and lasted for longer.
Since the end of the Second World War, the US has been moving – as has most of the world – to lower tariffs as part of the World Trade Organisation’s (WTO) predecessor, the General Agreement on Tariffs and Trade – until now. There have been sporadic increases on specific goods, but the effective tariff rate for the US has fallen from 10.9% in 1946 to 2.6% in 2023. The US federal government has also diversified its tax base, and customs duties are a minor contributor to its revenues.
Will this lead to reshoring? Structural change is not a two-way street
International trade generates quite diffuse benefits – lower prices and higher diversity of goods available, with each beneficiary getting a small boost which becomes very large when aggregated for a whole country.
But the losses are generally concentrated among those industries which have the most competition from abroad. If those are also heavily concentrated in the same places, and if workers find it hard to move and retrain, the quality of jobs they can find leaves their prospects heavily damaged. All these have been true in the US, with rural Appalachia and being significantly hard hit.
It’s probably true that economists were too sanguine about the effect that trade would have on totemic industries and on particular places. Looking back, a big bang of opening in one go in response to China joining the WTO might well have been the wrong way to manage the transition, and David Autor compellingly argues that it has probably contributed to the political make-up of today’s United States.
But as he says, the transition has happened – it won’t be undone, and it can’t be anyway. As we know full well in the UK as well, structural transformation is not a reversible process – all we can do is look forward to what can be done to manage things given where we are rather than row it back.
Broad-based tariffs are particularly badly suited to respond to sectoral effects. But even so, at the margin, there might be some new jobs in manufacturing in the US if some foreign producers’ goods are made uncompetitive by the new level of tariffs. But these are likely to be small in number, and may well be negative on net once we account for the effect of lower economic growth – particularly if it has an upward effect on the Federal Reserve’s policy interest rate. And it will hurt all American consumers.
The US is now a high-wage, service-based economy. Manufacturing is not what it was in the 1960s, and its competitiveness is on high-value added, high-skilled jobs. This will not bring back high-quality jobs for those without university degrees or return Rust Belt cities to their former glory – that moment has passed, and a new course must be charted. If only solutions were as easy as rolling back time.
To retaliate or not to retaliate – that’s the question
The UK Government appears to have breathed a sigh of relief, with the UK being hit with only the ‘baseline’ 10% tariff. Other countries and trade blocs have had higher tariffs imposed on goods from them, and have immediately retaliated.
Retaliation is not an economic decision; it’s a political one. To impose tariffs is to harm one’s domestic consumers (and voters), and so as an economic strategy by itself it makes little sense. But it can make sense from a political perspective if a country thinks it can force those imposing the initial tariff to think again, especially if producers who sell to those markets can yield significant influence.
One can see the attractiveness of retaliation, but it’s hard to see – at least for the moment – how retaliation might make the prospects of a lower tariff right now any better. But non-retaliation is a stance that politicians can find difficult to maintain, and therefore it wouldn’t be shocking if the UK Government changed tack.
Mostly, though, this is bad news for the Chancellor of the Exchequer
Rachel Reeves eked out as much headroom as she could in last week’s Spring Statement by cutting departmental spending and disability benefit. But her decisions – both last week and in the Autumn Budget – meant that she left herself no room for growth to be downgraded, or else her ‘iron-clad’ fiscal rules would be broken.
The main effect of the Trump tariffs and subsequent retaliations will be – as we discussed earlier – a retrenchment in global trade, which will in turn reduce economic growth globally. Across the world, less trade means less efficient production processes, and therefore lower output and/or higher prices for the same goods.
And that has substantial implications for an open economy like the UK. As the Office for Budget Responsibility highlighted in their scenario analysis, this sort of tariffs on a permanent basis would wipe out her fine-tuned headroom and would force her to tighten fiscal policy again if she wants to comply with her fiscal rules.
The Chancellor’s best hope, then, is that these tariffs turn out to be as short-lived as Trump Steaks.
João is Deputy Director and Senior Knowledge Exchange Fellow at the Fraser of Allander Institute.
Previously, he was a Senior Fiscal Analyst at the Office for Budget Responsibility, where he led on analysis of long-term sustainability of the UK’s public finances and on the effect of economic developments and fiscal policy on the UK’s medium-term outlook.
