The Economic Reality of Tariffs

Exploring the economic trade-offs of tariff policy and global protectionism

Nothing has been more important to the business and investment community than the implementation of widespread tariffs on virtually all trading partners.

The arguments or the stated goals of tariff policy are clear – protecting current American jobs from unfair foreign competition, reshoring manufacturing plants and high-paying jobs, and closing large trade deficits.

However, the economic reality of tariffs is unlikely to achieve these goals for the following reasons.

1) Tariffs Are A Tax

Tariffs raise the price of imported goods. Tariffs are not always passed through to the end consumer. Sometimes, businesses will absorb the increase in price in the form of a lower profit margin, but after-tax national income suffers.

2) Tariffs Protect Inefficient Industries

The reason businesses move out of a country is because another country has a competitive advantage in production. This dynamic increases the efficiency of capital. Tariffs blunt this advantage and encourage less efficient uses of capital. A business no longer has to compete on quality or price. This encourages stagnation over innovation.

3) Tariffs Drive a Misallocation of Resources

One of the most common knocks on excessive government intervention in the economy is that it picks winners and losers rather than letting the free market purely dictate the allocation of capital. Tariffs are not different as they place a government-directed hand on the allocation of capital.

4) Tariffs Increase Unemployment In The Final Analysis

In the first level analysis, tariffs can protect jobs in the targeted industry, but the second and third level analysis often show an overall increase in unemployment. There is an uncomfortable political trade-off. Free trade may negatively impact some domestic industries that get competed away in exchange for cheaper goods for the broader public. This negatively impacts one sector of the economy for a generalized boost in consumption for the larger segment of the economy. If goods become cheaper, consumers have more after-tax disposable income to spend on other goods and services, creating jobs in those sectors. Tariffs work in the opposite direction, helping a smaller domestic industry in exchange for more expensive goods for the broader public, reducing after-tax disposable income to spend on other goods and services, hurting growth and employment in those sectors. If the goal is to maximize overall GDP per capita, a proxy for the overall standard of living, tariffs strongly work against this goal.

5) The Fallacy of Trade Deficits

At face value, it seems that a trade deficit is negative for the deficit country, but trade balances naturally adjust through currency and capital flows. Closing the trade deficit is not necessarily a desirable goal. A trade deficit implies foreign capital is a source of savings in the National Savings and Investment Identity. How we utilize these savings is a different question.

6) Tariffs Often Lead to Retaliation

Tariffs and trade wars often lead to a generalized increase in the world tariff level, which furthers all the negative points listed above. In most cases, if a country places a tariff on you, that country is experiencing negative economic costs in doing so, as outlined in the prior five points. Retaliating with your own tariffs imposes those same negative consequences on you.

National Security Exception

In some cases, it is not wise to have critical resources dependent on a hostile nation. In this case, maintaining some domestic production for the sake of national security is likely appropriate. However, the reason for the tariff policy doesn’t negate the economic consequences. You simply trade improved national security for negative economic consequences. In some cases, this could be a strategic move.

The Bottom Line

Increasing the overall global or domestic tariff level is not a path to an improved standard of living. Tariffs have an undeniable economic cost that moves a country away from maximizing the growth rate in the standard of living. Trade policy is a complex political matter because there are winners and losers to the free trade option and the protectionist option. However, it is clear that the free trade option has the most positive net effect on the overall standard of living.

To be clear, if the end result of these tariff wars is a decrease in the global tariff level, that would be a long-run benefit to the United States and the global economy, less any short-term disruptions in achieving that result. If the end result is an increase in the global tariff level, negative economic consequences will be felt by the United States and the global economy.

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