This Q&A was originally published Wednesday by Utah State University — and is used with permission. The responses come from John Gilbert, a professor of economics in the Department of Economics and Finance in the Jon M. Huntsman School of Business at Utah State University. His area of research is international economics, and he has published extensively in international trade theory and international trade policy.
Q: What is a tariff, and how is it different from other taxes?
A: A tariff is a tax applied to imported goods. It doesn’t differ in any fundamental way from any other tax. When goods enter the country, the importing agent is charged a duty before they are able to receive the goods. This drives a wedge between the price they have to pay and the price the seller receives, with the difference being collected by the taxing authority.
Q: How do tariffs affect consumer prices?
A: Tariffs raise the consumer prices of imported goods and domestically produced goods that compete with imports. How much the consumer prices go up by will depend on how much, if any, of the levy the importing agent and the seller are willing/able to absorb. In past tariff events, a substantial majority of tariffs was passed onto domestic consumers in the form of higher prices. Even though the tax is only applied to imported goods, the price of domestically produced goods also rises as competitive pressure from outside is reduced. In this sense, tariffs act like a consumption tax on consumers combined with a production subsidy to domestic producers of the good on which they are applied.
Q: What purposes do tariffs usually serve?
A: Tariffs can serve multiple purposes. In some developing countries they are an important revenue source, for example. They may be used in an attempt to manipulate world prices, or to counteract real or perceived unfair trade practices. At the most basic level though, tariffs serve the purpose of encouraging domestic production of import-competing goods at the expense of production of export competing goods. In this sense they are tools of economic redistribution.
Q: When tariffs are abolished, do prices typically drop or remain higher?
A: In a market economy like the U.S., prices are determined by demand and supply conditions. Tariffs distort decisions, but don’t alter the underlying factors that determine those conditions. They don’t make firms or workers more productive, or generate the new resources that could increase production capacity, or change the preferences that drive demand. So, we would generally expect prices to come back down once tariffs are removed, although they can sometimes be sticky for a period for various reasons.
Q: Why does news of tariffs cause instability in the stock market?
A: Economists aren’t generally able to predict short-term fluctuations in the stock market. There are probably a variety of things going on. Tariffs will distort the economy, and thereby slow economic growth. They exacerbate inflationary pressure, which could slow down or reverse fed interest rate cuts, and further slow growth. The extent of retaliatory action is still unclear, and there has not been a lot of clarity about the timing, nature, purpose and magnitude of the tariffs that will be imposed. All this creates increased uncertainty for investors.
Q: What common items will be most affected by tariffs levied against Canada, Mexico, China and other international trade partners?
A: China, Mexico and Canada are the three largest suppliers of imports to the U.S., supplying around 45% of total US import demand. In the case of China that is mostly made up of electronics. Canada is mostly oil and fuel products, also wood products. Mexico is mostly machinery. Mexico and Canada also supply a large amount of food products and automobiles/auto components. This last industry is very tightly integrated across North America.
Q: What is the economic benefit for tariffs, and is it common for them to be levied against countries during trade negotiations?
A: Few economists see any substantial benefit to tariffs in most cases. They are a blunt instrument of industrial policy at best. It is true that tariffs can increase jobs in protected sectors, but those jobs will come at the expense of jobs in other sectors. Because global supply chains are so complex in modern manufacturing, it is difficult to predict which sectors will expand and which will contract, but a simple example can illustrate the problem. A tariff on steel raises the price of steel and induces steel producers to increase output, so employment in that sector rises. But this requires drawing inputs from other uses. Moreover, as the price of steel rises, industries that use steel (consumer durables, construction, autos) are hurt. Employment in those sectors contracts.
Tariffs are not uncommon in that most countries maintain tariffs on some goods. They are generally very low in developed economies, and somewhat higher in developing economies. In recent history, it is not common for them to be levied against other countries purely as a negotiation tactic. The reason is the recognition that threats have to be credible, which means it has to be in the interests of the country threatening tariffs to actually use them. But it is well understood that tariffs will generally hurt both the country imposing them and the country on which they are imposed, and that retaliation can increase the economic pain of imposing tariffs. So at least in the post WWII era, there has been a general consensus around avoiding heading down the trade war path.
Q: Do you expect to see companies bring manufacturing jobs to the U.S. to avoid future tariffs?
A: It is certainly an argument that can be made. Economists call it tariff-jumping. I think it is unlikely that there will be substantial investments in the near future. Building manufacturing plants is something that takes years, sometimes decades, of planning, and firms will not make large long-term investment decisions when there is little certainty over the economic environment. If a company does not think, or is unsure, that tariffs will remain in place, they are not going to engage in tariff-jumping investment. In any case, it isn’t clear that tariff-jumping changes the fundamentals around the effect of tariffs. The distortionary impacts of the tariff are not changed, and the profits earned on foreign investments in the U.S. belong to the companies doing the investing, not to domestic firms.