Trump is using tariffs as his main international economic policy tool and is providing two conflicting narratives on why he is using them. On the one hand, he suggests that raising tariffs is the key to making America wealthy again: the US government will supposedly raise trillions in tariff revenue, manufacturing production and jobs will move back to the US, and the US trade deficit will finally shrink. On the other hand, tariffs are an instrument to bring countries to the table and negotiate a deal.[1] Yet, of the two narratives, only one can stand. To bring back jobs and reduce the deficit, tariffs must be permanent. If they are a negotiating tool, they must be temporary.

Leaving behind the motivations for the tariff increases, economists tend to disagree that raising tariffs will make America wealthier. Ever since the first round of tariffs on Canada and Mexico was announced, experts have warned about the negative consequences: prices for US consumers will increase, fewer products will be available, exports will fall, and economic activity (GDP) will contract. And this is just for the US. Since the US is a large market with the power to affect world demand and prices, the negative effects of tariffs will be felt abroad too. Plus, if trade partners retaliate, the losses for all will just amplify further.

Tariffs are not always harmful however, as they can have both harmful and beneficial effects for the economy that imposes them. Most economists argue that the negative impacts outweigh the positive ones. Let us try to disentangle the key ways in which tariffs work.

How do tariffs affect the economy?

Here is an easy guide to tariffs and trade. This diagram lists the main actors involved, and the colours signal if they are likely to suffer or be helped as a consequence of higher tariffs.

 

Note: *lower prices charged by the exporter are positive for the import-imposing country, but they impact negatively on profit margins of foreign producers.[2]

Tariffs are a tax on imports which is paid by the importer. For example, a 25% tariff applied on a foreign car whose price (as charged by the exporter, and including transport costs) is $20,000, would result in a charge to the importer of $5,000.  When tariffs rise, the importing firm has a few options:

1 – Pass some of the tariff levy on their clients, e.g., the consumers -> higher prices

2 – Absorb some of the tariff themselves by reducing their profit margin -> less profits

3 – If they have market power, ask the exporter to cut their prices -> lower profits for the foreign exporter

Typically, a combination of all three will occur. While the exporter could also absorb part of the extra cost by reducing its profit margin, the evidence suggests that this does not happen in general, with exporters passing most / all the extra costs to the importer. However, higher final prices (because of tariffs) imply less sales, hence less revenues and profits for the exporters.

Options 1 and 2 will have a second round of effects, impacting mostly Gross Domestic Product (GDP), i.e. a measure of size of an economy.

4 – If tariffs hit consumer goods, demand will contract -> lower GDP

5 – If tariffs hit intermediate inputs -> the cost of production will rise -> the price of final goods made with such inputs will increase. This will:

• Reduce domestic sales -> lower GDP
• Reduce exports -> lower GDP

6 – Lower profit margins can induce a contraction of activity and workforce -> lower GDP

Option 3 can induce further negative effects:

7 –  If foreign firms must cut prices, or face lower demand, they might stop exporting -> fewer (consumer or input) goods   are available.

8 – Fewer/worse inputs can impact negatively on domestic firms’ productivity -> lower GDP

So far, the story sounds pretty grim, so why do countries even consider raising tariffs?

There are three main reasons:

(a) The positive side of tariffs is that they protect domestic producers from foreign competition, (b) they generate government revenue (aka, the trillions that Trump said the US would rake in by charging trade partners to sell in the US), and (c) if exporters drop their prices then the home economy gains from those lower prices.[3]

Protection for domestic firms allows them to expand, adding to GDP and creating jobs. The issue is that protection for a small number of economic actors will come at the expense of higher prices for everyone: e.g., car manufacturers might welcome the auto tariffs (US cars become relatively cheaper than the foreign ones), but everyone buying a car in the US will have to pay more for it. Importantly, domestic producers will very likely also need foreign inputs, and if the latter become more expensive, the potential gains from protection can evaporate rapidly.

Tariffs generate extra-revenue for governments, that could be spent to remedy the negative impacts described in points 1-6 above. Whether extra tariff revenues will be enough to compensate for the losses depends on the type of tariffs (e.g., which sectors are hit) and on the structure of the economy. Simulations based on the most recent data suggest that the increase in tariff revenues will not be enough to compensate for the other losses.

Furthermore, while tariffs add to government revenue, lower GDP and domestic spending will take away from it, through lower revenue from other taxes (direct and indirect ones).

Lastly, there are theories on how to set an “optimal tariff” schedule: if a country is large enough to affect world demand and prices, tariffs could induce a reduction in the price of imports, rather than an increase. However, the gains that materialize for the importer are generally at the expense of the exporter, and given today’s deeply intertwined global supply chains, increasing tariffs will most likely be harmful for everyone.

Trump has also argued that the tariffs will help reduce the US’ trade deficit. We do not cover this here, but again most economists would argue that this is seriously mistaken.

How does all this enter models used for simulations?

The mechanisms so far described are fairly intuitive. Almost all of them are at work in the models that economists use to simulate the impact of tariff changes. The details and the richness of predictions that a model will be able to deliver depend on its sophistication. To produce effects along the lines of points 1-6 (point 7 and 8 are harder to include in simulations), a model should have two key features:

1. General equilibrium structure
2. Multiple sectors with input-output linkages

A general equilibrium model allows for shocks on one side of the economy to reverberate in other parts of the economy. For instance, if an increase in US tariffs reduces a country’s exports to the US, that country will have lower revenues and might import less from third countries.

The input-output linkages consider the fact that, for instance, steel is used as an input in the production of cars. An increase in the tariff on steel will lead to an increase in the cost of producing cars, resulting in a higher price (and lower sales) for the automotive industry. There are also second and higher order effects related to input-output linkages. As vehicles are used to produce steel (e.g., trucks to move goods) the steel industry will see its input costs increase. This will result in higher prices for steel, which in turn increases the price of vehicles further, and so on, until prices stabilize as the successive price increases become progressively smaller. All these effects are accounted for in general equilibrium models with input-output linkages.

Why would US exports drop if the US raises its import tariffs, while other countries do not?

The inclusion of input-output linkages can explain some of the results, which might be puzzling at first. The reason is in the cost of intermediate inputs. By raising tariffs, the US is increasing its production costs. This will lower US sales everywhere, both at home and abroad. Ironically, the US might experience a larger drop in exports than other countries while still not facing any additional tariffs on its exports.

We have simulated the impact of Trumps’ Reciprocal Tariffs using such a model. Our simulations suggest that the tariffs might cost US consumers about $2,000 per capita each year, and that US goods exports to the world could fall by 25-35%. See this blog for more details as well as the impacts on other countries.

The overall message is clear: tariffs are unlikely to help the US economy, and will negatively impact third countries. And all of this does not even account for the large negative effects of uncertainty and the knock-on effects on investment.

Footnotes

[1] For instance, the 2018 trade war with China led to the US and China signing an agreement to de-escalate the trade conflict.

[2] We thank Michael Gasiorek and Charlotte Humma for their help designing this diagram.

[3] This is the argument that lies behind the application of an “optimum tariff”, which is the tariff that yields the largest gain for the domestic economy.

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