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Tariffs – A Many-Edged Sword - Revised and Corrected 11/18/24

There is a great deal of “news” these days about slapping tariffs on just about everything being imported into the U.S. But, a great deal of what we’re hearing is incorrect.

Tariffs are one the oldest trade negotiation tools, dating back millennia. The fundamental intention of a tariff on an imported product is to protect domestic industries and commodity producers from foreign competition. Tariffs are fundamentally anti-free-trade measures.

Historically, tariffs have come and gone based on economic circumstances. During wars, for example, countries typically raise tariffs to stimulate domestic production of goods important for national security, such as farming, technology, and products related to weapons manufacturing.

The heyday of tariffs was in the “Mercantile” period in history -- 17^th and 18^th Century – when the U.S., in particular, was trying to protect its nascent domestic industries and commodity producers from foreign competition. This generally worked because the global economy was much smaller then, most staple items were source locally, we were less globally interdependent, and having international trading partners was not nearly as important as it is today.

Back then, tariffs functioned more like “tolls” (which are essentially “user” fees) that were assessed and collected directly by the local, regional, or federal government at major ports and borders when someone tried to bring products into the country over a bridge or tunnel or at a dock. However, what’s important to recognize is that tariffs and tolls are different animals.

In our inextricably inter-connected, global, market economy, how tariffs function, whom they punish, and whom they generate revenues for is different from how tolls traditionally function.

Tolls produce revenues for the government without inflating the cost of the product for U.S. consumers because they are paid by the exporter to the U.S. Yes, that foreign manufacturer can raise its prices to compensate for the toll's cost, but then their toll goes up even higher, making their products even less competitive.

Tariffs can also produce revenues for the U.S. government because those tariffs are paid to a U.S. Customs authority at entry into the U.S. But tariffs (essentially an import "tax") are paid by the U.S. company that is importing the product or service, not the foreign competitor, who must either add the cost of that tariff to the price of the goods, products, or services they sell to U.S. consumers or take a hit to their profits.

For example, if a Chinese manufacturer sells electronics to a U.S. importing company, the U.S. company pays the tariff to U.S. Customs, not the Chinese manufacturer. And, yes, tariffs result in the Chinese product being more expensive in the U.S. market and therefore, less competitive. But both Chinese manufacturers and U.S. consumers suffer the consequences of that.

The inflationary impacts (or profit reduction impacts) of tariffs on goods and services U.S. companies import end up being inflationary and counterproductive (consumers pay more and/or U.S. companies are less profitable).

On the other hand, tolls (such as a docking fee at a port) hurt foreign competitors more because the toll (which might, for example, raise the shipping costs charged by the maritime shipping company) ultimately comes out of their profits.

In this scenario, the U.S. importer has no added cost that they need to pass on to U.S. consumers. And since most foreign producers greatly value their access to our market, it's more likely they will take a hit to their own profits than raise their prices, proportionately.

Misunderstanding this difference is the basis of great confusion about tariffs. And this confusion has had and will continue to have unintended consequences.

So why add tariffs?"

Crimes and Punishments

The term “free trade” sounds nice. Still, trading partners have always worked to exploit any advantage available. In international trade, the physical, practical, cultural, lawful, ethical, and other differences create an extremely uneven playing field even under the best of circumstances.

All countries subsidize certain domestic industries in one way or another, through tariffs, tax credits, tax deductions, lower or higher tax rates, direct financial assistance, and so on. (In the U.S., the oil and gas business is one of the most heavily subsidized industries, with taxpayer money.)

However, as we all know, some countries have strong worker and human rights protections, while others have almost none. Some countries acknowledge the rule of law, intellectual property rights, and international trading agreements, but many don’t. Some countries have strong consumer protection laws, while others do not, which encourages counterfeit and harmful products (toxic ingredients, faulty construction, etc.).

All of this can result in a legitimate desire to punish the bad actors. Sometimes that works but sometimes it doesn't. But let’s not kid ourselves about what’s at stake and who pays the cost. I'm not arguing for or against tariffs, per se, but if we are going to use tariffs to be noble warriors, we should be ready to pay for it.

Finally, failing domestic monopolies love tariffs. That’s another part that most politicians will never mention.

Unintended Consequences

During social, economic, or political stress, governments gravitate toward using tariffs as political weapons against rivals and to gain favor with voters. Unfortunately, history shows that this can have the opposite effect. What is intended to hurt a foreign rival ends up hurting an entire domestic industry or our entire economy.

The truth is that tariff wars are ultimately just a pissing contest, a game of chicken. He who flinches first loses, unless no one flinches and then everyone loses, because the added cost of tariffs, ultimately paid by consumers, are highly inflationary… until the whole game implodes under its own weight.

The most glaring example of this was the passage of the infamous Smoot-Hawley Tariff Act of 1930. It dramatically raised tariffs, which raised prices, crippled companies that were already operating on a lot of debt and at razor-thin margins, causing a sharp decline in global trade, which (along with the government raising interest rates to “punish ‘evil’ debt levels”) drove the U.S. and the world economy deeper into the Great Depression of the 1930s.

In theory, a tariff makes foreign products more expensive than the same product offered by a U.S. producer or at least creates parity. This is supposed to make U.S. goods and services more competitive and profitable. However, that makes the huge assumption that U.S. companies can produce competitive products or ones of equal or superior quality and value.

That’s a very big assumption. People will not automatically “buy American” if our domestic products are inherently inferior.

And what if demand for a foreign product remains high, despite the tariff, because it is simply a much better product or because it is an essential component of a U.S.-made product that cannot be easily duplicated by U.S. companies (e.g., military components, critical infrastructure components, rare earth minerals, proprietary technology, foods that cannot be grown here, etc.)?

Many U.S. companies need foreign products, services, and materials to produce their “made in the USA” products. They have no choice but to automatically raise prices for their products sold to U.S. consumers if tariffs are imposed on the products, services, and materials they need to import.

Another inherent assumption about tariffs is that “protecting” (often coddling) a U.S. company will not affect their motivation to innovate. Human nature has shown us otherwise. In most cases, a lack of competition makes companies more complacent and less competitive. Therefore, by thinking that a tariff will only hurt a foreign company rival, by hurting their access to the American market, we often inadvertently cripple our own.

For example, there is talk about implementing tariffs at levels unseen since the Great Depression, including 10%-20% tariffs across the board and a 60% tariff on goods from China. Such policies would push down US GDP by as much as 2.3% after two years, according to a report from the nonpartisan Tax Foundation. The last time tariffs like these were significantly increased it equated to $80 billion worth of additional taxes on American consumers.

Yet another assumption is that protected companies will continue to charge the same competitive prices they were charging before the tariffs went into effect. The reality is that since the prices for goods and services from their foreign competitors are now higher, domestic companies can charge more for their products and still look competitive with (or less expensive than) their foreign rival… and can do so without any improvements to their products or their productivity. Again, this is inflationary.

Granted that sometimes tariffs are justified, but what’s the right balance? That is the question we need to always be asking.

Summation

Some of the key unintended consequences of imposing tariffs that should always be considered include,

Reduced Economic Growth:

Tariffs tend to reduce overall economic output and growth. For example, estimates suggest that the Trump-Biden tariffs will reduce long-run GDP by 0.2% and employment by 142,000 full-time equivalent jobs.[1]

Higher Consumer Prices:

Tariffs often lead to increased prices. For example, the 2009 tariff on Chinese tires caused tire prices to rise by 26% for Chinese-made tires and 3.2% for domestic tires, costing Americans an extra $1.1 billion.[2]

Job Losses:

Tariffs protect jobs in targeted industries, but they lead to job losses in other sectors. A 2019 study found a net decrease in manufacturing employment due to tariffs, as the negative effects of rising input costs and retaliatory tariffs, outweighed the benefits to protected industries.

For example, the 2002 tariffs on foreign steel resulted in more jobs lost in steel-using industries than existed in the entire steel-producing sector. A 2020 study found that tariffs on steel and aluminum likely resulted in 75,000 fewer manufacturing jobs in steel-using industries while creating just 1,000 jobs in steel production.

Inefficiencies and Reduced Productivity:

By creating a protected domestic market, tariffs can blunt competitive pressures that otherwise force firms to remain innovative.[3] High tariffs can also lead to the misallocation of resources within industries, transferring capital from high-productivity to low-productivity (protected) sectors. Studies have shown that when monopolies created by tariffs were dismantled, productivity at individual factories often doubled in just a few years.[4]

A good example of this is the recent talk about placing a high tariff on Chinese autos and ending the $7,500 tax credit on the purchase of electric vehicles in the U.S.

With U.S. EV manufacturers already falling behind Chinese EV companies, this proposed "protectionist" tariff will only serve to make U.S. car makers even less competitive and even less likely to be able to compete in foreign markets. More than a half-century of auto industry protectionism has made this once giant, U.S. industry a minor contributor to our GDP.

Supply Chain Disruptions:

Tariffs usually create ripple effects throughout the domestic and global supply chain. Protecting one industry affects all industries that supply or purchase goods from the protected sector, forcing companies to restructure their supply chains, and leading to increased complexity and short term inefficiencies (price inflation).

Retaliatory Measures:

Tariffs almost always lead to retaliatory measures from other countries, escalating trade tensions, and harming the liquidity of global trade to the long-term benefit of no one. In the end, prices have risen, trade has fallen, and we’re all right back where we started.

Worse than that, other markets that we are trying to cultivate in other countries that are heavily reliant on exports face significant economic challenges when global trade is hit with tariffs. The result of the tariffs in these cases are counter-productive.

Uncertainty = Inefficiency, Doubt, and Fairness:

Even threatening tariffs creates uncertainty in markets, leading to delayed and inefficient decision-making by private capital. And it's no surprise that research has also found that big political donors were more likely to be granted tariff exemptions.

All things considered, the data would suggest that if used at all, tariffs should be as narrow and targeted as possible.

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[1] https://taxfoundation.org/research/all/federal/trump-tariffs-biden-tariffs/

[2] https://news.gsu.edu/2024/10/15/are-tariffs-good-or-bad-for-the-economy/

[3] https://taxfoundation.org/blog/trump-tariffs-impact-economy/

[4] https://www.minneapolisfed.org/article/2012/new-and-larger-costs-of-monopoly-and-tariffs

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