Tariff Basics

Put simply, a tariff is a specific tax levied on an imported good at the border. Tariffs have historically been a tool for governments to collect revenues, but they are also a way to protect domestic industry and production. The theory is that with an increase in the price of imports, American consumers would choose to buy American goods instead. In today’s global economy, many products we buy in the United States have parts from other countries, or were assembled in other countries, or were manufactured entirely overseas.

Key Takeaways

  • Tariffs are duties on imports imposed by governments to raise revenue, protect domestic industries, or exert political leverage over another country.
  • Tariffs often result in unwanted side effects, such as higher consumer prices.
  • Tariffs have a long and contentious history, and the debate over whether they represent good or bad policy rages on to this day.

In today’s free market-leaning global economy, tariffs have something of a bad reputation. And rightfully so: many economists, for instance, blame the Smoot-Hawley Tariff for worsening the Great Depression in the 1930s. In an attempt to strengthen the U.S. economy during the Great Depression, Congress passed the Smoot-Hawley Tariff Act which increased tariffs on farm products and manufactured goods. In response, other nations, also suffering, raised tariffs on American goods bringing global trade to a standstill. Since then, most policymakers, on both sides of the aisle, have turned away from trade barriers like tariffs towards free-market policies that allow nations to specialize in certain industries and incentivize optimal efficiency.

The U.S. had not imposed high tariffs on trading partners since the early 1930s. Because of the tariffs during that era, economists have estimated that overall world trade declined about 66% between 1929 and 1934. In the post World War II period, President Donald Trump was one of a few presidential candidates to speak about trade inequities and tariffs when he vowed to take a tough line against international trading partners, especially China, to help American blue-collar workers displaced by what he described as unfair trade practices.

How a Tariff Works

Tariffs are used to restrict imports by increasing the price of goods and services purchased from another country, making them less attractive to domestic consumers. There are two types of tariffs: A specific tariff is levied as a fixed fee based on the type of item, such as a $1,000 tariff on a car. An ad-valorem tariff is levied based on the item's value, such as 10% of the value of the vehicle.

Governments may impose tariffs to raise revenue or to protect domestic industries—especially nascent ones—from foreign competition. By making foreign-produced goods more expensive, tariffs can make domestically produced alternatives seem more attractive. Governments that use tariffs to benefit particular industries often do so to protect companies and jobs. Tariffs can also be used as an extension of foreign policy: Imposing tariffs on a trading partner's main exports is a way to exert economic leverage.

Important

The cost of tariffs are paid by consumers in the country that imposes the tariffs, NOT by the exporting country.

Tariffs can have unintended side effects, however. They can make domestic industries less efficient and innovative by reducing competition. They can hurt domestic consumers, since a lack of competition tends to push up prices. They can generate tensions by favoring certain industries, or geographic regions, over others. For example, tariffs designed to help manufacturers in cities may hurt consumers in rural areas who do not benefit from the policy and are likely to pay more for manufactured goods. Finally, an attempt to pressure a rival country by using tariffs can devolve into an unproductive cycle of retaliation, commonly known as a trade war.

Trump's Tariffs

It may feel like we’re talking about tariffs more now than we were under President Obama, and that's because we probably are. A large part of President Trump’s economic policy revolves around American protectionism, which typically means more tariffs. Putting American businesses and manufacturing first means taxing our global competitors in those industries.

The first tariffs imposed by the Trump Administration were on solar panels and washing machines. Robert Lighthizer, the U.S. Trade Representative announced that, after consulting with the Trade Policy Committee and the U.S. International Trade Commission, president Trump decided that, “increased foreign imports of washers and solar cells and modules are a substantial cause of serious injury to domestic manufacturers.” The first 1.2 million imported washing machines would be taxed at 20% and the subsequently imported washers would be taxed at 50% in the following 2 years. For imported solar panel components, they would now be taxed at 30% with the rate declining over four years.

Soon after the tariffs on washing machines and solar panels were imposed, the Trump administration slapped tariffs on imported aluminum. By June 1, a 25% tariff on all imported steel was imposed and a 10% tariff on aluminum from the European Union, Canada and Mexico was also imposed. What is notable here is that these were our top trading partners and allies, and they were not happy with these additional tariffs. In response, the EU issued a 10-page list of tariffs on U.S. goods ranging from Harley-Davidson motorcycles to bourbon. Similarly, Canada and Mexico are planning retaliatory moves against the tariffs.

At this point in mid-June, only a small fraction of the overall U.S. economy was impacted by these tariffs. In March of this year, Morgan Stanely estimated that Trump’s tariffs on washing machines, solar panels, steel, aluminum, have covered only 4.1% of U.S. imports. In terms of global trade, they cover just 0.6%, the bank calculated.

In a survey of economists conducted by Reuters, the Trump administration’s new tariff was very poorly received. Almost 80% of the 60 economists surveyed believed that the tariffs on steel and aluminum imports would actually harm the U.S. economy, with the rest believing that the tariffs would have little to no effect. All in all, none of the economists surveyed thought that the tariffs would benefit the economy.

Trump and China 

But, only a few weeks later, on July 6, fears of an all-out U.S. trade war seemed to be validated as the Trump administration imposed even more tariffs, this time on China. These tariffs came after the Office of the United States Trade Representative (USTR) released the results of its Section 301 investigation into China’s unfair trade practices. The 200-page report calls out China’s use of preferential industrial policy to unfairly support Chinese firms, the country's discrimination against foreign firms, and disregard for intellectual property.

In response to what Trump says are China’s unfair trading practices, the U.S. president imposed sweeping tariffs on $34 billion worth of Chinese goods. The tariffs target manufactured tech products from flat-screen televisions, aircraft parts, and medical devices to nuclear reactor parts, and self-propelled machinery. These tariffs, Trump hopes, will impact mostly Chinese businesses and not the American consumer, at least not immediately.

China promptly retaliated by imposing their own tariffs that target American agricultural products like pork, soybeans, and sorghum and warnings of “the largest trade war in economic history to date,” as reported by NPR's Colin Dwyer. The Chinese tariffs target American farmers and big industrial-agriculture operations in the mid-west. The same political groups that voted for Donald Trump in 2016 and, in theory, have the most influence on his policies. As the 2018 midterm elections approach, if President Trump’s own constituency and the powerful agro-farm sector are hit hardest by these tariffs, then perhaps they will pressure him to lower the barriers.

Impact on the U.S.

This looming trade war has many worried that American consumers will see price increases on American products. Companies affected by tariffs essentially have three options: they can absorb the extra expense, increase prices, or move production to another country. While the impact on consumer goods appears to be low at the moment, the Trump administration’s 25% tariffs on Chinese goods will inevitably hit products sold to American companies.

"Prices would likely rise in the near term as tariffs increase the cost of imports, and some firms would be forced to pass rising costs along to consumers or shutter," Wells Fargo investment strategy analyst Peter Donisanu wrote in a July 6 note to investors.

While the effects may be limited for now, if the U.S. and China, the worlds largest economies, commit to an all-out trade war, we could be looking at a complete shake-up of the global economy.