What is a Tariff?

A tariff is a tax imposed by one country on the goods and services imported from another country.

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Tariffs

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.

Key Takeaways

  • Governments impose tariffs 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.

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.

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.

Tariffs can protect domestic industries but often at the expense of consumers, who may have to pay higher prices.

History of Tariffs

In pre-modern Europe, a nation's wealth was believed to consist of fixed, tangible assets, such as gold, silver, land, and other physical resources (but especially gold). Trade was seen as a zero-sum game that resulted in either a clear net loss of wealth or a clear net gain. If a country imported more than it exported, its gold would flow abroad, draining its wealth. Cross-border trade was viewed with suspicion, and countries much preferred to acquire colonies with which they could establish exclusive trading relationships, rather than trading with each other. 

This system, known as mercantilism, relied heavily on tariffs and even outright bans on trade. The colonizing country, which saw itself as competing with other colonizers, would import raw materials from its colonies, which were generally barred from selling their raw materials elsewhere. The colonizing country would convert the materials into manufactured wares, which it would sell back to the colonies. High tariffs and other barriers were put in place to make sure that colonies purchased manufactured goods only from their colonizers. 

The Scottish economist Adam Smith was one of the first to question the wisdom of this arrangement. His "Wealth of Nations" was published in 1776, the same year that Britain's American colonies declared independence in response to high taxes and restrictive trade arrangements. Later writers such as David Ricardo further developed Smith's ideas, leading to the theory of comparative advantage. It maintains that if one country is better at producing a certain product, while another country is better at producing another, each should devote its resources to the activity at which it excels. The countries should then trade with one another, rather than erecting barriers that force them to divert resources toward activities they do not perform well. Tariffs, according to this theory, are a drag on economic growth, even if they can be deployed to benefit certain narrow sectors under some circumstances.

These two approaches—free trade based on the idea of comparative advantage, on the one hand, and restricted trade based on the idea of a zero-sum game, on the other—have experienced ebbs and flows in popularity. Relatively free trade enjoyed a heyday in the late 19th and early 20th centuries, when the idea took hold that international commerce had made large-scale wars between nations so expensive and counterproductive that they were obsolete. World War I proved that idea wrong, and nationalist approaches to trade, including high tariffs, dominated until the end of World War II.

At that point, free trade enjoyed a 50-year resurgence, culminating in the creation in 1995 of the World Trade Organization, which acts as an international forum for settling disputes and laying down ground rules. Free trade agreements, such as NAFTA and the European Union, also proliferated. Skepticism of this model—sometimes labeled neoliberalism by critics, who tie it to 19th-century liberal arguments in favor of free trade—grew, however, and Britain in 2016 voted to leave the European Union. That same year Donald Trump won the U.S. presidential election on a platform that included a call for steep tariffs on Chinese and Mexican imports.

Critics of multilateral trade deals to eliminate tariffs—who come from both ends of the political spectrum—argue that these deals erode national sovereignty and encourage a race to the bottom in terms of wages, worker protections, and product quality and standards. The defenders of such deals counter that tariffs lead to trade wars, hurt consumers, hamper innovation, and encourage xenophobia.