Should We (Ever) Tax Trade? A Theoretical Guide

Are there instances in which tariffs can improve welfare?

Nominal News is an economics newsletter written by a PhD Economist that translates the latest economic research into clear, policy‑relevant insights on current issues. Join 4,000 readers to stay-up-to-date with Nominal News directly in your inbox:

In the next few months, I will be going full time and turning on a paid feature. If you’d like to help me with some feedback (and a chance to win a 3-Month Paid Subscription tier) – please fill out the questionnaire below:

Nominal News Reader Questionnaire

---

Tariffs continue to dominate US economic headlines, especially as the US has recently reinstated them. This entire tariff episode, which started in 2017, has reinvigorated the economics debate around ‘free trade’. All of a sudden, even economists that would previously unequivocally support ‘free trade’, are starting to suggest that tariffs may have a place as a polity tool. One recent paper by Werning and Costinot (2026) (“WC”) goes over the theoretical instances when tariffs may be beneficial.

Photo by Bent Van Aeken on Unsplash

What You’ll Discover Today:

• How economists envision scenarios in which tariffs can be considered as a policy tool;

• Why, nearly universally, tariffs are an inferior policy solution;

• A unique way in which tariffs can re-distribute income.

The Problems with the Term “Free Trade”

First – I’m glad that ‘free trade’ is being revisited. In 2023, I raised the issue of ‘free trade’ being a misnomer, as any trade agreement is more than just tariffs or quotas. From our piece:

“The concept of ‘free trade’ is too vague to be meaningful. Trade agreements involve a lot of negotiation on issues that are beyond what we used to consider as ‘free trade’ – removing tariffs and quotas. The other components, especially regulatory issues, are just as important, not only for the negotiating countries, but even for the wider environment. But these tools are also manipulated by countries and special interest groups to create benefits for themselves. Economists should no longer be quick to say ‘free trade’ is good.”

So I am glad to see that the economic discussion is now focusing on whether maximizing trade improves welfare, and WC, in their paper, highlight what to consider before we can determine that.

Setting the Stage

To start off, it’s important to set the definition of a tariff:

Tariff: a percentage tax levied on the value of goods or services brought into a country, paid upon arrival of the good or service by the importer.

When an activity is taxed, the activity (assuming everything else does not change) is reduced. Thus, tariffs reduce the amount of imports that occur. Many criticisms of tariffs focus on this – we should not be dissuading ‘trade’, as more ‘trade’ is typically welfare improving.¹ So when should we dissuade trade?

Situations of Social Harm

WC start off by looking at cases where trade may cause some social harm. This social harm is something not taken into account by the individuals entering into a trade arrangement. A classic example of this is pollution. If I can import a good cheaper, I will do so, even if its production generates more pollution than if I had bought it domestically. I do not take into account the social harm of pollution, which is a cost on all members of society.

This means that absent a tariff (tax) on the import of this good, I will be consuming too much of this imported good from a society perspective given how much pollution I generate. A tariff would reduce my consumption of the good, which would in turn reduce the amount of pollution generated.

There are many examples of things we do not take into account when entering any trade transaction:

• Pollution;

• Personal moral standards – for example, if the good utilized child labor in its production;

• Geopolitical considerations – a topic that has recently become popular in tariff contexts with regards to ‘national security’;

• Reduced domestic knowledge – if in an industry, workers learn by doing (like semiconductor manufacturing), trade may reduce domestic production, which decreases learning on the job.

Tariffs, in theory, can mitigate some of these ‘social harms’ from trade. Before we evaluate the impact of tariffs, let’s turn to another case where tariffs may play a role.

Domestic and International Redistribution

Another example of when tariffs may be beneficial, mentioned by WC, is if they are intended to redistribute income. This income can be redistributed in three ways:

• From consumers to government – similar to a standard tax;

• From one group of consumers to one group of producers/workers;

• From one country to another.

The first case is straightforward – a tariff raises revenues for the government by collecting money from consumers.

To understand the second case, let’s assume the government puts tariffs on textile products. This ‘protects’ domestic textile workers. By increasing the price of imported textiles, domestic textiles, which were previously more expensive, may now be relatively cheaper. This in turn increases demand for domestic textiles, which increases wages for textile workers (and profits for textile manufacturing owners). Thus, domestic consumers end up paying more for the textiles, but the textile industry benefits.

The final case can be thought of commonly with the ‘foreigners will pay for the tariffs’ argument (a common argument used by tariff proponents). Basically, by imposing a tariff, a foreign exporter may need to reduce the price they offer their good to the importers. In this way, ‘foreigners’ transfer money to the domestic country, as they reduce the price. It is worth noting that recent research on current tariffs has shown very little to no response to price by foreign exporters.

So Can Tariffs Be Good? A Rebuttal

The above cases mentioned by WC give a good overview of situations of when tariffs may be welfare enhancing. But let’s see if tariffs are actually a solution in these instances.

Social Harm Cases

If we look at the first instance of social harm (e.g. pollution), tariffs can reduce social harms. BUT, this is only true if a similar tax is levied on domestic goods. For example, if domestic production is more polluting than foreign production, then a tariff will actually make the social harm worse.

The key element to note is imports and domestic production are never truly the same. Even if the product itself is the same, for example, steel, if the domestic or imported version was produced with more pollution, can they really be considered the same? Basically, are low pollution steel and high pollution steel interchangeable or should we differentiate them? Ensuring taxes and regulations are uniform on all goods is a complex issue, and are often the reason trade negotiations fail. But without this standardization of goods, trade agreements may lead to harmful outcomes, as was the case with San Diego fisheries.²

So just tariffs are not a good solution – a far better solution is a standardized tax and regulations to make goods truly similar.

Learning By Doing

In the case where there is a learning benefit from producing a good domestically, tariffs are probably a suboptimal solution. Instead, providing subsidies to the domestic industry would likely be superior. That’s because tariffs protect domestic producers from actual competition, which discourages domestic innovation.

We can think of tariffs as adding a weighted vest to your running competitor – it slows them down, but doesn’t improve you. On the other hand, subsidies, especially ones with an expiry date, encourage domestic producers to get better at production, and compete with foreign producers.

Therefore, although tariffs can help with developing nascent domestic industries, other solutions are likely to be superior.

Domestic Re-Distribution

Regarding domestic re-distribution, tariffs can help re-distribute income domestically. But as WC say in their paper, citing Dani Rodrik (another economist):

“Saying that trade policy exists because it serves to transfer income to favored groups is a bit like saying Sir Edmund Hillary climbed Mt. Everest because he wanted to get some mountain air. There was surely an easier way of accomplishing that objective.”

However, as WC point out, even though tariffs are a bad tool for this type of re-distribution, there might not be any other politically feasible way. Opening up to trade creates winners and losers domestically. In a perfect world, we would re-distribute the trade gains from the winners to the losers, but often, this does not occur.

In one of my research papers, I worked on the idea of gradual trade liberalization (for example, by slowly lifting a quota over several decades) and showed that it may help protect workers in an industry until they retire. Through this gradual liberalization, you effectively reduce the gains of winners and transfer them to the ‘losers’ from trade.

Trade Protectionism

The WC research is a very helpful theoretical guide, but I view the research piece as a double-edged sword. It has its benefits, as the paper acts as a “theoretical compass” to evaluate when a government may need to tax or subsidize trade. As mentioned previously, I have never been a fan of ‘free trade’, as the term hides a lot of nuance around regulations, rights and real costs, such as pollution. ‘Free trade’ oversimplifies what actual trade is.

At the same time, however, some ideas in this paper may be ripe for abuse. WC quote economist, Francis Edgeworth, commented on researching the theoretical benefits of tariffs:

“The direct [benefit]... of the theory is likely to be small. But it is to be feared that its abuse will be considerable . . . Let us admire the skill of the analyst, but label the subject of his investigation POISON.”

Tariffs are almost always a suboptimal policy – solely placing a tax on imports is costly and welfare-reducing compared to alternative policies (subsidies, re-distribution). This is especially true in a globalized world, where no importing or exporting country is sufficiently large to impact the market.

In my opinion, a government choosing to implement tariffs, even in their best use case, already signals policy defeat, as the government failed to convince the public of the benefits of superior policies. Rather than focusing their energies on inherently poor policies, governments and politicians should push for far superior solutions, of which economists have plenty.

Key Takeaways:

• Economists have considered many situations where tariffs may work (reduce social harm, domestic and international redistribution), but found that they’re always an inferior policy solution;

• Tariffs can impact economies in ways rarely considered, as they can re-distribute income domestically and internationally;

• Political considerations can make tariffs a viable, albeit sub-optimal tool to mitigate trade shocks.

If you would like to support us in reaching our subscriber goal of 7,000 subscribers, please consider sharing this article and pressing the like❤️ button at top or bottom of this article!

1. If two individuals voluntarily enter into an agreement, then they must both be benefiting from entering into this agreement. At least in theory.

2. To give an anecdotal example, you can look at the US tuna fishing industry in San Diego. Throughout the 1900’s to 1960’s, San Diego was a large producer of canned tuna, even informally known as the ‘Tuna Capital of the World’. From the 1970’s new regulations around sustainable fishing were introduced to protect fish populations. This pushed out the whole tuna industry, and tuna fishing in San Diego collapsed, with very few fishermen remaining in the region today. However, demand for fish in the US did not subside. Today, approximately 90% of the 7.1bln pounds of consumed seafood per year is imported. A significant amount of these fish come from fisheries that have far less stringent sustainability standards than the US fisheries have. Tuna is heavily over-fished globally. The issue arising here is simple – tuna fished by San Diego fishermen was inherently different from tuna being imported. For simplicity, one was sustainable and therefore costly, while the other was unsustainable and cheap. By enacting ‘free trade’ (i.e. simply the removal of tariffs or quotas) without harmonizing regulations first, we arrived at an outcome, where instead of having sustainably harvested fish, we have made the problem of overfishing even worse. This situation is further exacerbated by fishing subsidies that encourage overfishing.