Electoral Issue #5: Tariffs, Tariffs…

Tariffs are considered to be a bad economic policy. Are there any scenarios where tariffs make sense?

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Photo by John Simmons on Unsplash

Tariffs are becoming an increasingly popular policy in many countries around the world. The US recently imposed tariffs on steel imports. The European Union did the same to electric vehicle imports. 

At the same time, tariffs are one of the few policies, which economists are almost unilaterally against:

There is already a significant amount of great articles explaining why tariffs are counter-productive. Some examples of good articles on Substack:

• Joseph Politano
  – “Universal Tariffs are Universally Bad” – especially interesting example of the price dynamics of washing machines before and after the imposition of tariffs;

• Policy Tensor
  – “Do protective tariffs boost growth?” – a statistical analysis if tariffs boost growth (they do not)

• The Econolog – “Trump’s Tariffs – A New Economic Paradigm?” – discusses the multiple arguments made for and against tariffs;

• Nicolás Cachanosky
  – “Trump's Tariffs: A Cost to American Consumers” – how tariff costs are typically borne by domestic consumers.

A more interesting question is whether there is scope for tariffs to be a useful policy.

Problems with Tariffs

A tariff is a tax levied on a good that is being imported. The main ‘benefit’ of tariffs is raising revenues for the government. However, this revenue, at least partially, ends up coming from domestic consumers. This is because a tariff simply increases production costs of the imported good which is then sold locally. Some of this increase in production costs will translate to increased prices for consumers. If the pass-through to consumers is not 100% (i.e. a one for one increase in price), the producer will absorb some of the tariff cost by having reduced profits. For example, Irwin (2014) found that in 1890-1930, 40% of the cost of US tariffs on sugar was borne by US consumers.

Looking at the recent impacts of tariffs, Fuceri, Hannan, Ostry and Rose (2019) studies tariff increases over the period from 1963 to 2014. The authors found that tariff increases decrease domestic output, reduce domestic productivity, increase unemployment and worsen inequality. The reasons for these outcomes is that tariffs increase production costs, as tariffs are commonly also placed on intermediate goods needed in production such as steel, making it more expensive for domestic firms to produce. On the other hand, tariffs on final goods such as cars protect ‘inefficient’ domestic companies, as these inefficient companies face less competition. Thus, rather than innovating, these inefficient firms are protected from competition.¹

Evidence clearly points to the fact that tariffs are costly to the country imposing them. So when might they make sense? 

Tariffs – Correcting Externalities

Trade between countries is not as simple as often portrayed (as discussed in our previous article on ‘free trade’). The ‘same’ goods found in both countries can actually be produced quite differently, depending on the regulations in the countries. One difference can be the environmental standards of production. Some countries may have stringent regulations such as what chemicals can be permitted or how much pollution can be emitted.

In this instance, tariffs can be a tool to correct some of these environmental externality² differences between countries. For example, in the context of carbon emissions, the European Union is actually implementing a carbon tariff under a program called the “EU Carbon Border Adjustment Mechanism”, which attempts to address the issue of ‘carbon leakage’. Carbon leakage occurs when carbon polluting production leaves one country and moves to another. This results in simply a shift of the carbon emissions from one country to another without any reduction in global carbon emissions, or ‘carbon leakage’.

Burnel and Levinson (2024) go over the theory behind when such carbon tariffs the EU is considering could work most effectively in reducing global carbon emissions. They considered three scenarios:

• Only a domestic carbon tax (i.e. a tax on a domestic producer on emitting carbon);

• A domestic carbon tax and a carbon tariff (i.e. a tax paid based on the carbon emitted during the production of the imported good);

• Only a carbon tariff.

Domestic Carbon Tax

Implementing only a domestic carbon tax will only result in ‘carbon leakage’ and no measurable reduction in carbon emissions. This is because domestic goods producers will face higher production costs, so production will move abroad where there is no carbon tax. Any reduction in domestic production will simply be replaced by foreign production, resulting in no change in price of the good,³ and thus no fall in demand of the good. The level of carbon produced globally could actually increase in this case if global producers are more carbon polluting than domestic ones.⁴

Domestic Carbon Tax and Carbon Tariff

Implementing a carbon tariff in combination with a domestic carbon tax will ‘internalize’ the carbon externality. If a foreign country has looser carbon standards, a carbon tariff can equate the cost of carbon between the domestic and foreign country. Because domestic good production that emits carbon will now be more expensive (due the domestic carbon tax) and buying the good from abroad also has the ‘carbon tax’ (via the carbon tariff), demand for the produced goods falls reducing carbon emissions (a higher goods price reduces demand). Thus, a combination of a domestic carbon tax and carbon tariff can effectively reduce emissions and ‘internalize’ the pollution externality. 

Carbon Tariff

Implementing only a carbon tariff will have a more nuanced outcome. The carbon tariff would increase the price of the imported good, which would reduce the demand for the good and thus the carbon emissions. But domestic producers would now offset some of the fall in imports and produce more since their production costs are now relatively cheaper to the global producers. This would be a form of ‘reverse leakage’ – instead of carbon emissions going abroad, these emissions will now be brought back. The overall outcome on carbon emissions would depend on how much more polluting domestic producers are relative to the world. If they are more polluting, carbon pollution would go up.⁵

Tariffs – A Complex Tool

As shown by Burnel and Levinson, tariffs targeted to specific externalities, especially environmental ones, can result in a universally better outcome. These tariffs need to be coupled with domestic taxes on this externality in order to generate the desired benefits. However, general tariffs on their own do not result in any benefits to the imposing country, and actually can result in significant macroeconomic costs. Thus, although there is a place for tariffs in optimal policy design, it is important for them to be targeted to a specific externality.

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Interesting Reads from the Week

1. Note: An interesting survey which asked participants which policies they believe will benefit them the most. It appears many people do not consider indirect benefits.

2. Article:

   Pascal Michaillat
   gives us the October labor market update. From the article: “Main message: US labor-market tightness fell slightly to 1.07 in October 2024. So the US labor market is extremely close to full employment. The probability that the US economy is in recession fell further to 26%.”

3. News: US GDP growth for the third quarter of 2024 came in a 2.8%. The US economy continues its strong growth.

4. Article: If you’re interested in forecasts for the upcoming election (voting is on Tuesday, Nov 5),

   Carl Allen
   has you covered. His forecasts and modeling have been consistently the best. Follow/susbcribe to him if you’d like the latest updates on the election!

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The Electoral Issue Series:

Electoral Issue #1: Investing in the Future – Child Tax Credit

Electoral Issue #2: Why We Demand Bad Policy

Electoral Issue #3: Immigration

Electoral Issue #4: Minimum Wages

Electoral Issue #5: Tariffs, Tariffs…

1. To illustrate – suppose a foreign car maker can produce a good for $100, while a domestic producer can produce the good for $110. The domestic producer is less efficient and thus, the domestic producer’s output won’t be bought. A 20% tariff will increase the cost of the foreign producer to $120. Now no one will buy the foreign produced good and prefer the ‘inneficient’ domestic good.

2. Externalities are indirect costs or benefits that impact uninvolved parties caused by activities of another party (pollution impacting people’s health caused by factories and using your car leading to traffic congestion are examples of negative externalities; vaccinating oneself is a positive externality as it reduces the likelihood of others getting sick). Since these costs and benefits are not taken into account by private individuals when making decisions (i.e. they don’t ‘internalize’ them), some activities happen too much (pollution), while others not enough from the perspective of society.

3. We are assuming that domestic production is ‘small’ relative to world production and thus the price of the goods is set to the world price, akin to commodities such as gold and oil.

4. This case may actually be occurring in the fishing industry, where US fishing regulations are much more stringent than foreign fishing regulations. Since fish from abroad are cheaper than US based fish, the US imports significant amounts of fish, resulting in many fish coming from environmentally worse fisheries. 

5. A carbon tariff on its own acts as both a domestic carbon tax (by increasing the price of the imported goods) and a domestic carbon subsidy (by making domestic producers relatively better in comparison to global producers).