Tariffs are taxes, but on what?

Tariffs hurt more than just imports

Tariffs are taxes on imported goods, paid by the US. By now, I think most people understand this. Unfortunately, many people learned this too late with searches for “Trump tariffs” peaking well after the election, but it’s still a good start! Understanding that tariffs are taxes is the first step, understanding what exactly they tax is arguably even more important. While on paper tariffs are just a tax on goods imports, this post explains what tariffs tax indirectly, and who pays the indirect price.

Tariffs are taxes on exports

Tariffs are used to reduce how much of a certain good is imported by incentivizing domestic investment. Why does that investment take place? Well, the tariff is used the raise the price of foreign products equal to domestic products. This means domestic producers can now receive a higher price because of the lack of foreign competition, increasing their profitability relative to other sectors, which draws investment away from other sectors and towards domestic production of the protected good.

So tariffs work by making it relatively more profitable to invest in domestic production of a certain good than to invest in other things. Now consider what would happen if we placed a tax on exporting goods. Exporters would decrease the amount they can export and receive lower profits. This reduces their profitability relative to other sectors, drawing investment away from exporters and towards domestic production.

A simple model from Doug Irwin can be used to illustrate this. Start with a country that imports clothes and exports aircraft. Placing a tariff on clothes would increase the price domestic producers could receive, incentivizing domestic investment. Domestic investment would flow toward the clothing sector and away from the aircraft manufacturing sector. Now what would placing a tax on exporting aircraft do? Well, aircraft manufacturing would now be relatively less profitable than the clothing sector. So domestic investment would flow toward the clothing sector and away from the aircraft manufacturing sector. So taxing imports also taxes exports.

But why do import taxes harm exports specifically? The answer has to do with foreign exchange rates. For someone to buy a good from another country they need that country’s currency. The amount of currency it takes for one currency to buy another is the foreign exchange rate. Generally, the standard rules of supply and demand apply to exchange rates. So for example, if the US dollar is in high demand the US dollar “appreciates” in value, or becomes “stronger”. What this really means is the US dollar is more expensive for other currencies to buy which hurts our ability to export.

So what does a tariff do to exchange rates? Ideally, a tariff reduces the amount of the tariffed goods we import, which reduces our demand for the foreign currency used to buy that import. When demand for foreign currency goes down, its price relative to the dollar goes down. Conversely, that means the price of the US dollar relative to foreign currencies goes up. The amount of appreciation depends on how much of a country’s goods you tariff which Noahpinion does a good job explaining in his article about targeted tariffs vs broad tariffs. The important thing to understand is that tariffs typically appreciate exchange rates, which makes it more expensive for other countries to buy our exports.

This is partly why tariffs struggle to reduce trade deficits. An IMF study of 151 countries from 1963-2014 found:

that tariff increases lead, in the medium term, to economically and statistically significant declines in domestic output and productivity. Tariff increases also result in more unemployment, higher inequality, and real exchange rate appreciation, but only small effects on the trade balance.

Another way to view this is to understand that trade is just a way to indirectly produce the things we import by first producing things to export and then exchanging them. So tariffs must hurt the people producing the exports that were previously exchanged for imports now produced domestically. David Friedman explained this with his Iowa Car Crop model:

There are two technologies for producing automobiles in America. One is to manufacture them in Detroit, and the other is to grow them in Iowa. Everybody knows about the first technology; let me tell you about the second. First you plant seeds, which are the raw material from which automobiles are constructed. You wait a few months until wheat appears. Then you harvest the wheat, load it onto ships, and sail the ships eastward into the Pacific Ocean. After a few months, the ships reappear with Toyotas on them.

International trade is nothing but a form of technology. The fact that there is a place called Japan, with people and factories, is quite irrelevant to Americans’ well-being. To analyze trade policies, we might as well assume that Japan is a giant machine with mysterious inner workings that convert wheat into cars. Any policy designed to favor the first American technology over the second is a policy designed to favor American auto producers in Detroit over American auto producers in Iowa. A tax or a ban on “imported” automobiles is a tax or a ban on Iowa-grown automobiles. If you protect Detroit carmakers from competition, then you must damage Iowa farmers, because Iowa farmers are the competition.

Those are both things tariffs essentially always affect, however, there are two more potential reasons tariffs can harm exports. First is the potential to tariff intermediate goods and second is the potential for other countries to place tariffs on the US in retaliation.

Intermediate goods are goods companies use as components to produce other goods. Tariffing intermediate goods hurts domestic industry more than helps by increasing the cost of production for companies that use intermediate goods as input (Brian Albrecht goes into more detail). Tariffing steel, for example, may protect steel producers but harms firms that consume steel. In the US, steel‐consuming jobs outnumber steel‐producing jobs 80 to 1.

Tariffing intermediate goods also places US producers at a disadvantage to foreign producers, since only the US producers pay the increased production cost. Tariffing steel for example would make nail production in the US more expensive, but nail production in Canada would stay the same price. So US consumers would import more nails from Canada and other nations would as well.

Many other countries also choose to retaliate to the tariffs placed on them. So if the US places tariffs on Chinese steel, China will place tariffs on US soybeans. Although the cost of a tariff is primarily on the country implementing it, retaliatory tariffs still hurt US exporters by making it harder for them to sell in foreign markets. Exporters have to lower their prices to remain competitive against domestic producers in the tariff-imposing country, as well as exporters from other countries not subject to the tariffs.

Understanding that will make it obvious why Trump’s 2018-2019 steel and aluminum tariffs failed to help American manufacturing. As Federal Reserve economists Aaron Flaaen and Justin Pierce found in December 2019:

We find that U.S. manufacturing industries more exposed to tariff increases experience relative reductions in employment as a positive effect from import protection is offset by larger negative effects from rising input costs and retaliatory tariffs. Higher tariffs are also associated with relative increases in producer prices via rising input costs.

A February 2020 paper even estimates the equivalent export tax

Firms that eventually faced tariff increases on their imports accounted for 84% of all exports and they represent 65% of manufacturing employment. For all affected firms, the implied cost is $900 per worker in new duties. To estimate the effect on U.S. export growth, we construct product-level measures of import tariff exposure of U.S. exports from the underlying firm micro data. More exposed products experienced 2 percentage point lower growth relative to products with no exposure. The decline in exports is equivalent to an ad valorem tariff on U.S. exports of almost 2% for the typical product and almost 4% for products with higher than average exposure.

A report from the United States International Trade Commission estimated that whilst there was $2.8 billion worth of production increases in industries protected by the tariffs, was met by a $3.4 billion production decrease in downstream industries affected by higher input prices.

A 2024 study by David Autor et al. found:

Import tariffs on foreign goods neither raised nor lowered US employment in newly-protected sectors; retaliatory tariffs had clear negative employment impacts, primarily in agriculture

As mentioned agriculture was especially harmed by retaliatory tariffs (and exchange rate appreciation), and Trump had to use 92% of the revenue raised from his tariffs to bail them out.

The effect isn’t always temporary either. Even after a retaliatory tariff is removed, producers and consumers may remain uncertain of the possibility of another trade war and choose to buy from a friendlier nation instead. More importantly, when U.S. producers face disadvantages, other nations can use that time to establish and grow their own industries. Once those industries are built, the costs and efforts involved in starting them make it easier for these nations to maintain their presence in the market, even after the original trade disruptions are resolved. This was observed in a 2022 study focusing on Bush’s 2002 steel tariffs:

The tariffs did not boost local steel employment but substantially depressed local employment in steel-consuming industries for many years after Bush removed the tariffs. The tariffs also led to a persistent exit of steel-intensive manufacturing establishments, suggesting a role for plant-level fixed entry costs in translating the temporary shock into persistent outcomes

OK, that was a lot, but the main point of this post was to explain that tariffs also harm exports, since that’s what I think is most important to know. It’s also important to know that to understand some of the next points.

Tariffs are taxes on being poor

Tariffs tax poor people more than rich people. In other words, tariffs are a “regressive” tax as opposed to a progressive tax. Not all regressive taxes are necessarily bad, but progressivity is generally preferable.

Tariffs are regressive for a few reasons. Firstly, tariffs tax imports at a flat rate. So a 10% on a $10 banana tariff will increase the price by $1 for everyone. That may seem fair, but $1 is a higher percentage of a poor person’s income than a rich person’s income.

Secondly, poor people spend a higher percentage of their income on imported goods. A 2016 paper estimates the American consumer at the 10th percentile in the revenue distribution owes 69 percent of his or her purchasing power to international trade, the median consumer (at the 50th percentile) 37 percent, and the consumer at the 90th percentile only 4 percent. The 2016 US US International Trade Commission likewise found in its 2016 review:

U.S. consumers who are either middle income (income between $40,000 and $69,000) or lower income (income less than $40,000) benefit disproportionately from the savings associated with the tariff reductions

Tariffs also only tax goods, and poor people tend to spend a higher percentage of their income on goods over services.

Tariffs are taxes on goods relative to services

This is a novel argument I’ve only heard from Scott Sumner, so I want to make sure he gets the credit for pointing this out.

Remember all that time I spent trying to show that tariffs harm exports too? Well hopefully now we can move on to assuming the primary effect of a tariff is to reduce both imports and exports by about the same amount. Next, again consider that tariffs only tax goods and not services. This would mean a high tariff policy would tax the goods sector of the economy more than the service sector. The higher price of goods would also shift consumption away from goods and towards services. That would reduce goods as a share of GDP, and therefore increase the rate at which the service sector is overtaking the manufacturing sector.

I haven’t seen any empirical research on this or any other economist write about this, but it’s an interesting argument drawn from reasonable and empirically tested assumptions.

Tariffs are taxes on productivity

I’m not going to walk through the entire comparative advantage model (there are YouTube Videos and textbooks for that), but suffice it to say that if workers are employed in the areas a country has a comparative advantage in then their productivity will increase. The empirical evidence also backs this up, such as the same IMF study cited earlier:

tariff increases lead, in the medium term, to economically and statistically significant declines in domestic output and productivity.

Exposing domestic firms to international competition also makes markets more competitive, and economies of scale from international specialization also lead to efficiency gains.

But the simplest explanation is that importing goods doesn't just prevent domestic production, but rather prevents the production of more costly domestic substitutes. After a tariff is imposed domestic resources previously used (and still could be used) to produce other goods are reallocated to produce domestically an additional quantity of the protected good. This represents a loss because the goods in question could be imported at a better price, while domestic producers were able to produce something else instead.