Tariffs Explained: Who Pays, Who Profits, and How They Shape Global Trade

Tariffs are a hot topic of conversation right now. For most people if you ask them what a tariff is, they might describe it as a tax or fee of some kind and it has to do with foreign exchange. That’s the extent of the average person's knowledge on tariffs. So, let's break down what a tariff is and the reasoning behind why they are imposed.

What is a tariff & its function?

A tariff is a tax placed on goods when they cross national borders. The most common type is an import tariff, which taxes goods brought into a country. There are also export tariffs, which are taxes on goods a country exports, though these are rare. The United States does not allow export tariffs; the Constitution (Article I, Section 9) forbids them. Although tariffs have been around since 1789, for the most part, we have been living in an era of “free trade” until recently. In general tariffs are intended to protect critical industries from foreign competition or to prevent dumping of cheap goods into the country by foreign manufactured products, or both.

Tariffs are designed either to protect domestic industries or to generate revenue for the government.

Protective Tariffs

Protective tariffs make imported goods more expensive compared to locally-made products. Placing protective tariffs on goods encourages consumers to buy locally, shielding industries from foreign competition. Let’s use paperclips as an example so you can understand.

Most paper clips sold in the U.S. are still manufactured domestically, due in large part to a tariff of 127% on Chinese-manufactured paper clips. The tariff has been in effect since the 1990s when American paper clip manufacturers started facing tough competition from cheaper-priced Chinese imports. The manufacturers successfully argued that their Chinese rivals were "dumping" paper clips on the American market. That is, they were selling at a loss in order to drive domestic manufacturers out of business.

These tariffs can for sure be helpful to some industries but also harmful to others. Let’s take a look Tobacco as another example.

Tobacco is big business in the U.S., and American tariffs have protected the industry since the Great Depression. Some tobacco products imported to the U.S. are taxed as high as 350%.

But tariffs also go two ways. In 2018, in retaliation for U.S. trade policies, China announced a 25% increase in its tariffs on a list of 100 U.S. products, including cigars and cigarettes. That was not welcome news in North Carolina, which exported more than $156 million in tobacco products to China in 2017. See how this can easily become a political war?

Revenue Tariffs

Revenue tariffs aim primarily to generate income for the government rather than protect domestic industries. This usually involves placing a tax on imported goods, thereby increasing the price of these goods in the domestic market. Unlike protective tariffs, which aim to shield domestic producers from foreign competition by making imported goods more expensive, revenue tariffs are more focused on adding to the government coffers. Historically, tariffs were a vital source of funding in the U.S., accounting for over 40% of government revenue in 1900, though their importance in this role has significantly declined, contributing only 2% by 2013. Despite their fading popularity in the developed world, many developing nations still rely on tariffs for a large portion of their revenue.

Let's look at coffee to understand a revenue tariff.

Consider a small country that imports a significant amount of coffee because it does not have the climate conditions required to grow coffee domestically. To generate revenue, the government decides to impose a tariff on each kg of imported coffee. Suppose without the tariff, the price of a kg of imported coffee is $5. The government imposes a $1 tariff per kg, raising the price to $6. Consumers still buy the coffee, albeit at a higher price, and the government collects $1 for every kg sold. This additional revenue can be used for various public expenditures such as infrastructure, healthcare, or education.

The key here is that the primary goal of this tariff is to generate revenue rather than to discourage imports or protect local coffee producers. The tariff is set at a level that does not significantly reduce imports but rather generates a steady revenue stream for the government.

Today, tariffs are primarily used for protectionist purposes, such as addressing trade imbalances or safeguarding specific industries.

In 2018, for example, the U.S. imposed several rounds of tariffs on specific products, sectors, and countries, raising import tariffs from an average of 2.6% to 17% on more than 12,000 products. The effects of tariffs depend on the size of the economy imposing them. In large economies like the U.S., tariffs can increase import prices for consumers and businesses but may also lead to global price adjustments. For example, foreign producers might lower their prices to maintain access to the large U.S. market, creating "terms of trade gains." However, these tariffs also reduce overall trade volumes by discouraging imports and potentially harming global economic activity. In smaller economies, tariffs are less influential than in global markets. Foreign producers are unlikely to adjust their prices, meaning consumers bear the full cost of the tariff, leading to higher prices and decreased trade without the offsetting benefits seen in larger economies.

Tariffs benefit domestic producers by reducing competition from cheaper imports and provide revenue to the government. However, they impose costs on consumers through higher prices and can harm exporters in countries facing tariffs. Retaliatory measures by other nations often exacerbate these negative effects, as seen in 2018 when U.S. tariffs prompted retaliatory tariffs from China and the European Union. These countermeasures impacted $121 billion worth of U.S. exports, compounding the economic strain caused by the original tariffs.

Ultimately, while tariffs can protect domestic industries and influence trade balances, they can also lead to higher prices, reduced global trade, and strained international relations. Their effectiveness depends on carefully balancing these trade-offs.