Why do most economists think tariffs are a bad idea?

President Trump has threatened to impose tariffs on some of America’s main trading partners. In this month’s commentary our Chief Economist, Colin Warren, looks at how tariffs can harm economic wellbeing via their impact on prices, jobs, and productivity.

Tariffs have long been a controversial tool in international trade policy. Advocates claim they protect domestic industries and jobs, while critics argue they harm economic growth and consumer welfare. President-elect Donald Trump is a fan, and has said that tariff is the “most beautiful word in the dictionary.”[1]

Trump has made numerous threats to impose tariffs on America’s trading partners in recent months, the most recent being plans to impose a 25% levy on all goods imported from Mexico and Canada until those countries satisfactorily stop illegal immigration and the flow of illegal drugs such as fentanyl into the US. He has also said he would put an additional 10% tariff on imports from China.

These threats suggest that Trump is planning to use access to the US market as a bargaining chip to achieve policy objectives that extend beyond purely economic aims. Having been re-elected in part due to popular outrage over the high cost of living and a perception of stagnant living standards, pursuing this path is fraught with risk. Such tariffs could be highly disruptive and end up harming the very voters who propelled Trump to victory. In this commentary we explore why most economists think tariffs, taxes on imports, are a bad idea. 

The benefits of free trade

At its most basic level, economists think tariffs are a bad idea because they interfere with the principle of comparative advantage, a cornerstone of international trade theory developed by the 18th century economist David Ricardo. Ricardo showed that overall consumption and economic wellbeing increases if countries focus on producing goods they can make most efficiently (at the lowest cost compared to other goods) and trade for goods they are less efficient at producing. This allows both countries to benefit, even if one is better at producing everything.

Economists are in favour of free trade (i.e. trade without barriers and tariffs) because it encourages specialisation and makes production more efficient. It leads to more goods being produced, lower prices, and greater choices for consumers, benefiting all trading countries.

The costs of tariffs

Tariffs typically increase costs for consumers and businesses in the country that impose them. While importers pay the tariff itself, its impact on end-user prices will depend on factors such as exporters absorbing part of the cost, importers limiting price increases, or adjustments in exchange rates. Research has shown that most of the burden of tariffs imposed during the first Trump presidency fell on US businesses and consumers. A study published by the National Bureau of Economic Research (NBER) into the effects of the tariffs during 2018-20 showed that US importers (consumers and businesses) lost in aggregate 0.58% of GDP, i.e. they were 0.58% of GDP worse off in real terms than if the tariffs had not been imposed.[2]

Most of the tariffs under Trump’s first term were imposed on industrial products, such as steel, aluminium, and other intermediate goods. However, the imposition of 20-50% duties on imported washing machines, designed to protect domestic manufacturers, provides an illustration of the direct impact of tariffs on prices paid by consumers. One study found that the imposition of tariffs in 2018 was followed by an increase of around 12% in the price of washing machines, raising the average price by US$86[3]. Interestingly, the price of domestically-produced washing machines also rose, despite not being subject to the tariff. This suggests that domestic producers took advantage of reduced competition to expand margins. As a result of higher prices, the tariffs resulted in increased consumer costs of just over US$1.5bn.

Higher prices

Trump’s proposal for across-the-board tariffs on Mexico, Canada and China are likely to result in higher prices for a wide range of products including foodstuffs, beer, clothing, consumer electronics and cars. Mexico, Canada, and China are America’s biggest trading partners, and together account for around 42% of all imports into the US[4]. With the US importing nearly US$100 billion of auto parts and four million finished vehicles from Canada and Mexico, one estimate suggests that Trump’s proposals could add US$3000 (around 6%) to the price of a new car[5]. As more than 20% of oil processed by American refineries is sourced from Canada, tariffs could also raise gasoline prices by 10% in some parts of the country[6]. The cost of a beer imported from Mexico could rise by 4-12%[7].

It is somewhat ironic that one of Trump’s central policies is likely to drive up prices, given that a major reason voters turned against the Democrats in the November election was the soaring cost of living experienced during the outgoing Biden administration. Tariffs are not in themselves inflationary, as they represent a one-time increase in individual prices rather than a sustained rise in the general price level, which is the hallmark of inflation.

However, tariffs could trigger lasting inflation if they raise inflation expectations, which may in turn affect wage demands and corporate pricing strategies. With unemployment historically low and workers’ bargaining power therefore quite high (wages are currently rising at a 4.6% annual rate[8]), there is a clear risk that pay demands will rise in response to increased tariffs, triggering a wage-price spiral. These concerns are compounded by recent survey data which showed that 69% of Americans think that Trump’s plan to impose tariffs will lead to “much” or “somewhat” higher prices[9].

Another reason why most economists dislike tariffs is because they tend to be regressive, i.e. they tend to disproportionately affect lower-income individuals. As noted earlier, tariffs threaten to raise the price of basic consumer items. And since lower-income households spend a larger share of their income on consumption, they would bear a disproportionately higher burden of tariff-induced price increases.

Impact on jobs

Moreover, most economists dispute Trump’s claim that tariffs are a good way to protect and create American jobs. Although tariffs may temporarily protect jobs in targeted industries, they can lead to job losses elsewhere. A study by the Federal Reserve Board of tariffs imposed during the first Trump presidency found that they caused a reduction in manufacturing employment of 1.4%[10]. This came about as modest employment gains achieved by protecting domestic producers from foreign competition were more than offset by losses at other manufacturers which saw input costs rise and faced retaliatory tariffs in their export markets.

Even in industries where jobs are created or protected by tariffs, the cost is extremely high. In the case of the washing machine tariffs discussed above, researchers calculated that increased domestic employment of around 1,800 workers resulted in an average annual cost to consumers of over US$815,000 per job created after revenues from tariffs were taken into account[11].

Productivity effects

Most economists agree that rising productivity—the ability to produce more goods and services with the same amount of inputs—is essential for improving living standards and wages over the medium to long term. This is why the negative impact of tariffs on productivity is a major reason economists view them as a poor policy choice.

Tariffs can harm productivity in several ways. By shielding less efficient domestic industries from foreign competition, tariffs may divert labour and capital toward less productive sectors, reducing overall economic efficiency and stifling productivity growth. Additionally, reduced competition diminishes companies’ incentive to innovate or improve efficiency, which can undermine long-term economic growth. Tariffs also raise costs for businesses, potentially limiting their ability to invest in productivity-enhancing technologies. Furthermore, they may force firms to reconfigure supply chains, steering them away from optimal or cost-effective suppliers in an effort to avoid tariff-related costs.

Empirical evidence confirms that tariffs hurt productivity over the medium term. A study by the IMF using data from 151 countries over the period 1963-2014 concluded that a 3.6 percentage point tariff increase lead to a cumulative 0.9% decrease in labour productivity after five years[12].

When tariffs might be justified

Through their impact on prices, employment, and productivity, it is clear that tariffs can have a deleterious effect on growth and economic welfare. Of course, a case can be made for the implementation of targeted tariffs to safeguard certain domestic industries which are essential for national security (e.g. aerospace, advanced manufacturing etc.) or to ‘level the playing field’ where imports are artificially cheap due to foreign state subsidies (e.g. Chinese electric vehicles[13]). Tariffs might also be warranted on environmental or social grounds, to discourage the importation of goods produced under environmentally harmful or exploitative labour conditions. However, it would be difficult to justify the across-the-board tariffs proposed by Trump on these grounds.

Bad economics = bad politics?

Which tariffs actually end up being implemented might well depend on the extent of political support for the measures and the reaction of financial markets. As president, Trump would be able to unilaterally impose tariffs in certain areas via executive order, but across-the-board levies would probably require congressional approval. Wary of a political backlash, senators from states where employment would be vulnerable to a renewed trade war might refrain from voting for such measures. Indeed, although Trump voters overwhelmingly supported the idea of tariffs during the run-up to the election[14], indiscriminate import duties that lead to a jump in prices, a loss of jobs, and a pull-back in the stock market could force a change of mind. When it comes to tariffs, bad economics could quickly become bad politics. For Trump, ‘tariff’ might end up not being such a beautiful word after all.

9th December 2024