Seven Questions About Tariffs That Everyone Should Know

Quick Overview

Economists generally view tariffs as distortionary, causing welfare loss by creating a wedge between world prices and domestic prices, similar to introducing a crude instrument like acupuncture with a fork instead of targeted subsidies or taxes; however, tariffs can potentially improve welfare if they correct pre-existing market distortions, redistribute income domestically or internationally (optimal tariff argument), or if the world cannot absorb the tariff through price adjustments.

Key Points: US average tariffs were historically high until the post-WWII period, dropping to about 2% pre-2018, before rising to 4%-5% following the 2018 tariffs, and reaching heights not seen since the Great Depression (peak 20% in 1930) with recent statutory rates reaching up to 140% on some Chinese imports. The standard economic case against tariffs highlights that they create two distortionary triangles: a production distortion where domestic production uses a higher-cost technology than importing, and a consumption distortion where consumers buy less because the tariff-inclusive price exceeds the true marginal cost (world price). Tariffs can act as a second-best instrument to correct existing distortions, such as knowledge spillovers or imperfect competition, by incentivizing firms to produce more, although this is inefficiently bundled with a consumption tax, making targeted instruments like production subsidies superior ('acupuncture with a fork'). Tariffs can function as a redistribution tool, either domestically (affecting producers vs. consumers, or different worker groups) or internationally through terms of trade manipulation (the optimal tariff argument), where the resulting welfare effects are first-order rectangles, unlike the second-order welfare losses from distortions (triangles). Empirical analysis of the 2018-2019 trade war showed complete pass-through of tariffs at the border (price inclusive of tariff moved one-for-one with the tax), suggesting foreigners did not pay; furthermore, retail prices remained surprisingly stable, implying the cost was absorbed by retailers' profit margins, indicating potential domestic redistribution away from retailers. Research suggests that in a realistic setting with limited redistribution instruments (like only income taxes besides tariffs), tariffs may be used as 'predistribution' to affect earnings distribution, and in this context, free trade is not necessarily optimal. The argument that global tariffs are unfair because the US faces higher average tariffs than it imposes (US faces 3.5% vs. imposes 2% on average pre-2018) shows a qualitative asymmetry, but the magnitudes are small compared to potential gains from international redistribution via optimal tariffs.