Mastery Mondays

“Let's compete freely. Goddam tariffs! Free trade and free seas—that's what's right!” ― James Clavell

What Are Tariffs?

A tariff is a type of tax levied by a country on an imported good at the border. Historically, tariffs have been used by governments to collect additional revenue. But they are also a way for governments to try to protect domestic producers.

As a protectionist tool, a tariff increases the prices of imports. Due to that, consumers may choose to buy other, relatively less expensive domestic goods instead.

Key Takeaways

• Tariffs are duties on imports imposed by governments to raise revenue, protect domestic industries, or exert political leverage over another country.
• Tariffs often result in unwanted side effects, such as higher consumer prices.
• Tariffs have a long and contentious history, and the debate over whether they represent good or bad policy rages on to this day.

Understanding Tariffs

In today’s global economy, many products made in a home country consist of parts obtained from other countries. Or, these products might have been assembled overseas. As a result, tariffs can affect the prices of products made in the home country as well as those imported from other countries.

Many economists argue that tariffs create market distortions that can harm domestic consumers over time. They can also lead to a trade war if trading partners impose tit-for-tat tariffs.

The process of setting tariff rates involves a combination of economic, political, and strategic issues. Governments engage in complex negotiations and considerations of reciprocity with trading partners.

Tariffs also can be used as a political tool to manage relationships.

How a Tariff Works

Tariffs are used to restrict imports by increasing the price of goods and services purchased from another country. This makes them less attractive to domestic consumers. There are two types of tariffs:

• A specific tariff is levied as a fixed fee based on the type of item, such as a $1,000 tariff on a car.
• An ad valorem tariff is levied based on the item’s value, such as 10% of the value of the vehicle.1

Reasons for Tariffs

Governments may impose tariffs to raise revenue or protect domestic industries—especially nascent ones—from foreign competition. By making foreign-produced goods more expensive, tariffs can make domestically-produced alternatives more attractive.

Governments that use tariffs to benefit particular industries often do so to protect companies and jobs. Tariffs can also be used as an extension of foreign policy: Imposing tariffs on a trading partner’s main exports is a way to exert economic leverage.

Side Effects

Tariffs can have unintended side effects:

• They can make domestic industries less efficient and innovative by reducing competition.
• They can hurt domestic consumers since a lack of competition tends to push up prices.
• They can also generate tensions by favoring certain industries, or geographic regions, over others.
• When used to pressure a rival country, a relationship can devolve into an unproductive cycle of retaliation, sometimes known as a trade war.

For example, tariffs designed to help manufacturers in cities may hurt consumers in rural areas who do not benefit from the policy and are likely to pay more for manufactured goods.

Fast Fact

Governments assess tariffs based on what's needed to protect domestic industries, address trade imbalances, or respond to unfair trade practices.

Who Is Most Impacted by Tariffs?

Tariffs can affect consumers, businesses, and countries' economic development:

1. Tariffs often have a regressive impact, disproportionately affecting lower-income consumers. Since tariffs lead to higher prices for imported goods, individuals with limited financial means, who typically spend a higher percentage of their income on basic necessities, may bear a heavier burden than others.2

2. Small businesses, particularly those relying on imported materials subject to tariffs, face significant challenges, such as the consequence of increased costs. Small businesses have different constraints compared to larger companies; these constraints aren't just how much money they make but how much influence they can have on economic policies.3

3. Higher tariffs can impede developing countries' integration into the global economy, limiting their access to international markets, and potentially hindering economic development. These countries, with fewer resources, may not have the ability to purchase certain goods for consumption.4

U.S. Tariffs and Free Trade

In today’s market-leaning global economy, tariffs have earned something of a bad reputation. Many economists argue that they are harmful for the economy and consumers.

For instance, the Smoot-Hawley Tariff could be perceived as worsening the Great Depression in the 1930s. In an attempt to strengthen the U.S. economy during the Great Depression, Congress passed the Smoot-Hawley Tariff Act, which increased tariffs on farm products and manufactured goods coming into the United States.5

In response, other nations, also suffering from economic malaise, raised tariffs on American goods, bringing global trade to a standstill. Because of the tariffs during that era, economists have estimated that overall world trade declined about 66% from 1929 to 1934.6

A Laissez-Faire Approach to Trade

Since then, policymakers on both sides of the aisle have shied away from the use of trade barriers, like tariffs. They've preferred the free-market policies that allow nations to specialize in certain industries and incentivize optimal efficiency.

This more-or-less laissez-faire approach to U.S. trade remained in place after World War II and up until the election of President Donald Trump in 2016.

Tougher Talk About Trading Partners

Trump was one of a few presidents to speak openly about trade inequities and the threat of tariffs when he vowed to take a tough line against international trading partners, especially China.

He claimed this would help American blue-collar workers displaced by what he described as unfair trade practices.

In addition to tariffs on Chinese imports, the Trump administration also levied taxes on products made in Canada, Mexico, and the European Union (EU), among others.7

Some of these were subsequently rolled back by the Biden administration. However. President Biden never removed the tariffs on Chinese goods imposed by Trump. In fact, later in his administration, Biden increased them.8

Important

The cost of tariffs is paid by consumers in the country that imposes the tariffs, not by the exporting country.

Example of Tariffs

The First Trump Administration

The conversation about tariffs grew during the first administration of President Trump as part of his economic policy, which was known as “America First.” This policy concerned American protectionism, which typically means more tariffs.

The first tariffs imposed in 2018 were on solar panels and washing machines. Robert Lighthizer, the then-U.S. Trade Representative, announced that after consulting with the Trade Policy Committee and the U.S. International Trade Commission, Trump decided that “increased foreign imports of washers and solar cells and modules are a substantial cause of serious injury to domestic manufacturers.”9

The first 1.2 million imported washing machines would be taxed at 20%. Subsequently imported ones would be taxed at 50% in the following two years. Imported solar panel components would be taxed at 30%, with the rate declining over four years.9

Soon after, the Trump administration slapped tariffs on imported aluminum. After that, a 25% tariff on all imported steel was imposed, in addition to the 10% tariff on aluminum in many countries.1011

What is notable here is that many of these countries were top trading partners and allies of the U.S. They were not happy with these additional tariffs.12 In response, the EU issued a 10-page list of tariffs on U.S. goods, ranging from Harley-Davidson motorcycles to bourbon.13

The Reaction of Economists

In a survey of economists conducted by Reuters, the Trump administration’s tariffs were very poorly received.

Almost 80% of the 60 economists surveyed believed that the tariffs on steel and aluminum imports would actually harm the U.S. economy.14

The rest believed that the tariffs would have little to no effect. All in all, none of the economists surveyed thought that the tariffs would benefit the economy.14

The Result

So, did the Trump tariffs work in the end? According to economists from various nonpartisan and bipartisan think tanks, the answer is a resounding no.

A CNBC study discovered that Trump’s tariffs actually hurt consumers greatly and equaled one of the largest U.S. tax increases in decades.15

Researchers also found that the Trump tariffs lowered the real income of American workers and reduced gross domestic product (GDP) growth.16

In 2021, the Biden administration worked to change many of these harmful trade barriers.17

Fast Fact

Companies affected by tariffs essentially have three options: absorb the extra expense, increase prices, or move production to another country. In general, it is believed that Trump’s tariffs did more harm than good, costing companies billions of dollars, and reducing the demand for exported goods that were hit with retaliatory tariffs.18

U.S. Tariffs on China 

Fears of an all-out U.S. trade war seemed to be validated as the first Trump administration imposed more tariffs, this time on China. They came after the Office of the United States Trade Representative (USTR) released the results of its Section 301 investigation into China’s trade practices.19

The approximately 200-page report called out China’s use of preferential industrial policy to unfairly support Chinese firms, discrimination against foreign firms, and disregard for intellectual property.20

Trump, in response to what he said were China’s unfair trading practices, imposed sweeping tariffs on $34 billion worth of Chinese goods. The tariffs targeted manufactured technology products from flat-screen televisions, aircraft parts, and medical devices to nuclear reactor parts and self-propelled machinery.21

China promptly retaliated by imposing its own tariffs on U.S. agricultural products such as pork, soybeans, and sorghum.22

The Chinese tariffs targeted American farmers and big industrial-agriculture operations in the Midwest—the same political groups that voted for Trump in 2016 and, in theory, had the most influence on his policies.

The trade war continued after this, with both countries increasing tariffs—the U.S. in particular imposing levies on $200 billion worth of Chinese imports.23

These tariffs were shown to reduce employment and economic output, impacting the overall U.S. economy and people’s livelihoods.2 They also did significant damage to relationships with other countries, particularly allies.

What Is an Example of a Tariff?

An example of a tariff could be a tax on steel imports. This means that any steel imported from another country would incur a cost—for example, 5% of the value of the imported goods—that would be paid by the individual or business importing the goods.

What Is the Purpose of a Tariff?

Tariffs are a way for governments to not only generate revenue but also protect domestic businesses. Tariffs increase the price of imported goods, making domestic goods cheaper in comparison.

Who Benefits From a Tariff?

The importing countries usually benefit from a tariff, as they are the ones imposing the tariff and collecting the revenue. Domestic businesses also benefit from tariffs because they make their goods cheaper than imported goods, hence driving up the demand for their products.

How Do Tariffs Hurt Consumers?

Tariffs hurt consumers in the country that imposes the tariff because of the increased prices of imported goods. Since an importer has to pay the cost of the tariff on the goods that they import, they pass this increased cost on to consumers in the form of higher prices.

How Do Tariffs Affect You?

If you are a consumer, tariffs affect you because they result in an increase in the price of imported goods.

If you are a domestic producer, tariffs can help you by making your goods cheaper compared to international goods, thus increasing your sales.

If you export your goods to other countries that impose tariffs, this may reduce the demand for your goods, thus hurting your business.

The Bottom Line

Tariffs are taxes imposed on imported goods. They often result in higher prices for consumers. They can impact various demographics, and in particular burden lower-income consumers. They pose challenges for small businesses reliant on imported materials.

The first Trump administration focused a great deal of its attention on imposing tariffs. Broadly speaking, most economists feel they had little impact, positive or negative, for the overall economy of the U.S.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

1. ScienceDirect. "Ad Valorem Tariff vs. Specific Tariff: Quality-Differentiated E-Tailers’ Profitability and Social Welfare in Cross-Border E-Commerce."

2. Tax Foundation. "Trump Tariffs: Tracking the Economic Impact of the Trump Trade War."

3. U.S. Bureau of Labor Statistics. "The Effects of Tariff Rates on the U.S. Economy: What the Producer Price Index Tells Us."

4. Council on Foreign Relations. "What Are Tariffs."

5. U.S. Senate. “The Senate Passes the Smoot-Hawley Tariff.”

6. U.S. State Department, Office of the Historian. “Milestones: 1921–1936: Protectionism in the Interwar Period."

7. The Brookings Institution. "Did Trump’s Tariffs Benefit American Workers and National Security?"

8. Reason. "Trump Blames Biden for Never Removing the Tariffs Trump Imposed."

9. Office of the U.S. Trade Representative. “President Trump Approves Relief for U.S. Washing Machine and Solar Cell Manufacturers.”

10. The White House ARCHIVE: Trump Administration. "Presidential Proclamation on Adjusting Imports of Aluminum into the United States."

11. The White House ARCHIVE: Trump Administration. "Trump Steel Tariffs Bring Hope, Prosperity Back to Granite City."

12. European Parliament. "US Tariffs: EU Response and Fears of a Trade War."

13. European Union External Action. "EU Adopts Rebalancing Measures in Reaction to US Steel and Aluminium Tariffs."

14. Reuters. "Economists United: Trump Tariffs Won't Help the Economy."

15. CNBC. “Trump’s Tariffs Are Equivalent to One of the Largest Tax Increases in Decades.”

16. American Economic Association. “The Impact of the 2018 Tariffs on Prices and Welfare," Download PDF, Pages 201, 208.

17. The American Presidency Project. "FACT SHEET: The United States and European Union To Negotiate World’s First Carbon-Based Sectoral Arrangement on Steel and Aluminum Trade."

18. Reuters. “Trump’s Tariffs Cost U.S. $46 Billion to Date, Data Shows."

19. Office of the United States Trade Representative. "Section 301 Investigation Fact Sheet."

20. Office of the United States Trade Representative. "Findings of the Investigation Into China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation Under Section 301 of the Trade Act of 1974."

21. Office of the United States Trade Representative. "$34 Billion Trade Action (List 1).

22. Congressional Research Service. "China’s Retaliatory Tariffs on U.S. Agricultural Products," Page 2.

23. Peterson Institute for International Economics. “Trump’s Trade War Timeline: An Up-to-Date Guide.”

Today's World, Projecting Tomorrow

What do you think is going to be the outcome of all the tariffs being imposed?