Economist LINDA LIM explains what governments hope to gain by imposing tariffs and why these tools often backfire.

Import tariff

An import tariff is a tax imposed on foreign goods and services by the importing (home) country.  Like any tax, it raises revenue for the home government, and historically, this was a major source of government revenues.

It is the importer who actually pays the tax to the home government. If there are acceptable domestic substitutes for the foreign product, consumers (including businesses importing parts and equipment from abroad) can just shift their purchases from the foreign to a domestic product, to avoid paying the tax.  The importer could also shop for foreign products from countries whose exports are charged lower tariffs. Either response deprives the government of tariff revenue.

If there are no substitutes, the importer must pay the tax, typically assessed as a percentage of the imported item’s “border price”.  But the actual price increase could be lessened if the foreign exporter decides to lower their price to maintain sales. Similarly, the company which imports the product may decide not to pass along the full tax burden to their final domestic consumer, accepting lower profit margins instead.

Regardless, domestic prices in the tariff-levying country will rise. Domestic firms may not be able to make products as cheaply as the foreign country’s firms, which may be why the foreign products were preferred in the first place. Furthermore, domestic producers may raise their prices to match those of tariffed imports, or to meet increased demand, “because they can”.  This means higher inflation.

Tariffs also reduce economic growth.  Having to pay higher prices for imports means that home consumers have less disposable income with which to buy domestic goods and services, sales of which fall.  Home exports will also fall, exacerbating the growth slowdown. This is because foreign countries hit by tariffs will lose export income, thus reducing their ability to pay for imports. Those countries may also impose retaliatory tariffs.

Exporting enterprises in foreign countries can respond to home tariffs by increasing efficiency and innovation, creating better, cheaper, newer products that home consumers will still want to buy, and by relocating production to third countries not subject to similar tariffs.

A government could succeed in using tariffs to encourage more domestic production. Foreign firms that previously exported to the protecting home country might be induced by tariffs to invest here, contributing to growth.

However, this would depend on the home country having underutilized resources or “spare capacity” in capital, labor, skills, land and other inputs required for production.  If there is full employment, then production in the protected industry can increase only by diverting scarce resources from other industries. This is likely to push up costs and contribute to inflation.  Tariffs can also end up reducing innovation and growth in the longer term, since they protect inefficient home industries and firms that are unable to compete with imports over competitive export-oriented sectors.

Recognizing that tariffs hurt both producers and consumers, foreigners and citizens alike, the world community collectively embarked on multilateral trade liberalization after the Second World War, with successive negotiated “rounds” of mutual tariff reductions, following the principle of non-discrimination.  Countries can (and do) still impose tariffs on imports, but under mutually agreed international trade rules, the same tariff rate had to be applied to a given product from all countries.

Finally, tariffs are only one way that governments restrict imports, but all such measures have similar effects.  And in the rare historical cases where import protection has contributed to building a long-term competitive advantage for protected industries, it has been accompanied by other policies, most notably export-processing free trade zones which exempt exporting industries from import tariffs.

– By LINDA LIM, Professor Emerita, Stephen M. Ross School of Business, University of Michigan.

Interested in republishing this article? Please read our policies here.