Tariffs - The Economic Effect of Tariffs

How Tariffs Effect The Economy

Container terminal at dusk, view from cargo ship
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In my article The Softwood Lumber Dispute we saw an example of a tariff placed on a foreign good. A tariff is simply a tax or duty placed on an imported good by a domestic government. Tariffs are usually levied as a percentage of the declared value of the good, similar to a sales tax. Unlike a sales tax, tariff rates are often different for every good and tariffs do not apply to domestically produced goods.

The upcoming book Advanced International Trade: Theory and Evidence by Robert Feenstra gives three situations in which governments often impose tariffs:

  • To protect fledgling domestic industries from foreign competition.
  • To protect aging and inefficient domestic industries from foreign competition.
  • To protect domestic producers from dumping by foreign companies or governments. Dumping occurs when a foreign company charges a price in the domestic market which is "too low". In most instances "too low" is generally understood to be a price which is lower in a foreign market than the price in the domestic market. In other instances "too low" means a price which is below cost, so the producer is losing money.
The cost of tariffs to the economy is not trivial. The World Bank estimates that if all barriers to trade such as tariffs were eliminated, the global economy would expand by 830 billion dollars by 2015.
The economic effect of tariffs can be broken down into two components:
  • The impact to the country which has a tariff imposed on it.
  • The impact to the country imposing the tariff.
In almost all instances the tariff causes a net loss to the economies of both the country imposing the tariff and the country the tariff is imposed on.

Impact to the economy of a country with the tariff imposed on it.

It is easy to see why a foreign tariff hurts the economy of a country.
A foreign tariff raises the costs of domestic producers which causes them to sell less in those foreign markets. In the case of the softwood lumber dispute, it is estimated that recent American tariffs have cost Canadian lumber producers 1.5 billion Canadian dollars. Producers cut production due to this reduction in demand which causes jobs to be lost. These job losses impact other industries as the demand for consumer products decreases because of the reduced employment level. Foreign tariffs, along with other forms of market restrictions, cause a decline in the economic health of a nation.

The next section explains why tariffs also hurt the economy of the country which imposes them.

Be sure to continue to page 2 of The Economic Effect of Tariffs

Except in all but the rarest of instances, tariffs hurt the country that imposes them, as their costs outweigh their benefits. Tariffs are a boon to domestic producers who now face reduced competition in their home market. The reduced competition causes prices to rise. The sales of domestic producers should also rise, all else being equal. The increased production and price causes domestic producers to hire more workers which causes consumer spending to rise.

The tariffs also increase government revenues that can be used to the benefit of the economy.

There are costs to tariffs, however. Now the price of the good with the tariff has increased, the consumer is forced to either buy less of this good or less of some other good. The price increase can be thought of as a reduction in consumer income. Since consumers are purchasing less, domestic producers in other industries are selling less, causing a decline in the economy.

Generally the benefit caused by the increased domestic production in the tariff protected industry plus the increased government revenues does not offset the losses the increased prices cause consumers and the costs of imposing and collecting the tariff. We haven't even considered the possibility that other countries might put tariffs on our goods in retaliation, which we know would be costly to us. Even if they do not, the tariff is still costly to the economy.

In my article The Effect of Taxes on Economic Growth we saw that increased taxes cause consumers to alter their behavior which in turn causes the economy to be less efficient. Adam Smith's The Wealth of Nations showed how international trade increases the wealth of an economy. Any mechanism designed to slow international trade will have the effect of reducing economic growth.

For these reasons economic theory teaches us that tariffs will be harmful to the country imposing them.

That's how it should work in theory. How does it work in practice?

Empirical Evidence on the Effect of Tariffs on the Country Imposing Them

Study after study has shown that tariffs cause reduced economic growth to the country imposing them. A few of examples:
  1. The essay on Free Trade at The Concise Encyclopedia of Economics looks at the issue of international trade policy. In the essay, Alan Blinder states that "one study estimated that in 1984 U.S. consumers paid $42,000 annually for each textile job that was preserved by import quotas, a sum that greatly exceeded the average earnings of a textile worker. That same study estimated that restricting foreign imports cost $105,000 annually for each automobile worker's job that was saved, $420,000 for each job in TV manufacturing, and $750,000 for every job saved in the steel industry."
  2. In the year 2000 President Bush raised tariffs on imported steel goods between 8 and 30 percent. The Mackinac Center for Public Policy cites a study which indicates that the tariff will reduce U.S. national income by between 0.5 to 1.4 billion dollars. The study estimates that less than 10,000 jobs in the steel industry will be saved by the measure at a cost of over $400,000 per job saved. For every job saved by this measure, 8 will be lost.
  1. The cost of protecting these jobs is not unique to the steel industry or to the United States. The National Center For Policy Analysis estimates that in 1994 tariffs cost the U.S. economy 32.3 billion dollars or $170,000 for every job saved. Tariffs in Europe cost European consumers $70,000 per job saved while Japanese consumers lost $600,000 per job saved through Japanese tariffs.
These studies, like many others, indicate that tariffs do more harm than good. If these tariffs are so bad for the economy, why do governments keep enacting them? We'll discuss that question in the next section.

Be sure to continue to page 3 of The Economic Effect of Tariffs

Study after study has shown that tariffs, whether they be one tariff or hundreds, are bad for the economy. If tariffs do not help the economy, why would a politician enact one? After all politicans are reelected at a greater rate when the economy is doing well, so you would think it would be in their self interest to prevent tariffs.

Recall that tariffs are not harmful for everyone, and they have a distributive effect.

Some people and industries gain when the tariff is enacted and others lose. The way gains and losses are distributed is absolutely crucial in understanding why tariffs along with many other policies are enacted. To understand the logic behind the policies we need to understand The Logic of Collective Action. My article titled The Logic of Collective Action discusses the ideas of a book by the same name, written by Mancur Olson in 1965. Olson explains why economic policies are often to the benefit of smaller groups at the expense of larger ones. Take the example of tariffs placed on imported Canadian softwood lumber. We'll suppose the measure saves 5,000 jobs, at the cost of $200,000 per job, or a cost of 1 billion dollars to the economy. This cost is distributed through the economy and represents just a few dollars to every person living in America. It is obvious to see that it's not worth the time and effort for any American to educate himself about the issue, solicit donations for the cause and lobby congress to gain a few dollars.

However, the benefit to the American softwood lumber industry is quite large. The ten-thousand lumber workers will lobby congress to protect their jobs along with the lumber companies that will gain hundreds of thousands of dollars by having the measure enacted. Since the people who gain from the measure have an incentive to lobby for the measure, while the people who lose have no incentive to spend the time and money to lobby against the issue, the tariff will be passed although it may, in total, have negative consequences for the economy.

The gains from tariff policies are a lot more visible than the losses. You can see the sawmills which would be closed down if the industry is not protected by tariffs. You can meet the workers whose jobs will be lost if tariffs are not enacted by the government. Since the costs of the policies are distributed far and wide, you cannot put a face on the cost of a poor economic policy. Although 8 workers might lose their job for every job saved by a softwood lumber tariff, you will never meet one of these workers, because it is impossible to pinpoint exactly which workers would have been able to keep their jobs if the tariff was not enacted. If a worker loses his job because the performance of the economy is poor, you cannot say if a reduction in lumber tariffs would have saved his job. The nightly news would never show a picture of a California farm worker and state that he lost his job because of tariffs designed to help the lumber industry in Maine. The link between the two is impossible to see. The link between lumber workers and lumber tariffs is much more visible and thus will garner much more attention.

The gains from a tariff are clearly visible but the costs are hidden, it will often appear that tariffs do not have a cost.

By understanding this we can understand why so many government policies are enacted which harm the economy.

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