Tariffs are bad policy, but good politics

We are moving into a protectionist world, led by the US, as in the early 1930s. Donald Trump is of course, a committed protectionist — a true successor of Senator Smoot and Representative Hawley, who instigated the infamous Smoot-Hawley tariff in 1930. But, except by Trump’s standards, Joe Biden is also no slouch when it comes to protection, most recently with his tariffs on $18bn of Chinese exports. The US tariff on electric vehicles, in particular, is to be quadrupled to 100 per cent. “Where have you been for three-and-a-half years? They should have done it a long time ago,” responded Trump. He proposes tariffs of 10 per cent on all imports, apart from those from China, on which he hopes to impose tariffs of 60 per cent. These new tariffs, he hopes, would also partially offset the lost revenue from extending his highly expensive 2017 Tax Cuts and Jobs Act.

These policies are politically appealing. The impact of tariffs on those who are harmed is relatively invisible; the victims are usually powerless; and — hallelujah! — tariffs can be justified as a way to right wrongs done by nasty foreigners. Yet they are still bad policies.

To understand this one needs to make a distinction introduced into economics in the early 1960s and justified empirically in some classic analyses of the role of trade policies in the huge success of the export-oriented development of Taiwan, South Korea and, later, China.

The point is simple. Yes, there exist excellent reasons why we might want to intervene in the economy. We might want to lower inequality, reduce insecurity, promote infant industries, limit macroeconomic instability and minimise strategic vulnerabilities. But trade policy, especially protection, will rarely be the best way of achieving the objective. The argument for liberal trade is not an argument for laissez faire. It is an argument for using instruments other than trade barriers wherever possible.

To understand why tariffs are rarely the best policy instrument, one needs to understand what they do. Tariffs are taxes on consumers whose revenue goes in part to the government, but in large part to producers. So, they are examples of “tax-and-spend”, but the taxation is concealed in the elevated price of the good and the spending is concealed in the elevated rewards to producers.

Such policies are not well targeted at anything but these goals. Like any other tax, tariffs make the people who buy the good, be they consumers or producers, worse off. But they also have wider effects on the economy. Above all, they impose a “home-market bias”. To put that in general terms, a tax on imports is also a tax on exports. How does this work? Well, take the example of Trump’s proposed 10 per cent tariff on all imports. This can be thought of as initially being like a devaluation, but just for import substitutes. Imports of such goods will fall — that, after all, is the aim. But there is no reason why this should directly affect the current account balance, unless it also changes aggregate income and expenditure in the economy. So, with less demand for imports, the need to buy foreign currency will fall. That will strengthen the dollar, making exports less competitive. They, then, will shrink. Exporters are the most competitive producers in the country. Protecting producers of uncompetitive import substitutes at their expense does not look sensible.

This is not theoretical. Those of us who have worked in countries with highly protectionist trade policies have seen this outcome. I worked on India at the World Bank in the 1970s. Protectionist trade policy did not make the country self-sufficient. It crushed exports, making it far more vulnerable.

This is far from all. There are also adverse distributional effects. An excellent recent study, “Why Trump’s Tariff Proposals Would Harm Working Americans”, by Kimberly Clausing and Mary Lovely for the Peterson Institute for International Economics, reviews the evidence that Trump’s agenda for another term “amounts to regressive tax cuts, only partially paid for by regressive tax increases. A lower-bound estimate of costs to consumers indicates that the tariffs would reduce after-tax incomes by about 3.5 per cent for those in the bottom half of the income distribution.” Similarly, a study published by the National Bureau of Economic Research in January 2024 concluded that the 2018-19 trade war launched by Trump had “not to date provided economic help to the US heartland: import tariffs on foreign goods neither raised nor lowered US employment in newly protected sectors; retaliatory tariffs had clear negative employment impacts, primarily in agriculture; and these harms were only partly mitigated by compensatory US agricultural subsidies”. In all, lousy policy; good politics.

Will Biden’s more targeted support for production of electric vehicles do better? That is unlikely, for a simple reason. The policy will protect producers in the US market, but the US market is too small to make domestic producers globally competitive. According to the International Energy Agency, in 2023, the US market for battery-electric and plug-in hybrid vehicles was 17 per cent of China’s. US consumers no longer dominate world consumption. That is a big obstacle to a home-market-oriented industrial policy. (See charts.)

Something far more subtle will be needed. That something is subsidies. Biden has been quite right to use these. The rejoinder will be that the taxes needed to fund subsidies are anathema. But tariffs are higher taxes. Worse, they are inefficient, regressive and nigh on certain to cause retaliation. Yes, there are perfectly sound arguments for intervention in markets. But returning to the trade policies of the 1930s is quite mad.

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