Posted: FEBRUARY 13, 2025
Understanding Tariffs
...and How They Shape the Global Economy
I am from Washington, D.C. and around here, tariffs are surely the talk of the town these days. Tariffs and trade wars have been a major news headline in the past few months. There is a lot of debate around their use and effectiveness. There also seems to be a lot of misunderstandings around it, so here is a short blog that dives into the topic.
What are tariffs really, and why do they matter so much?
What are tariffs really, and why do they matter so much?
Tariffs Defined
In simple terms, a tariff is a charge imposed by the government on the goods and services that are imported from another country. Consider an American company like Chipotle who might be buying avocados from Mexico. Then the importing company, Chipotle (or its domestic distributor), will have to pay an extra fee on those avocados. The company has a few options to manage these tariffs: It can either pass the additional cost onto the consumer by raising prices, absorb the extra burden themselves without increasing the prices of the burritos, or pass down a portion of the extra burden and absorb the rest.
The response to tariffs also partially depends on whether or not a good domestic substitute for the product exists. If there is a cheaper U.S. equivalent, the importer may just switch to that alternative. If there are no cheaper alternatives, the importer may have to bear the additional cost. In some cases, the importer may choose to stop importing altogether, limiting choices for the consumers in the importing country.
In simple terms, a tariff is a charge imposed by the government on the goods and services that are imported from another country. Consider an American company like Chipotle who might be buying avocados from Mexico. Then the importing company, Chipotle (or its domestic distributor), will have to pay an extra fee on those avocados. The company has a few options to manage these tariffs: It can either pass the additional cost onto the consumer by raising prices, absorb the extra burden themselves without increasing the prices of the burritos, or pass down a portion of the extra burden and absorb the rest.
The response to tariffs also partially depends on whether or not a good domestic substitute for the product exists. If there is a cheaper U.S. equivalent, the importer may just switch to that alternative. If there are no cheaper alternatives, the importer may have to bear the additional cost. In some cases, the importer may choose to stop importing altogether, limiting choices for the consumers in the importing country.
When Can the Cost of Tariffs Passed on to Customers
A key point here is that tariffs affect global trade. Exporting countries may be impacted if the importing countries shy away from importing due to higher costs, and importing countries will be affected because the increased burden either raises consumer prices or puts pressure on profit margins.
When Did We Use Tariffs Before?
In order to understand the economic impact of these tariffs, let’s take a at closer look cases where we used them in the past:
The Hawley-Smoot Tariff Act: Following the stock market crash in 1929, President Hoover imposed tariffs on thousands of goods by passing the Hawley-Smoot Tariff Act of 1930. The tariffs were originally aimed at protecting U.S. farmers from foreign competition, but they were later extended to many other industries. The result was retaliatory tariffs by other nations and a plummeting global trade.
Many economists think that the Hawley-Smoot Tariff act was a contributing factor to the Great Depression. In 1986, then President Ronald Reagan said that the Hawley-Smoot tariffs “helped sink our country into the Great Depression.”
In order to understand the economic impact of these tariffs, let’s take a at closer look cases where we used them in the past:
The Hawley-Smoot Tariff Act: Following the stock market crash in 1929, President Hoover imposed tariffs on thousands of goods by passing the Hawley-Smoot Tariff Act of 1930. The tariffs were originally aimed at protecting U.S. farmers from foreign competition, but they were later extended to many other industries. The result was retaliatory tariffs by other nations and a plummeting global trade.
Many economists think that the Hawley-Smoot Tariff act was a contributing factor to the Great Depression. In 1986, then President Ronald Reagan said that the Hawley-Smoot tariffs “helped sink our country into the Great Depression.”
Hawley & Smoot
Representative Willis G. Hawley (R-OR) and Senator Reed Smoot (R-UT) on the steps of the Senate office building. (Library of Congress)
Retaliators and U.S. Imports after Smoot-Hawley.
K. J. Mitchener, K. H. O'Rourke, K. Wandschneider, The Smoot-Hawley Trade War, The Economic Journal, Volume 132, Issue 647, October 2022
K. J. Mitchener, K. H. O'Rourke, K. Wandschneider, The Smoot-Hawley Trade War, The Economic Journal, Volume 132, Issue 647, October 2022
Post-World War II: In the aftermath of World War II and the Great Depression, the desire for maintaining peace helped the formation of a new global economic system. In 1947, world leaders signed the General Agreement on Tariffs and Trade (GATT) to jointly lower tariffs in an effort to stabilize economies and stimulate growth. GATT created a framework for international trade that all members followed.
While tariffs became less important as a source of government income over time, they never lost their political appeal.
While tariffs became less important as a source of government income over time, they never lost their political appeal.
Signed in 1947, GATT was the first global effort between countries to lower trade barriers, promoting free trade.
Making the Case for Using Tariffs
So why keep tariffs around at all? Here are the main reasons governments use them:
So why keep tariffs around at all? Here are the main reasons governments use them:
1
Protecting Domestic Industries: Tariffs can make imported goods more expensive, helping local businesses compete and keeping jobs at home.
2
Generating Government Revenue: Historically, tariffs were a primary source of funds for many governments. Before income and corporate taxes were used, tariffs funded much of the U.S. government — around 50% of federal revenues in the mid-1800s.
Proportion of Total Federal Revenues from Customs Duties, 1820 through 1913
Congressional Research Service, The Library of Congress
Congressional Research Service, The Library of Congress
Share of tariffs as a source of income for the US government has fallen to 1–2% in modern times.
3
Bargaining Chip in Trade Negotiations: Countries use tariffs as bargaining tool in trade negotiations: "If you raise yours, we’ll raise ours."
4
Developing Key Industries: Sometimes tariffs can be used to help get young industries off the ground by protecting them from foreign competition. For example, South Korea used tariffs in the 1970s to help companies such as LG and Kia grow strong enough to compete globally.
5
National Security Concerns: Governments might use tariffs on products that are critical to defense or on technologies where they do not want to rely too much on foreign suppliers.
A view of the North entrance of the U.S. Treasury Department Building in Washington D.C. featuring the statue of Albert Gallatin, its 4th Secretary.
(Sealy j, CC BY-SA 4.0, via Wikimedia Commons)
(Sealy j, CC BY-SA 4.0, via Wikimedia Commons)
Drawbacks: When Tariffs Backfire
While tariffs can be beneficial in the short run, we may observe several downsides in the long run. Here are some of them:
While tariffs can be beneficial in the short run, we may observe several downsides in the long run. Here are some of them:
1
Higher Consumer Prices: While tariffs don’t always lead to immediate price increases when importers absorb them, often times they trickle down to consumers, making products eventually more expensive.
2
Reduced Competition and Innovation: When foreign competitors are not able to enter a market due to tariffs, domestic companies who are faced with less competition, may stop innovating.
For instance, before India opened up its car market in the 1990s, high tariffs meant little competition and carmakers like Hindustan Motors, known for its “Ambassador” model, barely changed for decades. Once tariffs were eliminated and global car manufacturers were able to compete in India, innovation took off and consumers were given better choices.
For instance, before India opened up its car market in the 1990s, high tariffs meant little competition and carmakers like Hindustan Motors, known for its “Ambassador” model, barely changed for decades. Once tariffs were eliminated and global car manufacturers were able to compete in India, innovation took off and consumers were given better choices.
3
Retaliatory Measures and Trade Wars: The impact of implementing a tariff on another country is often retaliation. Such escalations end up diminishing global trade and reducing overall economic growth.
A good example of escalating trade wars is China’s response to the 2018 U.S tariffs: When the U.S. imposed tariffs on hundreds of billions of dollars’ worth of Chinese goods in 2018, China retaliated with tariffs on U.S. agriculture, automobiles, and other key exports. By mid-2019, China had imposed tariffs on $110 billion worth of U.S. goods, while exports to China dropped from $130 billion in 2017 to around $106 billion in 2019. As a result, the American soybean exports to China plummeted by roughly 75% in just one year, from $12 billion in 2017 to $3 billion in 2018.
A good example of escalating trade wars is China’s response to the 2018 U.S tariffs: When the U.S. imposed tariffs on hundreds of billions of dollars’ worth of Chinese goods in 2018, China retaliated with tariffs on U.S. agriculture, automobiles, and other key exports. By mid-2019, China had imposed tariffs on $110 billion worth of U.S. goods, while exports to China dropped from $130 billion in 2017 to around $106 billion in 2019. As a result, the American soybean exports to China plummeted by roughly 75% in just one year, from $12 billion in 2017 to $3 billion in 2018.
What insights does Game Theory offer on the U.S. tariff policy approach? I can think of at least two:
1. Given the relative strength of the U.S. and the relative weakness of many other countries—both cyclically and structurally—the approach promises gains for America in the short-term. The key question is whether these gains materialize immediately or only after other countries attempt to resist and fail.
2. The longer-term outlook would become less favorable for the US if tariffs become a “repeated game.” The more it appeals to tariffs, the stronger the incentive for other countries to reduce their economic and financial dependence on the US and accelerate the fragmentation of an international economic order that has historically served America well.
Put differently, the weaponization of trade promises immediate gains for the US. But, if sustained over time, it risks eroding America’s central position in the global economy while encouraging other countries to look for alternative systems that bypass it.
1. Given the relative strength of the U.S. and the relative weakness of many other countries—both cyclically and structurally—the approach promises gains for America in the short-term. The key question is whether these gains materialize immediately or only after other countries attempt to resist and fail.
2. The longer-term outlook would become less favorable for the US if tariffs become a “repeated game.” The more it appeals to tariffs, the stronger the incentive for other countries to reduce their economic and financial dependence on the US and accelerate the fragmentation of an international economic order that has historically served America well.
Put differently, the weaponization of trade promises immediate gains for the US. But, if sustained over time, it risks eroding America’s central position in the global economy while encouraging other countries to look for alternative systems that bypass it.
Mohamed A. El-Erian
President, Queens' College, Cambridge University
4
Global Economic Slowdowns: When many countries start showing these protectionist tendencies, global trade volume drops. Supply chains get impacted, economies slow down, and all parties involved lose in the end.
If tariffs make it harder for exporting countries to sell their goods, they will end up with less money to import from the country that set the tariffs in the first place. This drop will hurt local exporters and contribute to a slowdown in the domestic economy.
If tariffs make it harder for exporting countries to sell their goods, they will end up with less money to import from the country that set the tariffs in the first place. This drop will hurt local exporters and contribute to a slowdown in the domestic economy.
To sum up, tariffs may seem like simple surcharges on imports, but their influence extends far beyond imports. By modifying the cost of goods and services, tariffs can impact consumer prices, increase domestic unemployment, impact geopolitical relationships, and shift global balances of power.
While they may offer protection for some vulnerable industries, the potential for retaliation requires us to think carefully before applying them.
While they may offer protection for some vulnerable industries, the potential for retaliation requires us to think carefully before applying them.