Posted: FEBRUARY 13, 2025
Understanding Tariffs
How Taxes on International Trade Shape the Global Economy
Tariffs have been making headlines again, sparking debates over trade wars, shifting supply chains, and rising consumer costs. But beyond the news soundbites, what exactly are tariffs, and how do they impact our everyday lives? Below, we’ll explore the ins and outs of these import (and sometimes export) taxes — from their historical roots to their modern-day applications.
What Exactly Are Tariffs?
At their core, tariffs are taxes placed on goods when they cross international borders. For instance, if a U.S. company wants to import avocados from Mexico, the avocados might be subject to an import tariff—an additional fee based on either a percentage of the goods’ value or a flat rate per unit. These taxes can significantly affect final prices, sometimes prompting importers to pass on the extra cost to consumers.
In a simple scenario, you’d imagine the importing business shoulders the tariff expense. However, market dynamics can shift these costs around. If there are no good domestic alternatives or if consumer demand is high, importers might pass those fees along to end users. On the flip side, if cheaper domestic substitutes exist, importers may have to absorb the tariff themselves to remain competitive, possibly slashing their own profit margins which may negatively impact their employees, suppliers and investors. They may also cease to import alltogether which tends to reduce competition in the domestic market, potentially limiting choices for consumers.
At their core, tariffs are taxes placed on goods when they cross international borders. For instance, if a U.S. company wants to import avocados from Mexico, the avocados might be subject to an import tariff—an additional fee based on either a percentage of the goods’ value or a flat rate per unit. These taxes can significantly affect final prices, sometimes prompting importers to pass on the extra cost to consumers.
In a simple scenario, you’d imagine the importing business shoulders the tariff expense. However, market dynamics can shift these costs around. If there are no good domestic alternatives or if consumer demand is high, importers might pass those fees along to end users. On the flip side, if cheaper domestic substitutes exist, importers may have to absorb the tariff themselves to remain competitive, possibly slashing their own profit margins which may negatively impact their employees, suppliers and investors. They may also cease to import alltogether which tends to reduce competition in the domestic market, potentially limiting choices for consumers.
Historical Case Studies: Learning from the Past
The Hawley-Smoot Tariff Act: During the Great Depression, the U.S. sought to protect its struggling industries by passing the Hawley-Smoot Tariff Act of 1930. While it did boost government revenues, it also provoked retaliatory measures from numerous trade partners. Global trade shrank substantially, intensifying the economic downturn in the lead-up to World War II.
The Hawley-Smoot Tariff Act: During the Great Depression, the U.S. sought to protect its struggling industries by passing the Hawley-Smoot Tariff Act of 1930. While it did boost government revenues, it also provoked retaliatory measures from numerous trade partners. Global trade shrank substantially, intensifying the economic downturn in the lead-up to World War II.
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 Shifts: Following the war, multinational institutions like the United Nations and the General Agreement on Tariffs and Trade (GATT) emerged. Their aim was to regulate and reduce tariffs, in hopes of promoting a more stable global marketplace. Over time, tariffs became a smaller slice of government income for many developed nations, though they remain politically potent even now.
GATT
Signed in 1947, The General Agreement on Tariffs and Trade (GATT) was the first global effort between countries to lower trade barriers, promoting free trade.
Why Governments Impose Tariffs
Although the specifics vary from one country to another, governments typically rely on five main motivations for establishing or increasing tariffs:
Although the specifics vary from one country to another, governments typically rely on five main motivations for establishing or increasing tariffs:
1
Protecting Domestic Industries: Tariffs can make foreign products more expensive, allowing domestic firms to stand on more equal footing — or even gain a price advantage. This protection can safeguard local jobs, especially in sectors deemed vital for economic or national security reasons.
2
Generating Government Revenue: Historically, tariffs were a primary source of funds for many governments — particularly before widespread adoption of income and corporate taxes. For instance, in the mid-19th century, when the US was significantly more reliant on imported goods than it is today, about 50% of U.S. federal revenue came from tariffs.
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
Trade Negotiation Leverage: Tariffs can be a powerful bargaining tool. Threatening or imposing them may encourage trading partners to loosen their own restrictions, opening up market opportunities.
For example, between 2018 and 2019, the U.S. placed tariffs on about $300 billion worth of Chinese goods, aiming to address trade imbalances and IP issues
For example, between 2018 and 2019, the U.S. placed tariffs on about $300 billion worth of Chinese goods, aiming to address trade imbalances and IP issues
4
Developing Key Industries: When industries are still in their early stages, temporary tariffs can shield them from more established foreign competitors. South Korea famously used this strategy in the 1970s to foster brands like LG and Kia, both of which now flourish in global markets.
5
National Security Concerns: Governments often apply higher tariffs (or outright bans) on products critical to security—think defense or advanced technology. The rationale is to ensure self-sufficiency in essentials during a crisis or conflict.
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 protect certain interests, they’re also known to produce unintended consequences:
While tariffs can protect certain interests, they’re also known to produce unintended consequences:
1
Higher Consumer Prices: Since tariff costs can trickle down to everyday shoppers, the result is often more expensive goods. This dynamic affects not just niche items but can also hit staple products that many households rely on.
2
Reduced Competition and Innovation: When foreign competition is kept out or severely hamstrung, domestic companies may lose the incentive to innovate or maintain competitive prices.
Historical examples include India’s car market, where limited imports stifled innovation until market liberalization introduced foreign automakers:
Historical examples include India’s car market, where limited imports stifled innovation until market liberalization introduced foreign automakers:
Before India’s economic reforms in the early 1990s, the government set high tariffs on imported cars and auto parts. This protected local carmakers, like Hindustan Motors, known for its “Ambassador” model, from foreign competition. With fewer competitors, local companies had little reason to improve their designs or production methods. As a result, the Ambassador’s design stayed nearly the same for decades and fell behind in safety, efficiency, and comfort compared to global standards.
When India lowered tariffs and allowed foreign companies like Suzuki, Hyundai, and Honda to produce cars locally, competition increased. This pushed domestic carmakers to modernize. Consumers gained more choices, better prices, and higher-quality vehicles.
When India lowered tariffs and allowed foreign companies like Suzuki, Hyundai, and Honda to produce cars locally, competition increased. This pushed domestic carmakers to modernize. Consumers gained more choices, better prices, and higher-quality vehicles.
3
Retaliatory Measures and Trade Wars: A classic case of tit-for-tat, a tariff hike by one country may provoke another country to impose tariffs of its own. Such escalations can diminish global trade, reduce overall economic growth, and harm the very industries tariffs were meant to protect.
For example, in response to 2018 U.S. tariffs, China imposed its own tariffs on U.S. goods, particularly targeting agricultural products, automobiles, and other key exports. By mid-2019, China had imposed tariffs on $110 billion of U.S. goods while exports to China dropped from $130 billion in 2017 to around $106 billion in 2019, reflecting the impact of retaliatory measures. Particularly impacted were American soybean producers as U.S. soybean exports to China dropped by about 75%, from $12 billion in 2017 to $3 billion in 2018.
For example, in response to 2018 U.S. tariffs, China imposed its own tariffs on U.S. goods, particularly targeting agricultural products, automobiles, and other key exports. By mid-2019, China had imposed tariffs on $110 billion of U.S. goods while exports to China dropped from $130 billion in 2017 to around $106 billion in 2019, reflecting the impact of retaliatory measures. Particularly impacted were American soybean producers as U.S. soybean exports to China dropped by about 75%, 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 multiple countries engage in protectionist policies at the same time, international supply chains become more expensive and less efficient.
If tariffs make it harder for other countries to sell their goods, those countries will have less money to buy exports from the country that set the tariffs. This drop in demand can hurt local exporters and slow down the domestic economy.
If tariffs make it harder for other countries to sell their goods, those countries will have less money to buy exports from the country that set the tariffs. This drop in demand can hurt local exporters and slow down the domestic economy.
Tariffs may seem like mere taxes levied at the border, but their influence extends far beyond import bills. By modifying the cost structure of goods and services, tariffs affect consumer prices, geopolitical relationships, and the global balance of power. While they can offer legitimate protection for key industries, the potential for retaliation and higher consumer costs should make policymakers—and business leaders—think carefully before applying them as a blunt instrument.
Tariffs, Explained
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