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How do Tariffs work?

Tariffs, while being somewhat relevant for the last 200 years (and around much longer than that) have, in the last decade, increasingly become the center of attention. From Trump’s Global Tariffs on Steel and Aluminum, his tariffs on Mexico, and his tariffs on China (as well as China’s tariffs on the United States), tariffs, whether you like them or not, are with us for now.

Tariffs are widely, fuck they’re probably unanimously considered bad for economic growth. I touched a little bit on this in my previous article on whether Trump’s tariffs were worth it.

So in this post I want to give a brief history of the tariff, and go more in depth on how tariffs work.

A Brief History of the Tariff

There’s isn’t really a specific time in history when tariffs were created. Tariffs are just a tax and are sometimes called just that, a tax, they’re also referred to as duties, customs, levies, possibly even fees. Taxes on imports and exports (which by and large is all a tariff is), have been around, well, for as long as humans have, to prove it here’s a massively overused quote on taxes:

“…but in this world nothing can be said to be certain, except death and taxes.”
― Benjamin Franklin

But with all seriousness, taxes (and therefore, tariffs) have been around a very long time.

However; it’s only in the last two centuries that tariffs in particular have caused such a stir, perhaps the most prominent being the American Revolution.

Tariff’s played a large part in History

The Stamp Act and the Sugar Act, which placed taxes on printed items and sugar, coffee and a few other goods were tariffs imposed onto colonists by the British Empire. This of course gave rise to the famous phrase, “No Taxation without Representation”, and served as one of the grievances the colonists had with their Imperial overlords.

Despite the eventual American revolt and independence, the British Empire continued to impose massive tariffs, into the early 1800s, of roughly 51% on any manufactured good. That’s really fucking high and would be unheard of in modern standards (knock on wood).  But, with the help of the industrial revolution and the abdication of Napoleon in France, the British Empire was incomparable in power and dominated the world as the only superpower for about a century, so they could easily get away with this (Pax Britannica).

The United States also dabbled with tariffs at this time, but to keep this a brief history, I’ll let what their opinion on what tariffs should be, be summarized by this graph:

Damn, protectionism used to be a real thing in the United States. The graph not only shows monstrously high tariffs but a huge variation in tariff rates, which I think kind of proves their efficacy of lack their of. Regardless the eventual decline and balancing out of dutiable imports answers that question.

When the British Empire began lowering tariffs and embracing free trade in the 1840s they experienced massive economic growth. Here’s a pretty straight forward graph I pulled off of Wikipedia showing the changes of GDP Per Capita of some of the world’s largest economies at the time.

It’s no strange coincidence that the huge spike in GDP Per Capita for the British Empire occurred at the same time they began lowering tariffs and institution free trade policies throughout their Empire.

Tariffs began to decrease in popularity from this period in time and free trade became increasingly popular.

To understand why tariffs are bad, and what exactly the cost of a tariff is, here’s part 2!

How do Tariffs work?

To break this down, let’s create a mini economy that consists of two hypothetical countries, Country A and country C, and a trade good, say wood.

Country A

Country A uses a lot of wood to manufacture wooden Furniture, whether that be tables, chairs or beds, and because of this it’s logical to assume that A has a high demand for wood.

But A, for whatever reason(poor land, lack of interest, lack of workers), doesn’t produce (and therefore cannot supply) much of their own wood, so any wood they do produce is expensive since the low supply is met with a high demand.

Country C

Luckily C produces a lot of wood, but doesn’t manufacture very much wooden furniture, perhaps due to a poorly educated workforce or a preference for metal furniture. They have a high supply of wood, but a low demand for it, which in turn will keep the price of wood low.

Free Trade

Naturally, trade is the solution to these out of whack supply and demand curves. Country C will trade its high supply of wood to Country A who will then use it to manufacture furniture. The profits from the furniture sales will then be used to buy even more wood from country C and so the cycle continues.

This transfer of goods is referred to as free trade as there is no additional taxes placed on any of the goods flowing in and out of the countries.

This entire concept of all parties involved maximizing their resources to produce the maximum amount of goods and achieving economic efficiency is referred to as a comparative advantage and it’s crucial to understand this concept to understand the impact a tariff can have on a country’s economy.

Comparative advantage

Let’s split the goods up by countries and do some simple math to obtain some logical conclusions:

Goods ProducedWoodFurniture
Country A110
Country B101

Above illustrates the amount of goods that each country can produce in a year. If A put all of their resources into producing wood, they would only produce 1 wood, not great. However, if A chose instead to produce furniture, they would produce 10.

Country C’s situation is the complete opposite, with the same resources within a year they produce 10 more wood than country A.

Country A has a comparative advantage in producing furniture over wood since they only miss out on 1 unit of wood for every 10 units of furniture.

Country C has a comparative advantage in producing wood over furniture since they only miss out on 1 unit of furniture for every 10 units of wood.

So the solution that maximizes both A’s and C’s output is for A to focus on furniture and C to focus on wood. This way highest amount of goods are produced for the available resources.

Reliance

A continues to buy wood from C to produce furniture. It’s cheap, so it allows the furniture industry in A to keep their expenses low which translates to an increased profit margin. With profits the furniture industry in country A will reinvest into themselves to grow larger and generate even more profits. This expansion will create more jobs and generate more tax revenue for A, increasing the economic growth and the general quality of life within country A.

Country C experiences the same effect. The growing demand for wood from country A will result in the wood industry in C to expand their own operations as well, also stimulating economic growth within the country.

After 20 years of trading the economies of both countries grow and look a bit more like this:

Goods ProducedWoodFurniture
Country A5100
Country C1005

Both countries now produce far greater amounts of each resource since over the past two decades they have excelled and grown in their respective industries. But it’s also important to note that the alternative options for both countries have changed very little, if at all, since there was little demand for those services within those countries.

Now is a good time to impose some tariffs.

Why are Tariffs Imposed in the first place?

On paper, tariffs are mainly imposed to generate additional revenue or to protect certain industries within a country. But like I mentioned earlier in the intro and as you are about to understand as you read on, economists unanimously agree that tariffs are terrible for economic growth and don’t accomplish either of these two objectives.

The real reason tariffs are imposed is political leverage. A country with a strong economy can impose massive tariffs on smaller countries, economically this would hurt everyone but the smaller countries would feel the impact more since their economies are much smaller.

If governments impose a tariff for any reason other than political leverage, they’re either lying or don’t understand how economics works.

So in our example, let’s say that country A has an issue with country C unrelated to their wood trading, for instance C may be allies with one of A’s enemies. Country A offers an ultimatum to C: cease friendly relations with our enemies or else! The or else here will of course be a tariff, of let’s do 10%.

Now in the real world it most likely won’t be as apparent as that, Country A may say that they want to protect their small wood industry and that importing wood from C is hurting them, or something along those lines to “justify” the tariff.

All wood being imported from country C into country A is now subject to a 10% tariff.

Who Pays the Tariff?

Country C does not want to pay an additional 10% tariff for all wood they export to country A, that would lower their profits. The only other alternative to offset this additional cost, and to maintaining their profit margins, is increasing the price their customers have to pay by 10%.

But obviously the furniture industry in country A doesn’t want to pay an additional 10% for their wood. That would lower their profits too!

However, the furniture industry in country A needs wood to make their furniture and so they have to choose. Either buy the now more expensive wood from C, or buy wood domestically, which due to its low supplies is very expensive. Ultimately whatever they chose the furniture industry in country A will suffer losses, especially if they are already operating on thin margins.

Disaster

As the furniture industry in country A begins to suffer losses due to the tariffs, it can no longer afford to keep as many factories open or have as many workers employed. Less factories and workers working in those factories means more unemployment, less taxes and an overall decline in economic growth in country A.

In country C, less wood being bought by country A means the same thing, less production and an overall decline in economic growth.

Spiral of death

As the demand for wood declines in country A in tandem with the decline of the furniture industry,  the wood that A produces domestically begins to experience a lower demand leading to a decline in the wood production industry in A as well as the furniture industry.

Country C experiences a similar effect.

Overall, due to tariffs, both countries now produce far less goods, have greater unemployment and have experienced negative economic growth. This of course doesn’t include the non-economic effects such as worsened relations and lowered trust between the two.

Resolution

If country C succumbs to A’s ultimatum it could be decades until their economics recover and their trading relationship becomes what it used to be.

If country C doesn’t succumb, both countries will be permanently damaged by the tariffs and are both worse off because of it.

Do Tariffs ever work?

Is there any time when tariffs do prove economically beneficial? Perhaps they may, but only ever to the bigger economy. Take the recent tariffs on Mexico imposed by the US on all imported goods.

The United States is Mexico’s largest trading partner and a 5% tariff, increasing by 5% per month with a 25% cap, on all goods would devastate their economy.

The US imposed this tariff to pressure Mexico in making progress towards tightening immigration and cartel activity which by and large are politically driven reasons. The Trump administration knew full well what negative effects it would have on the US economy.

Whether or not you agree with the politically driven reasons for the tariff, its implementation is effectively bullying and exploiting the United States larger economy to hurt the Mexican one.

The Cost

The Mexican government did indeed succumb to the United States’ requests and the tariffs were never imposed. But if the United States constantly uses tariffs as a mean of pushing their political agenda, how will that impact their international image and how likely will it be for countries to make future trade deals with the United States?



This post first appeared on Nickonomy, please read the originial post: here

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How do Tariffs work?

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