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Not All Tariffs Are the Same: A Case to Consider Optimal Tariff Policy
By Amanda Mayoral, CPA Economist
Summary Points:
- Despite popular misconception, economic theory has long suggested that tariffs can benefit a country, particularly one like the US.
- The most advantageous tariffs are optimal tariffs. This is because optimal tariffs balance the net effect of a tariff on consumers, producers, and the government.
- Empirical evidence on optimal tariffs is limited, some studies suggest that the U.S. can benefit from tariffs, even after considering retaliation.
- A tariff is beneficial for countries that have considerable market power globally, because in these cases the cost of the tariff is shared by foreign suppliers.
- Policy makers should consider optimal tariffs because they can improve a country’s economic position.
What is an optimal tariff and why should we care about it?
Contrary to statements by some economists, politicians and pundits in the media, economic theory has argued for many years that tariffs can have the power to benefit the US economy and improve the US’s trade position. In particular, a long-known economic tool to improve a country’s trade position has been the optimal tariff. It is called ‘optimal’ because it balances all the costs and benefits arising from a tariff on consumers, producers, and the government for the best outcome. That is, policy makers should consider implementing an optimal tariff in appropriate sectors because can improve a country’s economic position, more than any other tariff rate including zero.
Optimal tariffs work because they are shared with foreign suppliers. While tariffs are often criticized for being passed entirely onto consumers, economic theory and many years of evidence suggests that tariffs are often not fully passed onto consumers and can in fact be a beneficial tool for the overall economy.[1] Economic theory argues that optimal tariffs work because a country with market power, like the US, can shift the burden of a tariff onto its foreign suppliers.
The idea of an optimal tariff is not new. Francis Edgeworth (1894) first demonstrated that a country can benefit from a tariff if the foreign supplier modifies his prices in response. But the formal concept was introduced by Charles Bickerdike in 1906 who argued that an optimal tariff can be welfare improving for a country with market power. The concept was elaborated by Nicholas Kaldor in 1940 who showed that small tariffs could lead to a terms-of-trade gain.[2] More well-known modern economists have also acknowledged the positive benefits of an optimal tariff. For instance, in a 2018 column in the New York Times, Nobel-winning trade economist Paul Krugman commented[3]:
“a dirty little secret of standard trade theory is that big countries with substantial market power actually can gain from modest tariffs. The reason – the “optimum tariff” theory – is that by limiting their imports from the rest of the world, big countries with substantial market power can reduce the price of their imports relative to their exports, i.e., improve their terms of trade. This effect is large enough that for a country like the United States, the unilateral optimum tariff might be on the order of 30 percent.[4]”
Components of an Optimal Tariff
The effect of an optimal tariff is very unlike the caricatures discussed in the media today of a damaging policy guaranteed to increase prices and depress economic growth. Given the importance of tariffs, policy makers should understand both the costs and benefits this policy tool.
An optimal tariff is the rate of a tariff that provides the most economic benefits over any other tariff rate. In determining the optimal tariff, economists assume that it is a unilateral tariff, i.e. a country imposes the tariff without retaliation from others. The most economic benefits are found by calculating the net difference between all costs and benefits of a tariff:
Benefits of a Tariff
- Increased production for domestic workers and firms
- Increased capacity for the domestic manufacturing base
- Improved terms of trade (when the ratio of our export prices to our import prices improves, we are now selling the same good for a relatively lower price. This allows us to purchase more in the global market)
- More tariff revenue to the government, which the government can use either to cut taxes or spend on government programs
Costs of a Tariff
- Higher consumer prices
- Can provoke retaliation tariffs from other countries
Simple Example of the Effects of a Hypothetical Optimal Tariff
To understand how an optimal tariff works, consider a hypothetical example of an optimal tariff of 50% on imports of apparel, such as t-shirts. For the sake of this example, assume that we are the largest importer globally, consuming 80% of the world’s imports of apparel, although we also export apparel as well.
What happens to consumers? In this example, a tariff of 50% will be shared in part by the foreign suppliers and by domestic importers. Since we are the largest buyer of the goods sold by foreign suppliers, they will be willing to accept a lower price to maintain access to our large demand. Domestic importers will continue to buy apparel but the tariff will increase the purchase price. These importers will absorb some of the tariff and pass on the remaining part to consumers. To clarify, tariffs raised consumer prices because part of the tariff is paid by the foreign supplier, the domestic importer, and the rest by the domestic consumer.
What happens to foreign suppliers? Recall the foreign supplier is willing to pay part of the tariff to keep selling to our large market, that is, we have market power in apparel inducing foreign suppliers to cut their prices. Our export prices have not changed. By paying part of the tariff, the prices accepted by the foreign supplier are lower as are imports. This now means that the price we sell apparel has become relatively cheaper than the price we are buying it at. That is, for the same good, foreigners are getting paid less while our prices have remained the same. This is known as terms of trade effect and it improves our position in trade and raises national income.
What happens to domestic producers? There are four main effects. First, a tariff makes the domestic of imported apparel increase, making it easier for domestic producers to compete. Second, domestic production, employment, and wages in the apparel industry will increase as domestic producers take market share from importers. Third, increased production domestically will allow domestic firms to use more of their factories and machines to operate at full capacity. This is likely to drive down domestic costs, since higher capacity utilization reduces the average cost per unit. Lastly, increased domestic production can potentially improve the capacity of the domestic producers to innovate, invest, and produce more efficiently.
What happens to tariff revenue? The tariff cost is shared, meaning that some is paid by the foreign suppliers cutting their prices and some is paid by the domestic producers and consumers. The more market power we have, the more of the tariff is paid by the foreign supplier. But 100% of the tariff revenue goes to the government of the importing country. This increases the welfare of the domestic country. Further, tariff revenue can be higher when we have more market power because the effect of a tariff on reducing the total volume of imports will be less. Tariff revenue in large industries like apparel is typically significant, in the billions or tens of billions of dollars.
What are the longer-term effects? A major concern with tariffs is retaliation. If one country sets higher tariffs, partnering countries can do the same in retaliation. Escalating tariffs is known as a trade war. If every country were to set optimal tariffs, global trade would decline significantly. In this case, which is an extreme one, the optimal tariff policy would have more costs than benefits. A global trade war outcome is unlikely. Instead, it is more likely that countries are willing to accept higher prices to maintain access. For more than a century, from 1816 until 1929, the U.S. had higher tariffs than many of its trading partners, and this did not start a trade war.
To summarize, an optimal tariff (which we assumed might be 50% for apparel) is the tariff rate that finds the best outcome after considering all the costs and benefits of a tariff on consumers, producers, and the government. The optimal tariff rate would have been smaller if we were not the largest importer of apparel. To understand why, consider the effects discussed above for each group affected if we charged the 50% tariff when we don’t have the same market power. If we did not have market power, foreign suppliers would not pay as much if any of the tariff. This means that consumer prices would be higher and tariff revenue would be lower. The net effects in this scenario would be worse. Overall, optimal tariffs are really about market power.
There is Evidence to Show That Tariffs Could Benefit The US, Howe However More Research Is Needed
Empirical estimates on optimal tariff are relatively limited. There is no single universal tariff rate that works best, estimates of optimal tariff should be specific to each industry. This is because market power varies by industry, and the costs and benefits of a tariff depend on the market and product they are applied to. However, estimates on optimal tariff at the product level are relatively rare given the known challenges in measuring trade elasticities.
In 2008, Ralph Ossa estimated the optimum tariff for the U.S. could be 60.3% overall.[5] This means that an increase in U.S. tariffs of 60.3% would lead to increases in output in the affected industries, increases in wages for workers in those industries and an overall increase in welfare (2.3%).
Another estimate of an optimal tariff is by Alessandro Nicita, Marcelo Olarreaga, and Peri da Silva, examined in the context of a hypothetical global trade war. In this situation, countries retaliate and raise tariffs relative to their market power. Facing a trade war, the US would increase the tariff rate by 14 percentage points, according to its relative global market power.[6]
In the empirical literature, economists use either simulations or measures of the foreign export supply elasticity to explain tariffs. Research shows that larger countries tend to have more market power than smaller ones and therefore can charge larger tariffs.[7] Further, research has long showed that the largest countries can benefit from raising tariffs, beyond the benefits of free trade, even in the event of a tariff war or retaliation. [8] [9] [10]
Research has also showed that countries have adopted restrictive trade policies in markets where they have more market power.[11] Specifically, Broda, Limão, and Weinstein show how 15 countries set tariff rates according to their optimal rate before entering the World Trade Organization (WTO). Nations’ tariff rates generally fall after joining the WTO. This means that non-cooperative tariff practices may be more welfare enhancing than free trade policies, which is consistent with the optimal tariff principle.
Conclusions
Economic theory suggests that countries with market power like the US can set a tariff rate that can improve its terms of trade. When a country has substantial market power in a sector, it can use its market power to share a tariff with foreign suppliers. Sharing a tariff will improve its terms of trade and boost domestic manufacturing and jobs as well as total national income and welfare. Overall, an optimal tariff can improve a country’s economic position by finding the best balance between the costs and benefits of a tariff on consumers, producers, and the government.
Estimates of optimal tariffs are limited and more research is needed. Estimates of the optimal tariff for the U.S. range as high as 60%, but an optimal tariff, as with any tariff, must be assessed for specific markets and product categories. The costs and benefits of a tariff will vary with each product. Overall, as with any economic policy tool, policy makers should consider the various costs and benefits of a tariff. The US is one of the largest exporters and importers in many sectors of global trade. This means the US has considerable market power in many markets and could likely benefit from tariffs in many product categories, but more research is needed.
[1] Amanda Mayoral, “Tariff Incidence in the Real World: Why Consumers (Mostly) Didn’t Pay the Steel Tariffs”, Coalition for a Prosperous America, October 20, 2021
[2] Nicholas Kaldor, “A Note on Tariffs and the Terms of Trade”, Economica, New Series, Vol. 7, No. 28, Nov 1940, pp. 377-380
[3] Paul Krugman, “Steel Tariffs and Wages (Painfully Wonkish)”, The New York Times, April 4, 2018
[4] Alessandro Nicita, Marcelo Olarreaga, Peri da Silva, “A trade war will increase average tariffs by 32 percentage points”, VoxEU CEPR, April 5, 2018
[5] Ralph Ossa, “Trade Wars and Trade Talks With Data”, NBER Working Paper Series, Working Paper No. 17347, August 2011
[6] Alessandro Nicita, Marcelo Olarreaga, Peri da Silva, “A trade war will increase average tariffs by 32 percentage points”, VoxEU CEPR, April 5, 2018
[7] Marcus M.Opp, “Tariff wars in the Ricardian Model with a continuum of goods”, Journal of International Economics, Vol. 80, Issue 2, March 2010, pp 212-225
[8] John Kennan and Raymond Riezman, “Do Big Countries Win Tariff Wars?”, International Economic Review, Vol. 29, No. 1 (Feb., 1988), pp. 81-85
[9] Constantinos Syropoulos, “Optimum Tariffs and Retaliation Revisited: How Country Size Matters”, The Review of Economic Studies, Vol. 69, No. 3 (Jul., 2002), pp. 707-727
[10] Harry G. Johnson, “Optimum Tariffs and Retaliation”, The Review of Economic Studies, Vol. 21, Issue 2, 1953, pp 142–153
[11] Christian Broda, Nuno Limao, and David E. Weinstein, “Optimal Tariffs and Market Power: The Evidence”, American Economic Review Vol. 98, No. 5, December 2008, pp. 2032-65[/vc_column_text][/vc_column][/vc_row]
