What is a Tariff?

Posted on Tuesday, August 21st, 2018 MarketBeat Staff

Tariffs have been around for centuries, and controversial for just as long. In the United States, tariffs were an essential component of our national economy prior to World War II. In fact, the United States historically was the country most likely to impose tariffs. From the earliest days of our nation, tariffs were used as a way for the government to raise revenue.

However, even back in the days of our founding fathers, the use of tariffs (or the non-use of them) was a way for the government to impart favors by excluding favored companies from the list of those subject to tariffs. This concept of tariffs being used to pick winners and losers is one of the inherently controversial aspects of tariffs.

This article will explain what a tariff is, the two types of tariffs, alternatives to tariffs, why countries impose tariffs, whether or not tariffs work, and how tariffs affect trade policy.

What is a tariff?

A tariff is a tax (also referred to as a customs duty) that is applied to foreign goods entering another country. The effect of a tariff is to make certain goods from a foreign country more expensive in the country that they are being exported to. In theory, this will create a demand for the same goods being manufactured by domestic companies.

There are, essentially, two types of tariffs:

  1. A simple tariff – As the name suggests, the simple tariff is a fixed dollar amount that a foreign country has to pay on imported goods subject to the tariff. The amount of the tariff does not change with the price of the imported item. For example, let’s say the United States were to impose a simple tariff of $3 per pound on premium chocolate from Belgium that costs $15 per pound. The simple tariff would remain fixed at $3 even if the price of that chocolate rose to $20 or $30 per pound. 

  2. Ad valorem tariff – Ad valorem is Latin for “according to value”. An ad valorem tariff means a tariff that is levied as a fixed percentage of the value of the goods subject to the tariff. Unlike the simple tariff, an ad valorem tariff will increase or decrease depending on the cost of the goods. In our example, imagine the United States were to impose an ad valorem tariff of 15% on premium Belgian chocolate that costs $15 per pound. The tariff would be $2.25 per pound. If the cost of the chocolate increased to $20 per pound, the tax would increase to $3.00 per pound. If the cost of the chocolate declined to $10 per pound, the tariff would be reduced to $1.50 per pound.

What are non-tariff barriers?

Since the institution of organizations like the World Trade Organization, many countries will use a variety of non-tariff barriers such as licenses, quotas, sanctions, and voluntary export restraints to restrict trade. These non-tariff barriers often have different motives than tariffs.

  • Licenses - Licenses are used to restrict the number of companies that can import goods into a country. Licenses will generally increase consumer prices due to the lack of competition. In the United States, only certain industries require a license to import their goods.

  • Quotas - As the name suggests, quotas are used to limit the number of goods and services that can be imported into a country. After that limit is reached, restrictions apply.

  • Sanctions - These generally take the form of increased administrative actions or higher customs and additional trade procedures. Sanctions are punitive in nature and issued to severely limit a country’s ability to trade.

  • Voluntary Export Restraints - In our global economy, many countries set voluntary limits on how much of certain goods and services they will export to specific countries. These limits are based on availability and political alliances.

Why do countries impose tariffs?

The most basic reason countries impose tariffs is to raise revenue. In fact, prior to the United States adopting the income tax in 1918, tariffs were the largest source of our government’s revenue. Another reason why countries impose tariffs is to protect domestic industries from foreign competition. Because a tariff makes goods produced in foreign countries more expensive, they can help make domestic goods more appealing and may, in some cases, protect domestic jobs in the industries that are affected by the tariff.

 A related reason for a tariff is not simply to protect industries, but to protect a company’s intellectual property or to protect specific industries. For example, many nations including the United States use tariffs to support companies and industries that are related to their national defense.

Countries may also use tariffs as a tool of foreign policy. If a country feels that another country is violating established trade agreements, they may impose (or threaten to impose) tariffs as a way to gain economic leverage.

Do tariffs work?

There is no simple answer because tariffs are not a zero-sum game. The “success” of tariffs can only be viewed in the context of many other variables.

Let’s start with tariffs that are used as a source of raising revenue. Even before President Trump announced his tariffs early this year, the United States had tariffs on many goods that entered the United States. In fact, in the fiscal year that ended on September 30, 2017, the United States government collected $34.6 billion in customs duties and fees. Likewise, companies based in the United States pay tariffs on some of the goods they sell in foreign countries. This is not inconsistent with the concept of free trade. While free trade agreements (FTAs) are sometimes seen as the inverse of tariffs, in reality, many countries that have FTAs still impose some form of import or export duty. Of course, whether this is really “free trade” is still up for debate.

When it comes to protecting companies or industries from foreign competition, you can look to Isaac Newton to see how tariffs can produce unintended consequences. Newton’s third law of motion states that for every action there is an equal and opposite reaction.

This is because the effect of a tariff is to increase the cost of an imported good. Let's say an imported good costs $100 and that same good costs $110 when made in the United States. Imposing a 20% tariff on the imported good brings its price up to $120, making the item produced in the United States the lower-priced option. However, if U.S. companies were using the imported item as a material to manufacture other items, then they will see their costs increase.

But that’s where the effect of tariffs becomes more controversial. These higher manufacturing costs will either have to be absorbed by the company in the forms of lower profit, countered by reducing expenses such as by cutting jobs, or passed along to consumers in the form of higher prices.

To be more specific, when the United States imposed steel and aluminum tariffs on foreign producers, it raised the price of those materials for U.S. manufacturers. In this way, automobiles, appliances, and other related goods would become more expensive to consumers as those manufacturers pass the cost along.

With any event in the economy, there are winners and losers. The fact that, with tariffs, it is the government picking the winners and losers is why many economists do not view tariffs as being successful in the long term.

When it comes to protecting intellectual property, the benefits are equally unclear. While sharing our innovation with other countries as a cost of doing business may be seen as an unfair trade practice, it can spur additional innovation and help to bring the cost of goods and services down, which benefits consumers.

How do tariffs affect trade balances?

Starting with the aftermath of World War II, our economy has become increasingly dependent on international trade. This has created interest in a metric called a country’s balance of trade. This is more commonly expressed as a country having either a trade surplus or a trade deficit. When countries have a trade surplus with another country, the total value of the goods they export to that country is greater than the total value of the goods they import from that country. When the opposite is true, the country is said to be running a trade deficit with the other country.

However, having a trade surplus does not necessarily indicate a growing economy, nor does a trade deficit signal a slowing economy. For example, the United States has an enormous trade deficit, but one of the reasons for this is that we are a mature economy. The ability to import commodities at lower prices or to import goods at lower costs allows our economy, which is heavily reliant on consumer spending, to grow.

As we stated above, when one country imposes tariffs on another country, the affected country typically imposes a tariff on the first country in retaliation. This can quickly create a negative spiral known as a trade war, in which both exports and imports decrease for both countries. In the end, the tariffs have very little impact on a country’s ratio of imports and exports. Because of the quid pro quo nature of tariffs, the answer to the question “How do tariffs affect trade balances?” is “Not very much.”

The bottom line on tariffs

Tariffs have been around for centuries. As the economy becomes more international in nature, companies are looking for a global audience for their goods and services. This has led to the creation of the World Trade Organization and other such international organizations that promote free trade and make it more difficult for countries to impose tariffs and taxes. In addition, many countries have signed binding multilateral agreements which are intended to reduce tariffs.

However, despite the cries of “no taxation without representation”, we must admit that the emergence of a global economy introduces many questions that don’t have easy answers: How do we respond to the movement of some jobs to foreign countries? How will we protect intellectual property when our goods are manufactured overseas? How does a nation protect its sovereignty and its people?

These issues can create uncertainty. And tariffs are still used by countries as a way to manage that uncertainty. When tariffs are used as a protectionist strategy, it can protect domestic companies and jobs, but it can also cause prices to rise for consumers.

On the other hand, many countries use tariffs as a way of profiting from allowing international companies to do business within their borders. Being able to do business here can stimulate demand and cause that company to become more profitable, and the government commands a share of those profits.

Tariffs attempt to solve multiple complex problems at once, and in doing so, they create a ripple of direct and indirect consequences. This has made the use of tariffs controversial, and economists will continue to debate whether or not they do more good than harm.

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