How Will Trump’s Universal and China Tariffs Impact the Economy

President-elect Trump has promised to impose steep new taxes on trade, including a 10-20 percent tariff on all imports, at least a 60 percent tariffTariffs are taxes imposed by one country on goods imported from another country. Tariffs are trade barriers that raise prices, reduce available quantities of goods and services for US businesses and consumers, and create an economic burden on foreign exporters. on Chinese imports, and a 25-100 percent tariff on Mexican imports. At least a dozen estimates on Trump's proposed tariffs show they will have a harmful effect on the American economy, supporting the standard view among economists that tariffs reduce trade and distort production, leading to lower standards of living.

A tariff is a taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. on imported goods, applied at the border when a business or person in the US purchases a good from abroad. Tariffs increase the price of foreign-produced goods, incentivizing consumers to switch to domestically produced goods and providing domestic producers room to increase their prices. The benefits that domestic producers receive, i.e., higher prices and sales, come at the expense of consumers (including business consumers). For this reason, tariffs are redistributive, taking income from some and giving it to protected businesses.

While the protected businesses may grow because of the tariff, they are not low-cost producers. Thus, tariffs result in less efficient production, leading to reduced economic output and lower incomes over the long run. This is the standard analysis of tariffs going back to Adam Smith and the classical economists, who recommended keeping tariffs as low as possible (tariffs were a primary source of government revenue at the time).

The debate has its nuances, such as the potential impact of tariffs on the price level. Tariffs could have an inflationary impact or cause an economic downturn in the short run, depending on whether the Federal Reserve takes action to loosen policy and accommodate the tax increase (we'll discuss these questions in a forthcoming analysis). But no matter whether the short-term adjustment involves inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a "hidden tax," as it leaves taxpayers less well-off due to higher costs and "bracket creep," while increasing the government's spending power. or temporarily heightened unemployment, the long-run adjustment to tariffs involves lower incomes and production.

Over the long run, tariffs shrink the size of the economy by reducing work and investment. That's because tariffs increase the relative prices of imported and protected goods, and after paying those higher prices, people have less income left to spend elsewhere. Effectively, this means tariffs reduce the after-tax value of income by reducing how much consumption people can afford. The reduction in the after-tax value of income reduces incentives to work, which reduces hours worked and, in turn, capital investment. Fewer hours worked and a smaller capital stock result in a permanently lower level of output and income.

Additionally, tariffs lead to dynamic inefficiencies, which reduce productivity. By creating a protected domestic market, tariffs blunt competitive pressures that otherwise force firms to remain innovative. Instead of needing to constantly search for ways to improve processes and meet consumer demands, firms can sit back and enjoy higher profits from protection. Past (and ongoing) episodes of protection, both anecdotally and empirically, reveal that protected firms tend to use their higher profits to lobby for more and longer protection, rather than for increased research and development or capital expenditure.

Tariffs may also lead to inefficiencies through political favoritism and uncertainty. A new analysis of Trump's first term tariffs found firms that made political donations to Republican candidates were more likely to be granted tariff exemptions than firms that gave to Democrats. Increased uncertainty over trade and tariff policy itself can chill investment and decrease incomes.

That brings us to Trump's proposals. A dozen macroeconomic estimates have taken different approaches to analyzing Trump's proposed tariffs, from estimating the fall in aggregate demand arising from the tax hikes to using various trade models to our work at Tax Foundation estimating the effects of the tax increase on labor. All studies consistently find that Trump's proposed tariffs would have a negative impact on the United States economy.

The modeling highlights another major downside of imposing tariffs-the geopolitical pressure exerted on foreign governments to respond with retaliatory tariffs. When foreign governments impose taxes on US exports, it reduces how much US producers sell abroad, lowering incomes and shrinking output further. Most private forecasts of the effects of US-imposed tariffs model the impact with retaliation, ranging from tit-for-tat to more targeted responses. Estimates from Warwick McKibbin et al. suggest retaliation could more than double the economic losses from US-imposed tariffs.

Many of the same studies also included estimates of the economic effects from Trump's first term trade war, which range from a reduction in real output of 0.2 percent to 0.7 percent. The economic literature reports a similar range of effects on US output from the first trade war, from -0.17 percent to -0.50 percent.

One outlier estimate, excluded from the table below, produces results that suggest universal tariffs would grow economic output and incomes. A scathing review by international trade economists of the underlying assumptions in that estimate explains how researchers manipulated a trade model, against all economic evidence, to produce positive results from higher trade taxes. The reviewers characterized the effort as "intentionally misleading," with "key assumptions. . . [that find] absolutely no support in the economic literature."

President-elect Trump may want to impose tariffs to encourage investment and work, but his strategy will backfire. Tariffs will certainly create benefits for protected industries, but those benefits come at the expense of consumers and other industries throughout the economy.