What Is a Tariff and Why Are They Important?

What Is a Tariff?

Most countries are limited by their natural resources and ability to produce certain goods and services. They trade with other countries to get what their population needs and demands. However, trade isn't always conducted in an amenable manner between trading partners. Policies, geopolitics, competition, and many other factors can make trading partners unhappy.

One of the ways governments deal with trading partners they disagree with is through tariffs. A tariff is a tax imposed by one country on the goods and services imported from another country to influence it, raise revenues, or protect competitive advantages.

Understanding Tariffs

Tariffs are used to restrict imports. Simply put, they increase the price of goods and services purchased from another country, making them less attractive to domestic consumers.

A key point to understand is that a tariff affects the exporting country because consumers in the country that imposed the tariff might shy away from imports due to the price increase. However, if the consumer still chooses the imported product, then the tariff has essentially raised the cost to the consumer in another country.

There are two types of tariffs:

• A specific tariff is levied as a fixed fee based on the type of item, such as a $500 tariff on a car.
• An ad-valorem tariff is levied based on the item's value, such as 5% of an import's value.

Why Governments Impose Tariffs

Governments may impose tariffs for several reasons:

• To raise revenues
• To protect domestic industries
• To protect domestic consumers
• To protect national interests

Raising Revenue

Tariffs can be used to raise revenues for governments. This kind of tariff is called a revenue tariff and is not designed to restrict imports. For instance, in 2018 and 2019, President Donald Trump and his administration imposed tariffs on many items to rebalance the trade deficit. In the fiscal year 2018, customs duties received were $41.6 billion. In fiscal year 2019, duties received were $71.9 billion.

Protecting Domestic Industries

Governments can use tariffs to benefit particular industries, often doing so to protect companies and jobs. For example, in April 2018, President Donald Trump imposed a 25% ad valorem tariff on steel articles from all countries except Canada and Mexico. In March 2022, President Joe Biden replaced the tariff on steel products from the United Kingdom with a tariff-rate quota of 500,000 metric tons, and reached quota deals with several other countries.

This proclamation reopened the trade of specific items with the U.K. while taking measures to protect domestic U.S. steel manufacturing and production jobs.

Protecting Domestic Consumers

By making foreign-produced goods more expensive, tariffs can make domestically produced alternatives seem more attractive. Some products made in countries with fewer regulations can harm consumers, such as a product coated in lead-based paint. Tariffs can make these products so expensive that consumers won't buy them.

Protecting National Interests

Tariffs can also be used as an extension of foreign policy as their imposition on a trading partner's main exports may be used to exert economic leverage. For example, when Russia invaded Ukraine, much of the world protested by boycotting Russian goods or imposing sanctions. In April 2022, President Joe Biden suspended normal trade with Russia. In June, he raised the tariff on Russian imports not prohibited by the April suspension to 35%.

Unintended Side Effects of Tariffs

Tariffs can have unintended side effects:

• They can make domestic industries less efficient and innovative by reducing competition.
• They can hurt domestic consumers since a lack of competition tends to push up prices.
• They can generate tensions by favoring specific industries or geographic regions over others. For example, tariffs designed to help manufacturers in cities may hurt consumers in rural areas who do not benefit from the policy and are likely to pay more for manufactured goods.
• Finally, an attempt to pressure a rival country by using tariffs can devolve into an unproductive cycle of retaliation, commonly known as a trade war.

Advantages and Disadvantages of Tariffs

Advantages Explained

• Produce revenues: As discussed, tariffs provide a government a chance to bring in more money. This can relieve some of the tax burdens felt by a county's citizens and help the government to reduce deficits.
• Open negotiations: Tariffs can be used by countries to open negotiations for trade or other issues. Each side can use tariffs to help them create economic policies and talk with trade partners.
• Support a nation's goals: One of the most popular uses for tariffs is to use them to ensure domestic products receive preference within a country to support businesses and the economy.
• Make a market predictable: Tariffs can help stabilize a market and make prices predictable.

Disadvantages Explained

• Create issues between governments: Many nations use tariffs to punish or discourage actions they disapprove of. Unfortunately, doing this can create tensions between two countries and lead to more problems.
• Initiate trade wars: A typical response for a country with tariffs imposed on it is to respond similarly, creating a trade war in which neither country benefits from the other.
  

History of Tariffs

Pre-Modern Europe

In pre-modern Europe, a nation's wealth was believed to consist of fixed, tangible assets, such as gold, silver, land, and other physical resources. Trade was seen as a zero-sum game that resulted in either a clear net loss or a clear net gain of wealth. If a country imported more than it exported, a resource, mainly gold, would flow abroad, thereby draining its wealth. Cross-border trade was viewed with suspicion, and countries preferred to acquire colonies with which they could establish exclusive trading relationships rather than trading with each other. 

This system, known as mercantilism, relied heavily on tariffs and even outright bans on trade. The colonizing country, which saw itself as competing with other colonizers, would import raw materials from its colonies, which were generally barred from selling their raw materials elsewhere. The colonizing country would convert the materials into manufactured wares, which it would sell back to the colonies. High tariffs and other barriers were implemented to ensure that colonies only purchased manufactured goods from their home countries. 

New Economic Theories

The Scottish economist Adam Smith was one of the first to question the wisdom of this arrangement. His "Wealth of Nations" was published in 1776, the same year Britain's American colonies declared independence in response to high taxes and restrictive trade arrangements.

Later writers, such as David Ricardo, further developed Smith's ideas, leading to the theory of comparative advantage. It maintains that if one country is better at producing a specific product while another country is better at producing another, each should devote its resources to the activity at which it excels. The countries should trade with one another rather than erect barriers that force them to divert resources toward activities they do not perform well. According to this theory, tariffs drag economic growth, even if they can be deployed to benefit specific narrow sectors under some circumstances.

Late 19th and Early 20th Centuries

Relatively free trade enjoyed a heyday in the late 19th and early 20th centuries when the idea took hold that international commerce had made large-scale wars between nations so expensive and counterproductive that they were obsolete. World War I proved that idea wrong, and nationalist approaches to trade, including high tariffs, dominated until the end of World War II.

From that point on, free trade enjoyed a 50-year resurgence, culminating in the creation in 1995 of the World Trade Organization (WTO), which acts as an international forum for settling disputes and laying down ground rules. Free trade agreements, such as the North American Free Trade Agreement (NAFTA)—precursor of the United States-Mexico-Canada Agreement (USMCA)—and the European Union (EU), also proliferated.

The 2010s

Skepticism of this model—sometimes labeled neoliberalism by critics who tie it to 19th-century liberal arguments in favor of free trade—grew, however, and Britain in 2016 voted to leave the European Union. That same year Donald Trump won the U.S. presidential election on a platform that included a call for tariffs on Chinese and Mexican imports. He implemented tariffs on China when he took office, but suspended proposed tariffs on Mexico.

Critics of tariff-free multilateral trade deals, who come from both ends of the political spectrum, argue that they erode national sovereignty and encourage a race to the bottom regarding wages, worker protections, and product quality and standards. Meanwhile, the defenders of such deals counter that tariffs lead to trade wars, hurt consumers, and hamper innovation.

The Bottom Line

Tariffs have existed in one form or another for centuries. Trading partners implement them to politically influence a partner, protect domestic industries and consumers, and further national goals and interests.

Tariffs are not always negative, regardless of what you might see on the news. They can be a means to open negotiations again between trading partners, provide each a chance to voice concerns, and even help to stabilize a country's market.