What are tariffs and how do they work?
A tariff is a tax imposed on imported goods that raises the cost of those goods in the country into which those products are being exported. It is a location-based tax, focusing on where a product is produced rather than on the product itself.
For example, Mexican tequila brand, El Jimador manufactured by Grupo Herradura in Amatitan, Jalisco, Mexico might have a 25% tariff levied upon it when exported into the United States, but should Herradura produce El Jimador in San Diego, the tariff would not apply.
Why do governments impose tariffs?
Governments that impose tariffs do so for several reasons – to protect domestic manufacturers that produce at a higher cost to the imported item; to address unfair trade policies (such as foreign governments subsiding their industries which causes dumping e.g. electric vehicles from China into Europe); to earn tax revenues (albeit that this has proven inconsequential) and, for ideological reasons, a show of force.
But all the above does not actually fully explain the raison d’etre as to why governments impose tariffs. Trade protection has its foundations in politics, in the need to appease powerful minority lobby groups that are experiencing economic pain.
The political roots of trade protection
If we look back to the 1920’s, US farmers had taken-on extensive debt to invest in land and equipment to raise output because of high commodity prices after World War I. A subsequent decline in commodity prices ensued, farmers could not keep up with loan repayments, their response was to demand tariffs to protect their output. Similarly, the US Steel Manufacturers Association and the United Steelworkers Union, want to protect their industry in 2025, by maintaining tariffs on steel imports.
Do tariffs actually work?
Do tariffs work? Professor of Economics Thomas Grennes from North Carolina State University in his paper, The Economics of Tariffs: Can restricting international trade be good for the economy, argues that they do not.
Imports account for 16% of the US economy’s GDP whereas exports account for 11%. Any trade policy that effects the consumer risks hurting consumption which is 68% of US GDP.
Mark J. Perry from the American Enterprise Institute in his 2016 paper on US trade, quotes Dartmouth economist, Doug Irwin, that officially, 53% of US imports are so-called intermediate goods, but he believes this number to be understated.
The impact of tariffs on intermediate goods
Intermediate goods are unfinished products and fall into categories such as capital goods – machinery, equipment, aircraft parts, semiconductors; and industrial equipment such as lumber, chemicals, aluminium, and copper. These products are critical to manufacturing in the US.
Tariffs increase the prices of intermediate goods, forcing domestic manufacturers to shift their purchases to higher cost local alternatives. But tariffs not only increase the price of the imported good, they also lead to the domestic substitute product rising in price. Of course, tariff imposition seldom goes unpunished, and the consequence is counter tariffs. This all results in reduced levels of trade, and in turn falling incomes for all trading partners.
The case for free trade
Against this, free trade allows countries to focus on their core competencies, adding value to society and enriching all partners.
Tariffs and job creation: a historical perspective
The proponents of tariffs argue that they create jobs for the country imposing them. We have the benefit of history to evaluate this thesis. We mentioned earlier that powerful lobby groups persuaded the US government to impose tariffs in the 1920’s. This took the form of the Fordney-McCumber Act, which raised the average tax on agriculture and industrial imports into the USA by 40% in 1922. The Europeans immediately retaliated.
In 1929, due to the Federal Reserve hiking interest rates to stem stock market speculation, stocks collapsed, precipitating further protectionist thinking in America. Despite one thousand economists petitioning against it, President Herbert Hoover signed the Smoot-Hawley Tariff Act on the 17th of June 1930, further raising tariffs by 20%. This led to more reprisals and a full-scale global trade war ensued.
The Great Depression: the cost of protectionism
The combination of draconian trade policies, high interest rates, a stock market crash, and subsequent bank failures, resulted in the onset of the Great Depression in the summer of 1929. US industrial production fell 47%, GDP fell 30%, wholesale prices collapsed 33% and unemployment ballooned 20%.
Modern echoes of protectionism
Fast forward to 2025 and Donald Trump’s utterances ring loud “Tariff is the most beautiful word in the dictionary.’’ Against this, we juxtapose the genius of Milton Friedman ‘’tariffs diminish the efficiency of the international division of labour, by imposing them, you hurt yourself’’ and then of course, Warren Buffett’s views expressed only a few weeks ago. Tariffs are ‘’an act of war’’, ‘’over time they are a tax on goods’’, ‘’I mean, the tooth fairy doesn’t pay for them’’.
At Northstar, we certainly know whose opinion we share.