For a long time, the U.S. economy has been shifting from goods to services. If the U.S. shifts to a high-tariff policy, this shift to services will accelerate. To understand why, we need to look at some basic concepts of trade theory.
To illustrate some ideas, I would like to consider imposing a 20% tax on all imported goods, assuming that services are exempt. Consider the example of imported oil. For simplicity, let’s assume that the United States imports most of its oil (an assumption that is no longer valid).
If the world price of oil is $80 a barrel, a 20 percent tax would tend to raise the price by $16. However, since the tariff encourages domestic production and discourages domestic consumption, the price would probably rise by a little less than $16. So $16 would be the ceiling for the resulting price increase, which would be about 40 cents per gallon. The actual increase would likely be slightly smaller, about 37 cents, or about twice the federal 18.4 cent tax on gasoline.
Today, the United States is a major oil producer. We still import a lot of oil, but we also export a significant amount. In this case, the net effect of the tariff is more complex. Some of the oil currently being exported may be diverted to domestic consumption in some parts of the United States that currently import oil. In this case, the main effect may be higher transportation costs as the oil moves through other routes.
Most economists assume that tariffs are paid by consumers in the domestic economy. In principle, if a tariff has the effect of lowering the global price of imported goods, some of the burden can be borne by foreign exporters. On the other hand, if other countries retaliate with their own tariffs (which seems plausible), it is reasonable to assume that almost all of the tariff is borne by domestic consumers. In my view, that is the most reasonable assumption.
So is a 20% tariff similar to a 20% VAT? No, because VAT applies to both goods and services, while tariffs apply only to goods.
Will a tariff improve the current account balance? Probably not. The current account balance is domestic savings minus domestic investment. In most cases, the current account balance will increase only if the tariff revenue is used to reduce the deficit, thereby increasing domestic savings. And even in those unlikely cases, the effect will be rather small. The main effect of a tariff is All product transactionsBoth imports and exports. High tariff policies will reduce both imports and exports. Most importantly, the goods sector of the economy will be taxed at a much higher rate than the services sector, which will reduce the share of goods in GDP.
This may seem counterintuitive, since we tend to think that tariffs increase the production of goods previously imported. And they do. However, the negative impact on the production of goods is much larger. This is because the positive impact on domestic production due to the decrease in imports is offset by the negative impact of the decrease in exports. However, tariffs also shift consumption from goods to services. It is this additional effect (beyond the trade balance) that causes the economy to shift from producing goods to producing services.
Will a 20% tariff increase inflation? That depends on how the Fed responds. The Fed is likely to allow a one-time price increase, arguing that the tariff’s effect is “transitory.” If the Fed wants to avoid price increases, it will be forced to tighten monetary policy, which reduces nominal wages. Either way, tariffs tend to reduce real wages after taxes, unless they are offset by tax cuts elsewhere.
High tariffs on imported oil would discourage oil consumption, which is what many environmentalists like. Whether this is the goal of most high-tariff policy advocates is left to the reader.
PS. The world is complex, and we can make assumptions that lead to different outcomes. But what many people don’t seem to understand is that the first-order effect predicted by the standard trade model is that tariffs increase the production of services and decrease the production of goods.
Here is a simple trade graph for the special case where importing countries have no influence on global prices:
