Tariffs: A bad idea, poorly implemented

The president's trade policy is threatening a global recession.

By William Gale

It’s not every day that a president proudly pursues an agenda that threatens to create a global recession. But that’s what President Donald Trump has done with his tariffs. Trump’s “liberation day” announcement featured new tariffs—long been derided by most economists—on almost all countries, including some uninhabited islands. In response, the stock market dropped and consumer confidence tanked at the prospect of snarled supply chains, higher prices, and a global growth slow-down. A week later, Trump blinked, lowering most of the new tariffs to 10% for the next 90 days, except for China, which faces a staggering 145% tariff rate.

The whole policy is a debacle based on a series of misconceptions and fumbled steps.

First, the entire premise of the tariffs—that we face a trade deficit crisis that requires drastic action—is plain wrong. A trade deficit simply means that we import (buy) more goods from other countries than we export (sell) to them. There is nothing inherently sinister about this. Trade deficits are not evidence of unfair trade barriers or discrimination. Instead, they arise naturally from the idea that there are gains from trade. For example, you run a trade deficit with your local grocery store, and your employer runs a trade deficit with you. Your life would be much more difficult and costly if you had to produce everything you wanted to consume—and the same is true for the nation as a whole.

In fact, the existence of U.S. trade deficits stems automatically from the fact that the United States is a good place to invest and thus attracts more capital investment from foreigners than it invests abroad. A country that imports capital will have to run trade deficits. This means that tariffs will not—indeed, cannot—eliminate trade deficits. Ironically, Trump’s own 2017 tax cut legislation made the United States a better place to invest, which, other things equal, raises trade deficits further.

Second, the claim that other countries will pay the tariffs is contradicted by the evidence. Tariffs are borne by American consumers and businesses and, in particular, by lower-income households, who tend to consume more imported goods as a share of their budget.

Third, the claim that other countries subsidize their exports and therefore we have to retaliate is incorrect. These countries apply value-added taxes (VATs). VATs are domestic consumption taxes, just like retail sales taxes. No one would charge retail sales tax on exports, and no one would consider not charging retail sales tax on exports to be an export subsidy. The same logic applies to a VAT. The VAT, however, is collected in chunks at each stage of production rather than in one fell swoop at the final sale. This means that, under a VAT, before a good is exported, some tax has already been collected on input sales earlier in the production process. So, it makes sense to rebate all tax on value added before export. This is not an export subsidy—it is just what is needed to ensure that a VAT only taxes domestic consumption.

This also shows why the claim that VATs discriminate against the United States—often summarized as “they tax our imports but we don’t tax theirs”—is invalid. If a German or U.S. automaker sells in the German market, they pay the German VAT. If they sell in Japan, they pay Japan’s VAT. If they sell in the United States, neither pays any VAT because the United States does not have a VAT. The German and U.S. automakers are treated equally in each case.

Fourth, the administration calculated the “tariff” that each country had created in a nonsensical way. Rather than looking at actual tax rates, the calculation effectively boiled down to the ratio of the total trade deficit with the country divided by the size of the country’s exports to the United States, which was then divided by two for the “reciprocal” rate. For example, if we, as a rich nation, import a lot of diamonds from a country like Botswana that is too poor to buy much of our stuff, the implied “tariff” rate is quite high (38% before last week’s walk-back). The most charitable explanation for this calculation is that some anti-tariff advocate in the administration tried to sabotage the policy by duping tariff supporters into using a silly formulation. No one in the administration seems to want to claim credit for the calculation.

More generally, Trump wants to use tariffs as a negotiating tool and as a permanent revenue source, but he can’t have it both ways. If tariffs are negotiating tools, they will be reduced when deals are made and, therefore, revenue will be lower than advertised. If they are tools, rolling them out all at the same time is a poor tactic, as it strengthens the negotiating position of other countries, relative to a situation where tariffs are imposed on one country at a time. If, in contrast, tariffs are meant to be a permanent revenue source, they can’t be a negotiating tool. And, of course, the stock market and consumer confidence reactions make clear that people view them as bad policy.

Certainly, the best course of action would be to end the whole plan, including the universal 10% tariffs. Even if the White House wanted to boost U.S. manufacturing, there are better ways to do so. But Trump might have backed himself into a corner, refusing to budge until trade deficits fall, when the only feasible way to lower them in aggregate is to reduce net capital inflows. So, we might be forced to keep this misguided policy and face the potentially vast economic consequences that result.

William Gale holds the Miller Chair at the Brookings Institution and is co-director of the Urban-Brookings Tax Policy Center.

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