Revisiting the economics of tariffs

Economic Times

06-05-2025

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Amid the tariff battle between the US and China, the economic uncertainty in the global economy has escalated like never before. A similar stance was taken by the US in 1930 when the Smoot-Hawley Tariff Act was passed to raise the tariffs, and it faced retaliation from several countries, and in aggregate, it caused the global output to fall by more than two-thirds.Standard economic theory suggests that tariffs reduce overall welfare, as they lead to higher prices for consumers and lower efficiency in production. As a result, the overall gains, such as lower prices for consumers and higher sales or efficiency for producers (consumer and producer surplus), become smaller than they were before the tariffs were introduced. The Trump administration's plan to extend tariffs beyond China to other countries is likely to further affect the global economy by lowering allocative efficiency and increasing protectionist pressures worldwide.The ongoing exchange of tariffs between the US and China has once again highlighted the need to reassess their impact. Tariffs create two opposing effects: first, they reduce trade volume, limiting consumer choices in the country that imposes them; second, they may improve the importing country's terms of trade, as the exporting country might lower its prices to maintain market access. The overall effect of tariffs depends on which of these forces is stronger. However, given the significant tariff hikes by both China and the US, a sharp decline in trade volume is expected, and it is unlikely that any gains from improved terms of trade will be enough to offset this loss.Contrary to popular belief, tariffs do not enhance the economic welfare of nations in the long run. While the theory of an optimum tariff suggests that a country can improve its terms of trade and maximise its own welfare by imposing a tariff, provided the trading partner does not retaliate, this condition rarely holds in practice. Tariffs often provoke retaliatory measures, setting off a cycle of protectionism that ultimately erodes the initial welfare gains. The ensuing trade distortions lead to a contraction in trade volumes, increased production inefficiencies, and welfare losses on both sides. From a broader economic perspective, such outcomes reflect a failure to achieve Pareto improvements, situations where at least one party is better off without making another worse off. Instead, the retaliatory nature of tariff wars transforms what might have initially appeared to be a positive-sum interaction into a negative-sum game, where the combined welfare of the nations involved diminishes.A central argument advanced by the US administration to justify trade restrictions against China is the persistence of a bilateral trade deficit that has spanned several decades. The narrative posits that reversing this deficit is imperative to restoring economic balance. However, such a viewpoint requires a more nuanced understanding of what trade deficits truly represent in the context of a globalised economy. Firstly, a trade deficit is not inherently detrimental to an economy. In fact, under certain conditions, it may reflect the strength and attractiveness of a country's economic fundamentals. The US, for example, has maintained a consistent trade deficit with China over the years, yet key indicators such as a stable US dollar, robust GDP growth, and low unemployment suggest that the broader economy has remained resilient, if not strengthened.Moreover, the US continues to be a prime destination for foreign capital inflows, which contribute to expanding the current account deficit but simultaneously enhance domestic productivity. These capital inflows are often channelled into high-return sectors such as technology, innovation, and infrastructure. In this sense, the trade deficit is partly a reflection of the US economy's capacity to attract investment and sustain global confidence.Additionally, by importing lower-cost manufactured goods, the US can allocate resources towards high-tech and innovation-driven industries, which are more consistent with its comparative advantage. This specialisation promotes long-term productivity gains, consumer choice, and economic dynamism. Therefore, the simplistic equation of trade deficits with economic weakness overlooks the complex macroeconomic realities and structural advantages of the US economy. Addressing the deficit through protectionist policies may, paradoxically, undermine the very factors that underpin the country's global economic leadership.