Why economists hate tariffs?

Tariffs could unleash unpredictable, short and long-term consequences that harm both industries and consumers

First, allow me to indulge you with some history before we get into the thick of things.

Did you know that 200 years ago, 100% of the revenue that (many) governments made came from tariffs?

Yup. Back in the 1700s and 1800s, governments didn’t rely on income tax. Rather, it was trade tariffs that brought in the dough. Every ship that docked with food, spices, cotton, wine, anything…paid a tax that fed the coffers of every nation.

Now the argument for taxing these ‘imports’ into the country was fairly simple — the country needed the monies to fund their armies and roads and buildings, and they also needed to protect fledgling local industries and allow them to grow without the stress of foreign competition mowing them down.

And let’s just say that while trade was commonplace, these trade barriers were definitely a hindrance to free movement.

But in 1817, the British economist David Ricardo published his seminal work ‘Principles of Political Economy and Taxation’ (pdf) and posited a theory that would have massive implications for tariffs and global trade — a very drab sounding yet grand idea of comparative advantage.

And he took the example of Portugal and England, both of whom produced wine and cloth, to illustrate his thoughts.

As per Ricardo, Portugal could produce both wine and cloth more efficiently and at a lower cost than England. So technically, you could say that Portugal had an absolute advantage in both commodities and should just produce and sell wine and cloth.

However, Portugal had a greater efficiency advantage in producing wine. That was its forte. And England, while less efficient at both, was relatively less inefficient at producing cloth.

Therein lay an opportunity cost.

That meant if Portugal specialized in wine (where its comparative advantage was greater) and England specialized in cloth (where its comparative disadvantage was lesser), and they traded, both countries would end up with more wine and more cloth than if they tried to produce everything themselves.

At least that’s what Ricardo argued.

And this was a direct condemnation of the tariffs that existed in those times. He believed that if a country was imposing tariffs on certain goods to promote its domestic industry, it was a colossal waste of resources. And that instead, they could import those goods more cheaply from other countries and put their efforts into producing commodities where they had a comparative advantage instead.

But, as with most ideas, Ricardo didn’t create a revolution overnight. It took time for countries to embrace his ideas. And if you look at this chart from the White House that highlights how the US made its money, you’ll see clearly how long it took for them to ditch tariffs in favour of more liberal trade.

But hold on…we’ve simply been rambling on about the history of tariffs. Sure, we did tell you why 1 economist, David Ricardo, hated tariffs (which is inefficient resource allocation), but there’s more. So let’s break that down now, and we’ll tell you 3 big reasons why tariffs get all the flak.

1. Beggar-Thy-Neighbour

Remember when Donald Trump said he was going to impose massive tariffs on all products coming into the country from China? What did China do? They didn’t take this bullying lying down. They thumped their chest and said they’d retaliate and slap their own set of tariffs too. A tit-for-tat.

Now imagine such a scenario playing out across the world. Each country retaliates to the other and imposes tariffs willy-nilly. Think of the chaos this could unleash.

Actually, you don’t have to imagine this.

Because this actually played out during the Great Depression of 1929. After over a decade of a roaring economy and booming stock market, the American economy slowed down (we won’t get into the reasons as to what led to it now). Suffice it to say that the economic decline caused a massive stock market crash.

But in order to protect the economy and its industries, they enacted something called the Smoot-Hawley Tariff Act. The US raised tariffs on over 800 imported goods.

Other countries were miffed. They believed the US was trying to hurt them, and, in turn, they slapped retaliatory tariffs on American-made goods. It was a classic example of a beggar-thy-neighbour policy, with each country trying to hurt the other.

The end result?

US exports slumped from $7 billion annually to just $2.4 billion during 1929 and 1933, and global trade collapsed by a massive 70% too.

So while the Smoot-Hawley Tariff Act didn’t cause the Great Depression, it prolonged the pain for far longer than it should’ve lasted. In the US and globally.

Heck, some economists even believe that this contributed to World War II a few years later. Frosty trade relations broke trust and co-operation and unleashed all sorts of mayhem.

Now we may not enter a war-like situation today if there’s a worldwide scenario of retaliatory tariffs. But it’s a cautionary tale for our times. And the fear of a trade war could cause businesses to hit pause on expansion, hiring, and investing and that alone could trigger a global slowdown.

2. Inflation‘s ugly head.

So, during Trump’s first term as President, Whirlpool, an American home appliances firm, complained that foreign manufacturers with their low prices were destroying its home advantage. So Trump slapped tariffs on the import of washing machines. Anywhere between 20-50%. He said that it would save the domestic industry and also create thousands of new jobs within the country.

And if we’re being honest, it did create jobs. Around 1,800 of them. And the US collected $82 million in taxes thanks to this too.

But the cost?

Well, that outweighed any benefit.

Because imported washing machines became more expensive. The importers tacked on the additional cost of this tax and passed it along to the customers.

But, it wasn’t just the imported ones that jumped in price. Even locally-produced washing machines became more expensive.

Why so, you ask?

The American manufacturers could have decided to keep their prices at status-quo and just taken the free market share from their competitors. But no, they saw that demand was rising for their products, so they ramped up the price and decided to just take the extra profits.

Capitalism, baby!

And the net result was a 12% increase in the prices of washing machines

In fact, consumers bore a cost of $1.5 billion per year thanks to the higher prices created by these tariffs.

But it doesn’t end there.

Do you think companies rush to cut prices if the tariffs are repealed?

Nope. Once they increase it, it establishes a new baseline for prices. So even if the tariff goes away, the price has been permanently raised.

That is massively inflationary and hurts people like you and me.

3. Delayed Consequences

Ever heard about the Chicken Tax?

Okay, so this is a post-World War II incident. In the early 1960s, countries in Western Europe suddenly took a fancy to the low-priced American poultry and began to import boatloads of chicken. And when this began to irk the European farmers, the folks who ran the European Common Market (which was a predecessor to the European Union) decided to slap an additional tax, aka a tariff, on American chickens. As a result, in West Germany, the tax on imported chicken went up from 4.8 cents to 13.43 cents per pound.

Judging by the result, you could argue that the tariff was an immediate hit, because the imports of American chickens fell by 66% in a flash. People immediately changed their consumption habits.

And what did the US do, in turn?

The US retaliated with its own sets of tariffs on trucks, cognac, and potatoes.

Suddenly, this meant Volkswagen’s vans or light trucks became 25% more expensive in the US. People would most certainly not buy them because that would mean shelling out hundreds of dollars more for a European brand. It just didn’t make sense.

And in one fell swoop, a lucrative market across the Atlantic was killed for these European light-truck makers. Instead, American car makers boomed.

But guess what…even though the dispute between the two countries quietened down after a while, the US never repealed its tariff on light trucks. And as a result of that, by the early 2020s, American car makers Ford, GM, and Dodge accounted for 95% of light truck sales in the United States.

Also, as American car makers put their heart and soul into this light truck market, Americans came to love them, too. And over the past 50 years, this segment’s market share soared from just about 20% to over 65% of all new cars produced in the US. So when you hear about America’s love for SUVs, you now know that a large part of that is due to the Chicken Tax.

Source: US EPA

Now while that sounds absolutely fantastic for the domestic industry, peel the layers and you’ll see a larger picture emerge.

For starters, while American car makers made money on trucks — most SUVs included — they ceded market share in smaller cars (such as sedans) to foreign manufacturers.

Now that might not seem like such a bad thing since that segment only makes up roughly 30% of new car sales in the US these days. So you could argue that American car makers aren’t missing out on much.

But the extension of that is the fact that the European markets are virtually closed off to American carmakers. Europeans don’t like massive SUVs. And hence, American carmakers have nothing to sell.

So investors also tend to place a lower ‘value’ on America’s car makers.

But it’s not just that alone.

Because nearly 6 decades after the tariffs were introduced, America ran into a problem.

In 2022, shortly after Covid, America suddenly found that they weren’t producing enough trucks to meet the soaring demand. And since the Chicken Tax was still in place, they couldn’t import trucks. Instead, the price of the existing trucks in the market soared — both new and used — rose. Consumers suffered.

All thanks to an import tax that probably lived past its intended longevity.

As an economist, how do you model such massive changes to the industry decades down the line? It’s just not possible.

So now you see why economists tend to hate tariffs. It (usually) only creates problems.

And the next time someone challenges you to a debate on tariffs, remember David Ricardo; remember the Smoot-Hawley Tariff Act; remember washing machines; and remember the Chicken Tax.

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