What Is a Tariff and Why Are They Important?

What Is a Tariff?

Most countries are limited by their natural resources and ability to produce certain goods and services. They trade with other countries to get what their population needs and demands. Howevertrade isn't always conducted in an amenable manner between trading partners. Policiesgeopoliticscompetitionand many other factors can make trading partners unhappy.

One of the ways governments deal with trading partners they disagree with is through tariffs. A tariff is a tax imposed by one country on the goods and services imported from another country to influence itraise revenuesor protect competitive advantages.

Understanding Tariffs

Tariffs are used to restrict imports. Simply putthey increase the price of goods and services purchased from another countrymaking them less attractive to domestic consumers.

A key point to understand is that a tariff affects the exporting country because consumers in the country that imposed the tariff might shy away from imports due to the price increase. Howeverif the consumer still chooses the imported productthen the tariff has essentially raised the cost of the imported product for the consumer.

There are two types of tariffs:

• A specific tariff is levied as a fixed fee based on the type of itemsuch as a $500 tariff on a car.
• An ad-valorem tariff is levied based on the item's valuesuch as 5% of an import's value.

Why Governments Impose Tariffs

Governments may impose tariffs for several reasons:

• To raise revenues
• To protect domestic industries
• To protect domestic consumers
• To protect national interests

Raising Revenue

Tariffs can be used to raise revenues for governments. This kind of tariff is called a revenue tariff and is not designed to restrict imports. For instancein 2018 and 2019President Donald Trump and his administration imposed tariffs on many items to rebalance the trade deficit. The country collected $40.6 billion in customs duties in 2018 and $71.9 billion in 2019.

Protecting Domestic Industries

Governments can use tariffs to benefit particular industriesoften doing so to protect companies and jobs. For examplein April 2018Trump imposed a 25% ad valorem tariff on steel articles from all countries except Canada and Mexico. In March 2022President Joe Biden replaced the tariff on steel products from the United Kingdom with a tariff-rate quota of 500,000 metric tonsand reached quota deals with several other countries.

This proclamation reopened the trade of specific items with the U.K. while taking measures to protect domestic U.S. steel manufacturing and production jobs.

Protecting Domestic Consumers

By making foreign-produced goods more expensivetariffs can make domestically produced alternatives seem more attractive. Some products made in countries with fewer regulations can harm consumerssuch as a product coated in lead-based paint. Tariffs can make these products so expensive that consumers won't buy them.

Effective Feb. 12025Trump placed 25% tariffs on imports from Canada and Mexico and 10% tariffs on imports from China. The rationale was to force these countries to cooperate with the U.S. to stem the flow of illegal immigrants and drugs like fentanyl from entering the U.S.as well as to boost domestic manufacturing and raise revenues.

Protecting National Interests

Tariffs can also be used as an extension of foreign policy by putting pressure on trading partners. For examplewhen Russia invaded Ukrainemuch of the world protested by boycotting Russian goods or imposing sanctions. In April 2022Biden suspended normal trade with Russia. In Junehe raised the tariff on Russian imports not prohibited by the April suspension to 35%.

Unintended Side Effects of Tariffs

Tariffs can have unintended side effects:

• They can make domestic industries less efficient and innovative by reducing competition.
• They can hurt domestic consumers since a lack of competition tends to push up prices.
• They can generate tensions by favoring specific industries or geographic regions over others. For exampletariffs designed to help manufacturers in cities may hurt consumers in rural areas who do not benefit from the policy and are likely to pay more for manufactured goods.
• Finallyan attempt to pressure a rival country by using tariffs can devolve into an unproductive cycle of retaliationcommonly known as a trade war.

Advantages and Disadvantages of Tariffs

Advantages Explained

• Produce revenues: As discussedtariffs provide a government with a chance to bring in more money. This can relieve some of the tax burdens felt by a county's citizens and help the government to reduce deficits.
• Open negotiations: Tariffs can be used by countries to open negotiations for trade or other issues. Each side can use tariffs to help it create economic policies and talk with trade partners.
• Support a nation's goals: One of the most popular uses for tariffs is to use them to ensure domestic products receive preference within a country to support businesses and the economy.
• Make a market predictable: Tariffs can help stabilize a market and make prices predictable.

Disadvantages Explained

• Create issues between governments: Many nations use tariffs to punish or discourage actions they disapprove of. Unfortunatelydoing this can create tensions between the two countries and lead to more problems.
• Initiate trade wars: A typical response for a country with tariffs imposed on it is to respond similarlycreating a trade war in which neither country benefits from the other.
  

History of Tariffs

Pre-Modern Europe

In pre-modern Europea nation's wealth was believed to consist of fixedtangible assetssuch as goldsilverlandand other physical resources. Trade was seen as a zero-sum game that resulted in either a clear net loss or a clear net gain of wealth. If a country's imports exceeded its exportsa resourcemainly goldwould flow abroadthereby draining its wealth. Cross-border trade was viewed with suspicionand countries preferred to acquire colonies with which they could establish exclusive trading relationships rather than trading with each other. 

This systemknown as mercantilismrelied heavily on tariffs and even outright bans on trade. The colonizing countrywhich saw itself as competing with other colonizerswould import raw materials from its colonieswhich were generally barred from selling their raw materials elsewhere. The colonizing country would convert the materials into manufactured wareswhich it would sell back to the colonies. It used high tariffs and other barriers to ensure that colonies only purchased manufactured goods from their home countries. 

New Economic Theories

The Scottish economist Adam Smith was one of the first to question the wisdom of this arrangement. His "Wealth of Nations" was published in 1776the same year Britain's American colonies declared independence in response to high taxes and restrictive trade arrangements.

Later writerssuch as David Ricardofurther developed Smith's ideasleading to the theory of comparative advantage. It maintains that if one country can better produce a specific product while another country is better at producing anothereach should devote its resources to the activity at which it excels. The countries should trade with one another rather than erect barriers that force them to divert resources toward activities they do not perform well. According to this theorytariffs drag economic growtheven if they can be deployed to benefit specificnarrow sectors under some circumstances.

Late 19th and Early 20th Centuries

Relatively free trade enjoyed a heyday in the late 19th and early 20th centuries when the idea took hold that international commerce had made large-scale wars between nations so expensive and counterproductive that they were obsolete. World War I proved that idea wrongand nationalist approaches to tradeincluding high tariffsdominated until the end of World War II.

From that point onfree trade enjoyed a 50-year resurgenceculminating in the creation in 1995 of the World Trade Organization (WTO)which acts as an international forum for settling disputes and laying down ground rules. Free trade agreementssuch as the North American Free Trade Agreement (NAFTA)—precursor of the United States-Mexico-Canada Agreement (USMCA)—and the European Union (EU)also proliferated.

The 2010s

Skepticism of this modelsometimes labeled neoliberalism by critics who tie it to 19th-century liberal arguments in favor of free tradegrewhoweverand Britain in 2016 voted to leave the European Union. That same yearTrump won the U.S. election on a platform that included a call for tariffs on Chinese and Mexican imports. He implemented tariffs on China when he took officebut suspended proposed tariffs on Mexico.

Critics of tariff-free multilateral trade dealswho come from both ends of the political spectrumargue that they erode national sovereignty and encourage a race to the bottom regarding wagesworker protectionsand product quality and standards. Meanwhilethe defenders of such deals counter that tariffs lead to trade warshurt consumersand hamper innovation.

The Bottom Line

Tariffs have existed in one form or another for centuries. Trading partners implement them to politically influence a partnerprotect domestic industries and consumersand further national goals and interests.

Tariffs are not always negativeregardless of what you might see on the news. They can be a means to open negotiations again between trading partnersprovide each a chance to voice concernsand even help to stabilize a country's market.