There was a lot of talk about tariffs during the recent presidential election. Last night, the president-elect announced via social media post that his administration would be enacting across the board tariffs of 10% on all goods imported from China and 25% tariffs on goods coming in from Mexico and Canada. The markets are seemingly shrugging off these threats today, probably because it’s not clear if this is just continued campaign rhetoric or something more substantial, but when it’s all said and done, who actually pays for tariffs?
A tariff, also known as an import duty, works basically like any sales tax. Consumers, in this case importers, pay an additional amount when they buy a product from overseas and the tax or tariff goes to the Federal government. It is a percentage amount levied during the importation process. The buyer, American companies mostly, pay the tax. They then add that amount to the cost of goods purchased. And like with any other sales tax, the company can pass it on or adjust their final sales price to absorb some of the hit from the tax. Or even absorb the total themselves. How many companies do you think will decide to do that?
The incoming administration seems to believe they can make up the revenue that will be lost when they cut income taxes by enacting tariffs. They also like to use them as pressure points for other policy priorities and to try to induce certain behaviors. And that pressure may work to a certain extent. But the strategy also ignores the effect of substitution.
Since tariffs increase the final sale price of any item, consumers will resort to substitution. With some products, substitution is not possible. Things like bananas and coffee can only be imported. But take a thing like wine. I very much like some of the red wines coming from the Valle de Guadalupe region in Baja California Norte, Mexico. The quality is excellent and the pricing is competitive. If a 25% tariff increases the price by the same amount, it is easy to substitute that wine for a similar California red and avoid the tax.
When you multiply this kind of decision making across hundreds of thousands of products, the revenue that could be raised by tariffs becomes very unpredictable.
Enacting tariffs also runs the risk of mercantilism or trade wars. We saw that this morning with the President of Mexico responding to yesterday’s announcement by threatening tariffs on American goods heading into Mexico as a tit for tat measure. This creates headwinds for American producers that do a lot of business thru exports. Again, because the tariffs are ultimately paid by the consumers in the destination country.
Tarriff and tax policy is technically decided by Congress but the president does have some ability to use executive orders, as was done before, to levy some tariffs. Ultimately, we will have to wait and see what kind of tariff schedule actually comes out after the new administration is sworn in and it is wise to ignore the social media announcements for now.
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