The Effect of Tariffs on the US Economy
1. Introduction
On March 4, 2025, President Donald Trump announced a series of tariff policies, marking a pivotal shift in U.S. trade policy. These measures included an additional 25% tariff on imports from Canada and Mexico, a 10% tariff specifically on Canadian energy resources like oil, natural gas, and electricity, and an additional 10% tariff on imports from China. These actions reignited debates about the efficacy and consequences of tariffs on the U.S. economy.
On April 2, 2025, President Donald Trump announced a comprehensive set of tariffs aimed at reshaping U.S. trade relationships. Dubbed “Liberation Day,” the initiative introduces a baseline 10% tariff on all imports, effective April 5, 2025. Additionally, higher “reciprocal” tariffs will target specific countries with significant trade imbalances or perceived unfair trade practices, beginning April 9, 2025. Imports from Taiwan, a key manufacturer of semiconductors, will be taxed at a rate of 32%, while South Korea will face a 25% tariff, Japan 24%, and the European Union 20%. China, where Apple and many other tech companies manufacture their products, will be subject to a 34% tariff. Furthermore, a 25% tariff will be imposed on all foreign-made automobiles starting April 3, 2025. The tariffs imposed on various countries were calculated as half of the tariffs imposed by those countries. Exactly how those tariff numbers that countries charge us came to be seemed complicated at first. Commerce Secretary Howard Lutnick said United States Trade Representative (USTR) economists had worked for years on a metric that reflected all trade barriers set up by a given country. Indeed, Trump said when announcing the tariffs that they calculated tariff and non-tariff barriers, such as currency manipulation, to come up with their numbers. It turns out, however, that one can calculate those numbers simply by dividing the goods trade deficit by goods trade exports. Mary Lovely, Senior Fellow at the Peterson Institute, remarked "It is like finding you have cancer and finding the medication is based on your weight divided by your age. The word 'reciprocal' is deeply misleading."
Tariffs are taxes imposed on imported goods. They have long been utilized by governments to protect domestic industries, generate revenue, and influence international trade dynamics. This Community Policy Report examines the multifaceted effects of tariffs, analyzing their impact on various economic stakeholders including consumers, producers, government revenue, and global trade relationships. We will present an assessment of both potential benefits and drawbacks, supported by historical and contemporary case studies.
2. The Foundations of Free Trade and Tariff Protection
Before getting into the specifics of what tariffs do, let’s be clear that the arguments for and against free trade are not new. Indeed, David Ricardo, an influential 19th-century economist, developed the theory of comparative advantage to argue in favor of free trade. In his seminal 1817 work "On the Principles of Political Economy and Taxation," Ricardo demonstrated that countries benefit from specializing in producing goods where they have a relative efficiency advantage (we now call comparative advantage) and then trading with other nations, even if one country could produce all goods more efficiently than another. Definitely a “win-win” outcome.
Ricardo argued that tariffs and other protectionist measures harm overall economic welfare by preventing countries from achieving the benefits of specialization and trade. He showed mathematically that free trade leads to increased total production and consumption possibilities for all participating nations, while tariffs artificially protect inefficient domestic industries at the expense of consumers and economic growth.
So, why do we trade with other countries? We do so because it allows us (and them) to be able to purchase goods and services at a lower (opportunity) cost.
3. The Effect of Tariffs on Consumers
One immediate effect of tariffs is the increase in prices for imported goods, which often leads to higher costs for consumers. This happens because the tariff is “passed on” to the consumer. It is typically not the case, however, that the full amount of the tariff is passed on to the consumer. Since demand curves slope down and supply curves slope up, consumers end up paying more and the sellers receive less. There is a "wedge" between what the buyer pays and the seller receives. Tariff revenue that accrues to the government is the amount of the tariff times the quantity sold. The "burden" of the tariff is split between buyers and sellers.
Let’s take an example of a $10 bottle of Canadian maple syrup. If a 25% tariff is introduced when imported it is into the U.S., the $2.50 tariff will have to be paid by someone. But, how much more the buyer pays and how much less the seller receives depends on how steep or shallow are the demand and supply curves (economists use the term elasticity). So, the price the buyer pays may rise from $10 to $11.50 and the price the seller receives falls to $9.00, the difference being the $2.50 tariff that goes to the government.
In the case of the recent tariffs, this could mean increased prices not only on Canadian maple syrup and Mexican avocados, but anything coming through the Canadian, Mexican, or Chinese borders, which includes gas, computers, clothes, and groceries.
The price of foreign goods can increase, but domestic producers may also raise their prices. This is because there are fewer international competitors and those international competitors cost more. This further diminishes consumer surplus—the difference between what consumers are willing to pay and what they actually pay.
The 2018 U.S. tariffs on washing machines provide an instructive example. These tariffs resulted in an average price increase of $86 per unit, costing American consumers approximately $1.5 billion in total (BBC).
However, it's important to note that a country may benefit if tariffs lead to more domestic production, potentially creating more jobs and increasing wages in certain sectors. These benefits must be weighed against the direct cost increases.
The above graph illustrates the economic effects of a tariff imposed on an imported good. The domestic supply and demand curves intersect to determine the equilibrium price, P, and quantity, Q, in a market without trade restrictions.
At the world price P1, the quantity of imports is the difference between Q1 (domestic supply) and Q2 (domestic demand). The world price is lower than the domestic price precisely because the foreign country can produce that good at a lower cost. When a tariff is imposed, the price of imports rises to P2 (world price plus tariff). This increase in price reduces the quantity of imports from Q2 minus Q1 to Q3 minus Q4, as domestic consumers demand less of the imported good, and domestic producers supply more.
The consumer surplus, represented by the green area, decreases due to the higher price, while the producer surplus, marked in pink, increases as domestic producers gain from reduced foreign competition. The yellow area represents government revenue generated from the tariff, calculated as the tariff rate multiplied by the quantity of imports (which is paid by the domestic consumers as discussed above). However, the imposition of the tariff creates two deadweight loss triangles, shown in orange, which represent the efficiency losses from reduced trade and misallocation of resources.
Moreover, if tariffs are placed on intermediate products used in production, such as steel, they create a cascading effect impacting all products produced using steel, such as cars and refrigerators. When steel becomes more expensive due to tariffs, this cost increase permeates throughout all manufacturing sectors that utilize steel as an input—including automobiles, appliances, construction equipment, and countless other consumer goods.
4. The Effect on Domestic Producers and the Labor Market
While consumers may face higher prices, domestic producers often benefit from tariffs due to decreased foreign competition. As shown in the above graph, producer surplus increased due to the tariff. This protection can lead to increased production and higher revenues within the sheltered industries.
However, this protective measure can also result in inefficiencies. Shielded from international competition, domestic firms may lack the incentive to innovate or improve productivity, potentially leading to complacency and long-term stagnation.
The sugar industry offers a historical example of this dynamic. High domestic sugar prices, often double those of the global market, have led many candy manufacturers to relocate production to countries with cheaper sugar. Kraft Foods moved its Life Savers plant from Michigan to Canada in 2002, citing $90 million in savings over 15 years. In 2003, Spangler Candy shifted half of its production to Mexico due to sugar costs making up 70% of its expenses, while Adams & Brooks moved two-thirds of its production there. Company leaders emphasize that relocating is necessary for survival.
The same 2018 tariffs the U.S. imposed on imported washing machines show both sides of the coin. While they were designed to protect domestic manufacturers like Whirlpool, they also led to price increases of about 12% on washing machines, resulting in higher costs for consumers and reduced sales for retailers.The higher prices cost consumers an estimated $1.5 billion, far exceeding the benefits to domestic producers.
In addition, domestic workers do not necessarily benefit from tariffs. A study conducted by Aaron Flaaen and Justin Pierce at the Federal Reserve Board shows that by mid-2019, the increased cost of steel and aluminum due to tariffs was associated with 0.6 percent fewer jobs in the manufacturing sector than would have been the case without the tariffs. Their analysis suggests there were approximately 75,000 fewer jobs in manufacturing attributable to the March 2018 tariffs on steel and aluminum, as shown in the chart below.
It is true that there were jobs gained, but far more jobs were lost due to the tariffs, hurting American workers. The challenge for policymakers is that industries using steel as an input (like auto manufacturing, construction, and appliance production) employ far more workers than the steel production industry itself.
5. Inflation Pressures from Tariffs
Tariffs, in and of themselves, do not create inflation. Tariffs are imposed on particular goods, such as washing machines. What happens is that the relative price of washing machines to other goods rises. But, we cannot pay more for washing machines and still buy the same amount of other goods! Unless, of course, there is a monetary or fiscal response. John Cochrane provides an excellent description concerning relative prices vs. the price level for more than just tariffs. The U.S.-China Trade War, beginning in 2018, saw the U.S. impose tariffs on Chinese imports to address trade imbalances and alleged unfair trade practices. China responded with its own tariffs on U.S. goods. Research indicates that U.S. consumers and businesses bore the brunt of these tariffs through higher prices (that does not necessarily mean persistent inflation!).
6. Conclusion
President Trump's recent tariff policies represent a significant shift in U.S. trade policy with wide-ranging economic implications. While tariffs may provide short-term protection for specific domestic industries, the evidence presented in this CPR indicates that their overall economic impact tends to be negative for the broader economy.
As policymakers navigate these complex trade decisions, they should carefully weigh the costs against the potential benefits. Effective trade policy requires balancing domestic industry protection with consumer welfare and broader economic health—a challenge that historically has proven difficult to resolve through tariffs alone.