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Tariffs are discriminatory taxes collected at the border on imported goods but not levied on similar goods originating domestically. Tariffs are sometimes very large (everywhere in the 1930s and in some developing countries in the early twenty-first century) and sometimes very low (Hong Kong in the early twenty-first century). Tariffs are substantially discriminatory between international trading partners. Regional trade agreements such as the European Union (EU) and the North American Free Trade Agreement (NAFTA) remove tariffs between the members while imposing tariffs on nonmembers. Tariffs also significantly discriminate between goods. Tariff schedules of most countries contain over 10,000 lines with tariffs ranging in some cases from 0 percent to over 100 percent.

Tariffs come in specific and ad valorem forms. Specific tariffs are charges per unit, for example, $1,000 per automobile. Ad valorem tariffs are levied as a percentage of invoice value. A 5 percent tariff levied on a $20,000 automobile yields a $1,000 specific tariff equivalent. The automobile example also illustrates how to calculate the ad valorem equivalent of a specific tariff: divide the specific tariff by the invoice price. Ad valorem tariffs are much easier to use for comparison purposes across goods and countries. Comparison including specific tariffs requires prices to deflate the specific duties, which is often extremely burdensome.

Both specific and ad valorem tariffs are common. Ad valorem tariffs are the only sensible type when there is no natural quantity unit (boxes of parts). But ad valorem tariffs are disadvantageous where corrupt border officials are suspected; underinvoicing will lower the tax paid, with importer and border official splitting the difference. History also matters: The United States has many specific tariffs despite the likely honesty of its customs officials.

Some tariffs vary with the level of trade. The tariff quota is a tariff that steps upward when trade passes a preset amount. Another example is an antidumping duty, which is equal to the difference between last year’s price differential between the exporting firm’s cost (or foreign price) and its U.S. sale price.

Tariff Costs And Benefits

Tariffs provide revenue to the government that levies them. This benefit is offset by the cost to users of paying the tax. Less obviously tariffs provide a benefit to domestic producers who experience less stringent competition from imports. The balance of these three effects is typically calculated to yield a net loss to the economy. A tariff reduction is typically calculated to reduce net loss by the height of the tariff times the increase in imports induced by the tariff reduction. The marginal net cost of tariffs is thus proportional to the height of the tariff.

A potentially important complication is that import competition may cause periods of unemployment for domestic workers; hence, tariffs provide a benefit by employing more workers. Typical calculations for the U.S. economy show that the costs of employment-increasing tariff hikes per job saved are greater than the wage paid in the job—usually several times the wage.

What explains the use of tariffs in view of their cost to the economy? Politics. The pressure of domestic producers and trade unions that gain from tariffs is largely unopposed. Consumers are unorganized whereas producers who import intermediate goods often refrain from resisting tariffs as they push for tariffs on the import of goods that compete with their output. Two contrary forces push tariffs down. Most importantly, politicians tempted to grant higher tariffs also know that the resulting reduction in general prosperity harms their prospects of retaining power (at the next election or, less certainly, against a coup). More subtly, the interest groups themselves bear a share of the overall cost of tariffs, tending to restrain their demands. Political economy models that view tariffs as objects for sale in political markets with these forces at work have been fitted to data on the pattern of protection, and the model appears to statistically explain the pattern well.

The discriminatory aspect of tariffs (differing across trading partners and across goods) typically adds to the cost of tariffs. Discrimination across trading partners results in costly trade diversion. The purchase of goods shifts from the lowest cost source (increasing net loss in proportion to the tariff if the source is not a partner) to the favored partner (with marginal net benefit equal to the zero tariff). Discrimination across goods imposes a more subtle cost on the economy with a similar structure. Think about increasing the dispersion of tariffs while preserving the average tariff. The increase in tariffs on already high-tariff goods reduces trade where it is most costly whereas the reduction in tariffs on low-tariff goods increases trade where it is least costly.

Discrimination across trading partners and across goods is substantial and has increased with the overall liberalization of trade since the mid-1900s. Regional trade agreements have proliferated even as multilateral negotiations have reduced overall tariffs. Wide tariff reductions have exempted certain product categories, such as agriculture and apparel, in rich countries.

International Trade Relations

Tariffs tend to reduce prices of exports from foreign economies. This spillover implies that part of the cost of tariffs is borne by foreigners. Since national governments will thus be tempted to overuse tariffs, nations agree to restrict their tariffs in international negotiations and enforce their agreements through international institutions such as the World Trade Organization (WTO). The dispute settlement process of the WTO generates frequent headlines and gives a false impression that international relations are becoming more acrimonious. As with family therapy, if the parties are arguing, it is better than if they are not talking. Imperfections in particular negotiation rounds or institutions should not obscure their very positive role in preventing much worse outcomes, such as the tariff wars of the 1930s.

Two basic principles of the WTO and its predecessor institutions are nondiscrimination between partners and reciprocity. Reciprocity means that the parties alter their tariffs to balance the exchange of market access provided. For example, a round of tariff negotiations might increase U.S. imports by one trillion dollars while reciprocally increasing access to foreign markets by one trillion dollars. Importantly, the WTO permits the United States to withdraw market access of, say, one billion dollars, by raising its tariffs in a particular product while reciprocally authorizing the foreign countries to withdraw one billion dollars of market access by raising foreign tariffs.

Regional trade agreements are the great exception to nondiscrimination. The principles of the WTO permit it on the reasoning that a move toward free trade between the members is better than the move away from liberal trade due to trade diversion. Opinions among trade economists diverge over whether regional agreements are a building block or a stumbling block to multilateral liberalization.

Bibliography:

Anderson, James E., and Eric van Wincoop. 2004. Trade Costs. Journal of Economic Literature 42: 691–751.
Anderson, James E., and J. Peter Neary. 1992. Trade Reform with Quotas, Partial Rent Retention and Tariffs. Econometrica 60 (1): 57–76.
Bagwell, Kyle, and Robert W. Staiger. 2002. The Economics of the World Trading System. Cambridge, MA: MIT Press.
Krugman, Paul, and Maurice Obstfeld. 2006. International Economics: Theory and Policy, 7th ed. Boston: Addison-Wesley.