Politics & Society

Economics 101: What Is a Tariff? Learn How Tariffs Work in Economics With Examples

Written by MasterClass

May 23, 2019 • 5 min read

There’s almost nothing more contentious in the world of trade than tariffs. They’ve been around for as long as people have been trading goods across seas and states. To this day, economists debate their exact effect on economic growth. So what are tariffs, and how do they work?

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What Is a Tariff?

A tariff is a tax imposed by one country on goods and services imported from another country.

  • Tariffs may result in increased prices for domestic consumers, which in turn may make imported goods less appealing relative to domestically produced goods.
  • Historically, governments have relied on tariffs to protect or promote domestic industries from foreign competition while also raising government revenue.

2 Types of Tariffs

Tariffs are set by the government and collected by the customs authority. In the United States, they’re collected by Customs and Border Patrol on behalf of the Department of Commerce.

There are two major types of tariffs: specific tariffs and ad valorem tariffs.

  • Specific tariffs specify a fixed fee on a particular type of good. For example, the U.S. imposes a 51% tariff on imported wristwatches (excepting those countries with which the U.S. has a free trade agreement). This tariff applies regardless of the cost of the watch.
  • Ad valorem tariffs are based on the worth of the item. For example, the U.S. imposes a 2.5% tariff on automobiles imported from the European Union, while the European Union imposes a 10% tariff on automobiles imported from the U.S. (The Trump administration has threatened to raise the U.S. tariff to 25%, and the EU has promised to reciprocate.)

What Is the Purpose of Tariffs?

Throughout history, governments have turned to tariffs for various reasons.

  • Historically, they’ve helped governments protect domestic industries from foreign competition while also raising revenue.
  • Today, tariffs are also the most basic tool countries use in a trade war. If the countries involved are large enough, they may use tariffs as a way to exert significant pressure on one another in order to exact concessions on trade or other areas.
  • The idea is that by making foreign products more expensive, governments can encourage their citizens to buy from domestic producers instead (producers that might not be able to compete otherwise). In theory, it’s a way for governments to boost the domestic economy while reducing their trade deficit.
  • In practice, it’s much more complicated. Increasing prices (remember, a tariff is a tax) can lead to a reduction in GDP in the short term, as goods and services become more expensive for consumers. In the long run, protected industries may also become less efficient or innovative due to a loss of competition.
  • Retaliatory tariffs can also cause major damage to industries that rely on exports or industries that have complex supply chains dependent on international trade.
  • Believers in more liberalized or free trade are generally opposed to tariffs, on the belief that lower barriers to trade benefit all parties: by keeping prices low and allowing international commerce to flow unimpeded.

When and How Did Tariffs Originate?

From roughly the end of the Renaissance until the nineteenth century, most western nations relied on a system of high protective tariffs to protect or promote domestic industries.

  • The era of mercantilism, as it’s come to be called, emphasized promoting domestic industries and exporting as many manufactured goods as possible while importing only raw materials, preferably from colonial possessions.
  • Beginning in the late eighteenth century, however, classical economists influenced by the work of Adam Smith began to advocate for free trade (or “laissez-faire economics”) as an alternative to mercantilism, though different states (especially Germany and U.S.) continued to pursue mercantilist policies into the early twentieth century.
  • Tariffs have played an important role in the history of the U.S. Alexander Hamilton, the first U.S. treasury secretary, advocated for a protectionist system of high tariffs to incubate American industries until they had achieved the economies of scale required to compete with international rivals. For the early American government, it wasn’t just a trade policy: it was also the major source of revenue for the federal government. Prior to the advent of the federal income tax, tariff revenues made up the vast majority of the federal budget.
  • So what changed? After World War II, the victorious Allied powers developed a system of multinational institutions to promote international cooperation and create greater economic ties between nations in the hope that greater economic integration would make large-scale military conflict less likely.
  • Some of these institutions included the International Monetary Fund (IMF) and the forerunners to the European Union as well as the World Trade Organization (WTO).
  • Thus, liberalized trade became a cornerstone of what’s called the postwar international order. Today, the WTO is the main international body that handles trade between nations. Its objective is to reduce tariffs and promote free trade agreements worldwide.

How Are Tariffs Decided?

Tariffs aren’t just a matter of economic policy: they’re also a political tool (or weapon) used in settling international trade disputes. Therefore, what goods and services are targeted, and how severely, can be a political question as much as an economic one.

  • One common reason to enact tariffs is to promote infant industries that may not otherwise be able to compete directly with more developed foreign industries. This theory was extremely important in the early days of the U.S. when high tariffs were used to shield early American industries like textiles and manufacturing.
  • Tariffs have also been used to protect industries related to national security. This is why countries often protect their domestic defense and aerospace industries with tariffs on foreign manufacturers, among other policies. National security is also the justification given by the Trump administration for enacting steep tariffs on imported steel and aluminum, despite protests from the defense industry.
  • In the context of a trade war, retaliation is also a major factor. For example, in 2018 the Trump administration enacted tariffs on hundreds of billions of dollars worth of goods from China, which the administration accused of unfair trade practices. After Donald Trump raised tariffs on European steel and aluminum, the EU responded with its own retaliatory tariffs targeting American bourbon, motorcycles, and orange juice, among other goods. These retaliatory tariffs were chosen specifically to impact the states of U.S. political leaders who supported the Trump administration’s trade policies.

Learn more about economics in Paul Krugman’s MasterClass.