Tariffs: Definition, Types, Effects & Example (2024)

Tariffs Definition

Before anything else, let's go over the definition of tariffs. A tariff is a government tax on goods imported from another country. This tax is added to the price of the imported product, making it more expensive to buy compared to the locally produced products.

A tariff is a tax on imported goods that is designed to make them more expensive for consumers and thus, make domestically produced goods more competitive.

A tariff aims to protect local industries from foreign competition, generate revenue for the government, and influence trade relations between countries.

For example, let's say that Country A produces phones for $5 each, while Country B produces phones for $3 each. If Country A imposes a tariff of $1 on all phones imported from Country B, the cost of a phone from Country B would now be $4. This would make it less attractive for consumers to buy phones from Country B, and they may instead choose to purchase phones made in Country A.

Tariffs are a form of protectionism that a government sets to protect domestic markets from foreign imports. When a nation imports a good, it is typically because foreign goods are cheaper to buy. When domestic consumers spend money in foreign markets rather than their own, it leaks funds out of the domestic economy. To remain competitive, domestic producers have to lower their prices to effectively sell their goods, costing them revenue. Tariffs discourage the purchase of foreign goods and protect domestic producers by raising the price of imports so that domestic prices do not fall as much.

Another reason governments impose tariffs is as political leverage against other nations. If one country is doing something that the other does not approve of, the country will impose a tariff on goods coming from the offending nation. This is meant to put the nation under financial pressure to change its behavior. In this scenario, there is typically not just one good on which a tariff is placed, but a whole group of goods, and these tariffs are part of a greater sanctions package.

Since tariffs can be a political tool as much as an economic one, governments are careful when they place them and have to consider the repercussions. The legislative branch of the United States was historically responsible for placing tariffs but eventually granted the executive branch a portion of the ability to set trade laws. Congress did this to give the president the ability to place tariffs on goods that are deemed a threat to national security or stability. This includes goods that could be harmful to US citizens like certain weapons and chemicals, or goods that the US might become reliant on, putting it at the mercy of another nation, and making the US unable to support itself.

Just like taxes, the funds resulting from tariffs go to the government, making tariffs a source of revenue. Other forms of trade barriers and protectionist measures, like quotas, do not provide this benefit, making tariffs the preferred method of intervention to support domestic prices.

Difference Between Tariffs and Quotas

The difference between tariffs and quotas is that quotas limit the amount of a good that can be imported and a tariff makes it more expensive. A quota increases the price of a good because it creates a shortage in the domestic market by limiting how much of a good can be imported.

Both tariffs and quotas are trade barriers that are meant to reduce imports of a foreign goods into the market and keep domestic prices high. They are different means to the same end.

Table 1 - Difference Between Tariffs and Quotas

Even though tariffs and quotas have a similar result - an increase in price in the domestic market - the way they arrive at that result differs. Let's take a look.

Figure 1 below, shows a domestic market once a tariff has been applied on the imported good. If a nation engages in international trade without government intervention, the price of the good in the domestic market is at P_W. At this price the quantity demanded by consumers is Q_D. Domestic producers are not able to meet this level of demand at such a low price. At P_W they are only able to supply up to Q_S and the rest, Q_S to Q_D, is supplied by imports.

Fig. 1 - Effect of a Tariff on the Domestic Market

Domestic producers complain about low prices limiting their ability to produce and profit so the government places a tariff on the goods. This means it is more expensive for importers to bring in their goods. Instead of taking this reduction in profits, the importer transfers the tariff cost to the consumer by raising the purchase price. This can be seen in Figure 1 as the price increases from P_W to P_T.

This price increase means domestic producers can now supply more goods, up to Q_S1. The quantity demanded by consumers has been reduced since the price increased. To fill the supply and demand gap, foreign imports only make up Q_S1 to Q_D1. The tax revenue that the government earns is the number of goods supplied by imports multiplied by the tariff.

Since the government collects the tax revenue, it experiences the most direct benefit of a tariff. Domestic producers are next in line to benefit by enjoying the higher prices they can charge. The domestic consumer suffers the most.

Fig. 2 - Effect of a Quota on the Domestic Market

Figure 2 shows what happens to the domestic market once a quota has been set. Without the quota, the equilibrium price is P_W and the quantity demanded is Q_D. Much like under a tariff, the domestic producers supply up to Q_S and the gap from Q_S to Q_D is filled by imports. Now, a quota is set into place, limiting the quantity imported to Q_Q to Q_S+D. This quantity is the same at every level of domestic production. Now, if the price were to remain the same at P_W, there would be a shortage from Q_Q to Q_D. To close this gap, the price increases to the new equilibrium price and quantity at P_Q and Q_S+D. Now, domestic producers supply up to Q_Q, and foreign producers supply the size of the quota from Q_Q to Q_S+D.

Quota rent is the profit that domestic importers and foreign producers are able to earn when a quota is put in place. Domestic importers are able to cash in on quota rents when the domestic government decides to license or provide permits to those domestic firms who are allowed to import. This keeps the profits from quota rents in the domestic economy. Quota rents are calculated by multiplying the quota's size by the price change. Foreign producers who import their goods benefit from the price increase caused by the quota as long as the domestic government does not regulate who can import with permits. Without regulation, foreign producers benefit since they can charge higher prices without changing production.

Even if domestic producers do not earn quota rent, the increase in price allows them to increase their levels of production. That means domestic producers benefit from quotas because the increase in production for them results in higher revenue.

Whoa! Don't think you know all there is to know about quotas yet! Check out this explanation on quotas to fill in any gaps! - Quotas

Types of Tariff

There are several types of tariffs that a government can choose from. Each type of tariff has its own benefit and purpose.

One law, statement, or standard is not always the best solution for every situation, so it must be modified to produce the most desirable result. So let's look at the different types of tariffs.

Table 2 - Types of Tariffs

The ad valorem tariff is the one that is the most familiar type of tariff since it functions in much the same way as an ad valorem tax one might come across, such as a real estate tax or sales tax.

Positive and Negative Effects of Tariffs

Tariffs, or taxes on imported goods, have long been a polemical issue in international trade because they can have both positive and negative effects on economy. From an economic perspective, the negative effect of tariffs is that they are often seen as a barrier to free trade, limiting competition and increasing consumer prices. However, in the real world, countries can face significant differences in their economic and political power, which can lead to abusive actions by larger countries. In this context, tariffs effects are positive because they are seen as a tool for protecting domestic industries and correcting imbalances in trade relations. We will explore both the positive and negative effects of tariffs, highlighting the complex trade-offs involved in their use.

Positive effects of tariffs

The positive effects of tariffs include the following:

1. Protection of domestic industries: Tariffs can protect local industries from foreign competition by making imported goods more expensive. This can help domestic industries to compete, grow and create jobs.
2. Revenue generation: Tariffs can generate revenue for the government, which can be used for public services and infrastructure development.
3. National security: Tariffs can be used to protect national security by limiting imports of certain products that could be used for military purposes.
4. Correcting trade imbalances: Tariffs can help to reduce trade imbalances between countries by limiting imports and promoting exports.

Negative effects of tariffs

The most important negative effects of tariffs include the following:

1. Increased prices: Tariffs can increase the price of imported goods, leading to higher consumer prices. This can particularly affect low-income households, who may be unable to afford higher prices.
2. Reduced consumer choice: Tariffs can limit consumer choice by making certain products more expensive or unavailable. This can lead to reduced competition and less innovation in the domestic market.
3. May lead to trade wars: Tariffs can lead to retaliation from other countries, which may impose tariffs on the importing country's products. This can lead to a trade war, harming both countries' economies.
4. Potential market inefficiency: Tariffs can lead to inefficiencies in the market, as they can distort prices and reduce economic efficiency.

Tariff Examples

The most common examples of tariffs are tariffs on agricultural products (grains, dairy, vegetables), industrial goods (steel, textiles, electronics) and energy products (oil, coal, gas). As you can see, these kinds of goods are crucial for the economy and society as a whole. Below is a list of three real-world examples of tariffs implemented in different countries:

• Japan's tariffs on agricultural imports: Japan has long protected its agricultural industry through high tariffs on imported agricultural products. These tariffs have helped to sustain Japanese agriculture and maintain rural communities. While there have been some calls for Japan to reduce its tariffs as part of trade negotiations, the country has largely been able to maintain its tariffs without significant negative effects.²
• Australia's tariffs on imported cars: Australia has historically protected its domestic car industry through very high tariffs on imported cars (up to 60% in the 1980s). In recent years, the Australian car industry has declined, with major producers pulling out of the country and there have been calls to reduce the tariffs even to 0%.⁴
• Brazil's tariffs on steel imports: Brazil has imposed tariffs on various steel products to protect its domestic steel industry. These tariffs have helped to sustain local steel manufacturing jobs and support the growth of the Brazilian steel sector but have led to trade wars with the US during Trump's presidency. ³

Trade War Example

A good example is a tariff placed on solar panels in 2018. Domestic solar panel producers petitioned the US government for protection from foreign producers like China, Taiwan, Malaysia, and South Korea.¹ They claimed that cheap solar panels that were being imported from these countries were damaging the domestic solar panel industry because they could not price match. The tariffs were placed against solar panels from China and Taiwan with a four-year lifespan.¹ The World Trade Organization (WTO) restricts the amount of time that tariffs can be imposed on other member countries without entitling the exporting country (China and Taiwan in this case) to reparations due to the loss of trade caused by the tariffs.

After the tariffs were set, the US experienced an increase in the price of solar panels and their installation. This resulted in fewer people and companies being able to install solar panels which set the US back in its efforts to switch to more sustainable energy sources.¹ Another effect of the tariff is that the solar industry might lose some large customers such as utility companies if they are unable to compete with the prices of energy sources such as wind, natural gas, and coal.

Finally, the US could also face retaliation from countries subject to the tariffs. Other countries can place tariffs or sanctions on US goods which would hurt US industries and exporters.

Why does the federal government impose tariffs?

The federal government imposes tariffs as a way to protect domestic industries, keep prices high, and as a source of revenue.

What is the purpose of a tariff?

The purpose of a tariff is to protect domestic producers from cheap foreign goods, to provide revenue for the government, and as political leverage.

Is a tariff a tax?

A tariff is a tax on imported goods set by the government.

Can the president impose tariffs without congress?

Yes, the president can impose tariffs without congress if the import of the good is deemed a threat to national security such as weapons or goods that will undermine the country's ability to support itself in the future.

Who benefits from a tariff?

The government and domestic producers are the ones who benefit the most from tariffs.

What is an example of a tariff?

An example of a tariff is the tariff placed on solar panels for China and Taiwan in 2018.