Tariffs

7 Technically, e has to adjust by 1/(1+ τ ) to perfectly offset the tariff, or in this case 9.09% Tariffs are a familiar tool to President Trump and his team, since they were used—with success—extensively in 2018- 2019 in trade negotiations with China. Those tariffs passed with little discernible macroeconomic consequence—inflation remained stable or even declined, and GDP growth continued to perform quite well despite the Fed’s hiking cycle. It is therefore reasonable to expect tariffs once again to be a primary tool.

Tariffs and Currency Offset

Before discussing how unilateral and multilateral tariff regimes might work in practice, I first review some economics of tariffs. There are several critical dimensions to study: inflation, incidence, and efficiency (including how tariffs compare to other types of taxes).

In the analysis that follows, the critical question is to what extent currencies adjust to offset changes in international tax regimes.

A recent rigorous theoretical treatment and literature review is given, for instance, in Jeanne and John (2024). The classic reason currencies offset changes in tariffs is that tariffs improve the trade balance, which then puts upward pressure on the currency for traditional reasons. But currencies might also adjust because nations’ central banks adjust interest rates to offset inflation and demand changes; or because end-supply is determined by comparative advantage and end-demand by preferences, and currencies adjust to offset changes like taxes; or because the growth prospects of the tariffing country improve relative to the tariffed country, attracting investment flows (so long as tariffs do not exceed “optimal” levels; see below).

To illustrate the mechanism simply, let px be the price of a good charged by (foreign) exporters, denominated in their own currency, e the exchange rate (dollars per foreign currency unit), and τ the tariff rate. Then the price paid by (American) importers is: pm= e(1+ τ ) px Suppose we begin with e=1 and τ=0. The government imposes a 10% duty on imports but the foreign currency depreciates by 10% as well. Then the price paid by importers becomes: pm= 0.9(1.1) px =0.99px

In other words, the exchange rate move and the tariff almost completely offset each other.7 The after-tariff price of the import, denominated in dollars, didn’t change. If the after-tariff import price in dollars doesn’t change, there are minimal inflationary consequences for the American economy (but not so for the exporting country).

Now, underlying this simple example are a number of assumptions which must be made clear:

1. The exchange rate must move by the right amount.
2. Primitive and intermediate value added in final exports originate predominantly in the exporting nation.
3. Passthrough from exchange rates to exporter prices px is complete. Importantly, since imports are often invoiced in USD, the exchange rate doesn’t automatically affect.

Instead, a strengthening in the dollar improves exporter profit margins if exchange rates do not passthrough into prices.

4. Passthrough from wholesale import to retail consumer prices is complete. As I will discuss below, these assumptions may not hold perfectly, in which case there is room for more volatility in prices, international trade and markets. Further, to the extent there are no meaningful changes to , then there will be no rebalancing of trade flows as a result of the tariffs. If imports from the tariffed nation become more expensive, then there will be some rebalancing of trade flows but also higher prices; if imports from the tariffed nation do not become more expensive because of currency offset, then there’s no incentive to find cheaper imports. One must choose between higher prices and rebalancing trade. Revenue is an important part of this story, as discussed below.

Inflation

While in principle tariffs can be noninflationary, how likely is it? In the macroeconomic data from the 2018-2019 experience, the tariffs operated pretty much as described above. The effective tariff rate on Chinese imports increased by 17.9 percentage points from the start of the trade war in 2018 to the maximum tariff rate in 2019 (see Brown, 2023). As the financial markets digested the news, the Chinese renminbi depreciated against the dollar over this period by 13.7%, so that the after-tariff USD import price rose by 4.1%. In other words, the currency move offset more than three-fourths of the tariff, explaining the negligible upward pressure on inflation. Measured from currency peak to trough (who knows exactly when the market begins to price in news?), the move in the currency was 15%, suggesting even more offset.

Measured CPI inflation moved from slightly above 2% before the start of the trade war to roughly 2% by the armistice. Measured PCE inflation went from slightly below the Fed’s target to further below the Fed’s target. Of course there were cross-currents like the Fed’s tightening cycle at the time, but any inflation from this trade war was small enough that it was overwhelmed by these cross-currents. This explains the Trump camp’s view that the first U.S.-China trade war was noninflationary.

While the macroeconomic data appear consistent with the currency offset theory, academics studying goodslevel microdata take a harsher view of this experience. For instance, Cavallo, Gopinath, Neiman and Jang (2021) study detailed microdata of goods imported by retailers and find that the dollar import price moved up by the amount of the tariff, and that the appreciation of the dollar did little to offset the tariffs. In other words, they argue

D I F FERE N CE I N TR A D E TA R I FF A N D A F TE R-TA R I FF U S D I M PO RT PR ICE 201 8 –1 9 Jan Apr Jul Oct Jan Apr Jul Sep -5% 0% 5% 10% 15% 20% 2018 2019 Figure 4 Changes in effective tariff rates and currency offset. Source: Brown (2023), Federal Reserve, authors’ calculations.

Figure 5 Core CPI and PCE inflation, annual rates. Source: BLS, BEA that the move in the currency didn’t passthrough into import prices.8 Similar conclusions are drawn by Fajgelbaum et al (2020) and Amiti, Redding and Weinstein (2019).

What can bridge the gap between the macrodata arithmetic and the results of microdata studies? First, examples like Cavallo et al tend to study short run effects, and it is possible currency passthrough into prices will be much slower than tariff passthrough: it’s much less salient, and importers tend to hedge their currency exposures anywhere from a few months to a few years out. If the importers hedge currency risk, it will take time for level shifts in the currency to pass through into invoiced prices. It would be bizarre for any economist to think that passthrough will never occur, since a competitive marketplace will result in producers lowering prices to marginal cost; if economists began to believe currencies didn’t affect the prices of traded goods, they’d have to reimagine several branches of economics. Amiti et a (2018) refer to the lack of exchange rate passthrough as a “puzzle” and speculate that over a longer period, exchange rate effects will materialize.

Second, Cavallo et al find that the price hikes occurred for prices paid by importers, not prices sold by retailers, limiting the ability of tariffs to result in increases in consumer prices but squeezing margins. That means that for the measures of inflation commonly prioritized, like the Consumer Price Index, or the price index for Personal Consumption Expenditures, there was little consequence. That helps reconcile the micro- and macro experiences. However, it would be bizarre for economies with sufficient competition not to see importers over time restore their margins by shifting suppliers if currency weakness isn’t passed through.

Third, interpreting goods-level microdata is difficult in light of re-export diversion. To avoid the tariffs, many Chinese companies began exporting goods or components to third countries, engaging in some minor processing, and then re-exporting to the United States. Iyoha et al (2024) find that rerouting of Chinese imports increased by roughly 50% since the tariff increases. And Freeman, Baldwin and Theodorakoplous (2023) find that, while just 8 More formally, because imports are invoiced in USD, the currency move doesn’t automatically affect the import price. If imports are invoiced in USD and the dollar appreciates, foreign profit margins improve, and then over time competition should whittle that margin so that then the dollar-invoiced import price declines.

over 60% of manufacturing intermediates imported into the U.S. came directly from China, incorporating the value-added of manufacturing intermediates that originated in China but were imported from other trade partners brought that number above 90%. The decision for Chinese exporters whether to evade tariffs via re-export is affected by the demand elasticity for their exports in the United States, introducing a critical bias into microdata studies. It is likely that the goods that are still directly exported to the U.S. and therefore subject to the tariffs are the ones over which the Chinese exporters retain the most pricing power and the greatest ability to pass through price increases on Americans. The goods on which Chinese exporters do not have pricing power, and over which they might have to absorb the tariffs, are the ones most likely to be re-exported via a third country. Chinese exporters will not pay the cost of diverting exports if they can push through price increases on purchasers. This practice severely upwardly biases the results of the microdata studies: only those goods with the highest ability to foist increases on Americans continue to be labeled as “made in China,” and other goods receive minor processing elsewhere and get labeled as different origin. In other words, difference-in-difference and related approaches will over-estimate the effect of tariffs on prices in microdata. Nevertheless, let’s consider the results in Cavallo et al at face value, and suppose America puts a 10% tariff on all imports, per President Trump’s proposals. With complete passthrough, that would lead to a 10% increase in prices of imported goods in the United States. Further suppose the dollar behaves as in 2018-19 and appreciates by the same amount as the tariff, 10% on a broad basis. Gopinath (2015) estimates that USD passthrough to imported prices is about 45% in the first two years, and that a 10% move in the USD impacts CPI by 40-70 basis points. Gopinath (2015) calculates that 6% to 12% of all consumption derives from imported sources, while Briggs (2022) estimates that number at about 10%. With 10% of consumption from imported sources, 100% passthrough, and a 10% tariff, consumer prices will go up by one percentage point.

Incorporating the 40-70 basis point drag on inflation from the stronger dollar would indicate a total tariff passthrough into price levels of 0.3% to 0.6% of the CPI. All else equal and in a calm economic environment, such a modest increase would be a one-time boost to the price level and thus transitory, rather than contribute to lasting inflation. In more turbulent times and greater inflationary cross-currents, such a change may work its way into inflation expectations and become more persistent, contributing to a goods-wage inflationary spiral. The economic context into which tariffs are levied will be of significant importance, and the fragility or robustness of inflation expectations and local supply elasticities at current macroeconomic equilibrium can play substantial roles. Certainly there was no indication in 2018-2019 of a goods-wage spiral.

If the currency markets adjust, tariffs can have quite modest inflationary impacts, between 0% and 0.6% on consumer prices. Given the inflation volatility of recent years, this is nontrivial, but hardly earthshaking. Clearly, the experience of 2018-2019 was that there were only imperceptible increases on the general price level. Moreover, the totality of tax reform, deregulation, and energy abundance can serve as meaningful disinflation drivers that smother any incipient inflationary impulses; it is quite possible that even with substantial tariffs, Trump Administration policy is overall disinflationary. I will later turn to the likelihood of whether currency markets will adjust, as well as to the risks of retaliation, which can alter the tariff analysis.

Incidence, Revenue, and Trade Flows

Like inflation, the question of who bears the burden of the tariff will depend on what prices adjust, but there are more nuances. In a world of perfect currency offset, the effective price of imported goods doesn’t change, but since the exporter’s currency weakens, its real wealth and purchasing power decline. American consumers’ purchasing power isn’t affected, since the tariff and the currency move cancel each other out, but since the exporters’ citizens became poorer as a result of the currency move, the exporting nation “pays for” or bears the burden of the tax, while the U.S. Treasury collects the revenue.

While the effective price paid by U.S. importers may not change very much with perfect currency offset, U.S. exporters now face a competitiveness challenge insofar as the dollar has become more costly for foreign importers. Presumably, they have hedged most of their currency exposures, and this can help lessen that pain in the short run. Thus there is a tradeoff: if currencies perfectly adjust, the U.S. government collects revenue in a noninflationary way paid by foreigners via reduced purchasing power, but exports may become encumbered. Policymakers can in part alleviate any drag on exports by an aggressive deregulatory agenda, which helps make U.S. production more competitive. Recent work by Goldbeck (2024) flags the increase in regulatory-related compliance under the Biden Administration as costing the economy over 1% of GDP per year, while research from Laperriere et al (2024) suggests those costs could be twice as large. Improvements in competitiveness driven by regulatory reform can offset drags on competitiveness due to currency appreciation. By contrast, if currency offset does not occur, American consumers will suffer higher prices, and the tariff will be borne by them. Higher prices will, over time, incentivize a reconfiguration of supply chains. American producers will have improved competitiveness selling into the American market, and importers will be incentivized to find alternatives to the tariffed imports. As trade flows adjust, the trade balance can decline, but then the tariffs will no longer collect much revenue.

These tradeoffs are listed in Table 2, though of course reality may fall in between these extremes: PERFECT CURRENCY OFFSET NO CURRENCY OFFSET Inflation Noninflationary (after-tariff USD price unchanged) Inflationary (tariff passed through) Incidence Paid for by tariffed nation via reduced purchasing power from weaker currency Result in more expensive consumer goods Trade flows Little effect on trade flows, as effective import prices don’t increase and regulatory reform offsets currency effects on exports Rebalancing over time as imports are more expensive relative to domestic production Revenue Treasury raises revenue As trade rebalancing away from the tariffed goods occur, Treasury raises less revenue

Table 2: Comparison of outcomes under total and no currency offset of tariffs Once again, there is a disconnect between the macro experience and studies of the microdata on questions of incidence. However, note that in Cavallo et al (2021), the microdata indicate that price hikes occurred for prices paid by importers, and that those prices were not passed through to retailers. In other words, the incidence fell on reduced retailer profit margins, rather than consumers themselves. This helps further bridge the gap between the microdata and the macro experience in price data. The same questions about the microdata studies pertain to the finding of reduced wholesaler margins as well: primarily that this is a short-term effect, and that in the long-run changes to wholesaler profitability will lead to other changes that will end up passing through the cost. Over time, wholesalers will find ways to source products more cheaply. Moreover, this result implies that profitability was enhanced for Chinese exporters, since they experienced both currency depreciation and passthrough of tariff costs to retailers—over time, competition among them will lead to reduced profitability, or rebalancing of trade flows to other exporters or domestic producers.

Currency Offset and Financial Markets

While reducing volatility in consumer prices, currency offset can actually imply greater and not less volatility in financial markets, at least in the short term. For instance, the volatility of early August was deeply intertwined with moves in the Japanese yen. Carry traders borrowing in yen to buy higher-yielding assets in other currencies were highly levered, and the assets they were long were also held by other types of highly levered investors. When the carry trade began to unwind somewhat—due to a shift in the stance of the Bank of Japan and an increase in the unemployment rate in the United States—the long assets were sold by levered traders managing their risk exposures. The result was significant financial market volatility, in which the Nasdaq Composite Index fell 8% in three sessions.

USD / JPY N ASD AQ Composite N A S DAQ CO M POS ITE A N D U S D/J PY 0 15,000 16,000 17,000 18,000 19,000 0 125 135 145 155 165 March April May June July August 2024 Figure 6 During the flash-crash of early August, the correlation between the yen and stocks was near complete. Source: Bloomberg

Similarly, imagine a very large tariff on China, say a sharp increase in the effective tariff rate from roughly 20% to roughly 50%, offset by a similar move in the currency. A 30% devaluation in the renminbi would most likely lead to significant market volatility. Because China’s communist economic system necessitates strict control over the capital account to keep funds locked in domestic assets, the incentives to find ways around capital controls could be devastating for their economy.

Capital outflows from China can potentially result in asset price collapses and severe financial stress. According to Bloomberg, total debt in the Chinese economy exceeds 350% of GDP (Figure 7); this level of leverage entails the possibility for massive vulnerabilities to leakages in the capital account. Bursting bubbles in China as a result of currency devaluation could cause financial market volatility significantly in excess of that caused by the tariffs themselves.

Financial market volatility from currency moves may far exceed the volatility from total passthrough of tariffs into consumer prices. For example, consider the case of total passthrough of a 10% tariff, that boosts consumer prices by 1%, with no currency offset. Such a move is a one-time shift in the price level, not a persistent increase in the inflation rate, and may therefore be ignored by the central bank, in which case there are not likely to be much in the way of financial fireworks. If the central bank fears second-round effects taking hold, it may hike rates—say, by 75 basis points, half of what it would if it considered a persistent 1 point increase I the inflation rate. Such an adjustment to monetary policy will likely induce less volatility than a 10% move in currency markets. It’s worth noting that value-added taxes are a form of tariffs because they exempt exported goods but tax imported goods, and central banks usually do not respond to them, because legislated price changes are typically thought not to be indicative of underlying supply-demand imbalances. (Indeed, the fact that other countries have VATs and we do not says something about initial conditions.)

Even without a currency or monetary response, tariffs can affect profitability. For instance, Amiti et al (2021) estimate that firms more exposed to tariffs experienced steeper declines in equity value in the days following tariff announcement. There are a few problems taking these results at face value, however: many of these estimates are statistically insignificant from zero effect, and markets are prone to excess volatility. What matters is whether there is a lasting effect from the tariffs, and as any investor knows, initial market responses often unwind or reverse over time. C H I N A TOTAL ECO N O MY D EBT (% G D P) 0% 100% 200% 300% 400% 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 China Total Economy Debt (% G DP) Figure 7 Excessive levels of debt in the Chinese economy. Source: Bloomberg

How Likely is Currency Offset to Occur?

The economic and market consequences of tariffs hinge on the extent to which they are matched by offsetting changes in currencies, so it is important to consider the likelihood that currencies do adjust. In the U.S.-China trade war of 2018-2019, currency offset was effective. However, there were several crosscurrents at the time that make the comparison cloudy.

For instance, the dollar was appreciating more broadly than just vs. China; during the period discussed above, the DXY dollar index maintained by the Intercontinental Exchange, which measures the dollar against other developed nations, also increased by about 10%. As mentioned above, currency moves in one pair can affect other assets too, just as an unwind in the yen carry trade affected all financial markets.

Given the significance of the USD-RMB pair to the global economy and markets, it is possible a good portion of the move in DXY was driven by the move in USD-RMB. Such a possibility is bolstered by trends in interest rates over the period. The most powerful financial variable for explaining currency moves in developed markets is typically the spread in interest rates at the front end of the yield curve; market participants usually use two-year yields, but the convention varies depending on the interest rate and economic environment. In the period of the trade war, the yield advantage of UST securities was declining relative to the yields on other G7 debt; the spread declined from about 2% in January 2018 to about 1.65% at the trade war armistice in September 2019.

The decline in spreads occurred despite the rate hikes from the Federal Reserve over the course of 2018. This happened because markets marked down their expectations for future rate hikes as the economic data came in over the course of 2018. Of course, currency markets would typically follow changes in expected policy rather than the (already-priced-in) policy hikes occurring in real-time. A fully-expected change in policy should have no effect on currency markets. Thus it is highly unlikely the dollar appreciated because of monetary policy during this period; it appreciated in spite of monetary policy.

2 YE AR YI E LD SPR E AD VS . FX UST 2s - G7 Average Dollar index (D M) 90 91 92 89 95 96 100 1.5 1.6 1.4 2.0 2.1 2.2 2.3 2.4 2.5 0 0 Jan Apr Jul Oct Jan Apr Jul Sep 2018 2019 1.7 1.8 1.9 93 94 97 98 99 Figure 8 Dollar index vs. the spread on sovereign U.S. two-year debt relative to the average on two-year debt for other G7 nations. Source: Bloomberg

In 2025-2026, the yield spread of Treasury securities over other nations’ debt may narrow if the Fed continues its cutting cycle catching up to other central banks and the special factors boosting U.S. growth—like fiscal policy— further fade and U.S. growth converges down to the rest of the world’s. A declining-yield environment might make it more difficult for the dollar to rally to offset tariff hikes, although the experience of 2018-2019 shows currencies can move against interest rate differentials.

Alternatively, concerns over U.S. debt sustainability may come to the fore and prevent the dollar from appreciating to offset tariffs. The U.S. deficit for last fiscal year and this fiscal year are both near 7% of GDP9, during a peacetime expansion—an unprecedented degree of fiscal laxity. And with the Social Security Trust Fund set to run out of money in 203310, at which time the government will likely be forced to borrow to pay mandatory expenditures, budget woes draw inexorably nearer.

Since currencies always trade relative to each other, markets would have to become inordinately preoccupied with U.S. budget problems for this to prevent a rise in the dollar. Given many other nations’ precipitous demographic trends, they have severe budget problems lurking in their futures as well, even if their primary deficits are not projected to rise as much. Moreover, because tariffs raise revenue, deficit concerns are likely to be allayed by hikes in tariff rates, suggesting this is an unlikely channel to prevent appreciation.

A further reason the dollar might not appreciate as in 2018-2019 is if it starts from stronger levels. In 2018, the DXY index was at the bottom of its post-2014 range. At writing, it is in the middle of that range. This would be more of a concern if the DXY was stretched near the top of its long-term range.

Finally, the dollar will be cross-buffeted by cyclical and secular changes to growth. There may be other changes which weigh on economic growth and prevent dollar appreciation. By contrast, former President Trump has expressed a desire to take steps to aggressively deregulate portions of the economy. If doing so serves as a boost to growth, it may provide further noninflationary support for the dollar.

Summing this all up, it is of course possible that currency offset does not occur in the next iteration of tariffs, but considering plausible reasons why that might be the case, offset seems more likely than not.

Tariff Implementation

A sudden shock to tariff rates of the size proposed can result in financial market volatility. That volatility can take place either through elevated uncertainty, higher inflation and the interest rates required to neutralize it, or via a stronger currency and knock-on effects thereof. President Trump, and those likely to staff his economic policy team, have a history of caring deeply about financial markets and citing the stock market as evidence of economic strength and the popularity of his policies. A second Trump Administration is likely therefore take steps to ensure large structural changes to the international tax code occur in ways that are minimally disruptive to markets and the economy. There are several steps that would help mitigate any adverse consequences.

Graduated Implementation

Even in the 2018-2019 trade war, President Trump didn’t implement 25% tariffs on Chinese imports in one swoop with no warning. He discussed these plans publicly and threatened China if it didn’t reform its trade practices, before implementing tariffs. Subsequent to open threats, they were implemented in such a manner that the roughly 18-point increase in effective tariff rates was spread over more than a year. 9 To consider its effects on aggregate demand, supply and markets, last year’s deficit has to be adjusted to offset accounting technicalities surrounding the Biden Administration’s failed attempts to forgive student loans, see: https://www.cbo.gov/publication/59544 . 10 https://www.ssa.gov/OACT/TRSUM/index.html

In going to 60% tariffs on China or 10% globally, such an approach becomes even more important. During his first Administration, President Trump sought to use tariffs to procure a trade agreement from China, which ultimately found shape in the “Phase 1” agreement—a commitment to improve practices on intellectual property, cyber security, nontariff barriers, openness to financial services, and purchases of agricultural commodities— that was subsequently violated and disregarded by China. Because tariffs are a negotiating tool, the President was mercurial in their implementation—the uncertainty over whether, when, and how big adds to leverage in a negotiation, by creating fear and doubt.

In a second term, there’s less cause to negotiate with the Chinese up front, since they already abdicated their responsibilities under the Phase 1 agreement. When someone has already demonstrated they walk away from their commitments, why bother trying to procure more, without some form of security—like placing their UST reserves in escrow?

Instead, to help minimize uncertainty and any adverse consequences of tariffs, the Administration can use credible forward guidance, similar to what is used by the Federal Reserve across a range of policies, to guide expectations. The U.S. Government might announce a list of demands from Chinese policy—say, opening particular markets to American companies, an end to or reparations for intellectual property theft, purchases of agricultural commodities, currency appreciation, or more.

The U.S. can proceed to gradually implement tariffs if China does not meet these demands. It might announce a schedule, for instance, a 2% monthly increase in tariffs on China, in perpetuity, until the demands are met. Such a policy will 1) gradually ramp tariffs at a pace not too different from 2018-2019, which the economy seemed able to easily absorb; 2) put the ball in China’s court for reforming their economic system; 3) allow tariffs to exceed 60% midway through the term, which is something President Trump has expressed wanting (“60% is a starting point”); 4) provide firms with clarity over the path for tariffs, which will help them make plans to deal with supply chain adjustments and moving production outside of China; 5) limit financial market volatility by removing uncertainty regarding implementation.

2018-2019 did not severely hobble China’s economy and bring back all its supply chains to the United States. In part, this is because it was a one-time shock to tariff rates, which was mostly offset by the currency. By contrast, a plan like the one set forth above would result in a perpetually rising tariff rate on a known and gradual path. That would likely instill much greater capital pressures on China and more rearrangement of supply chains.11 And with significant pressure on China, it is likely to achieve greater trade concessions. Critically, in the wake of their abdication of Phase 1 commitments, Chinese obligations under trade agreements should now be secured rather than unsecured.

Graduated Scales, Leverage and Security

The last trade war saw gradations of tariff rates for different types of products imported from China. It is likely that the next Trump Administration take a similar approach with respect to both products and trading partners. While President Trump has proposed a 10% tariff on the world as a whole, such a tariff is unlikely to be uniform across countries.

Scott Bessent, a Trump advisor floated as potential Treasury Secretary, has proposed putting countries into different groups based on their currency policies, the terms of bilateral trade agreements and security agreements, their values and more. Per Bessent (2024), these buckets can bear different tariff rates, and the government can lay out what actions a trade partner would need to undertake to move between the buckets. 11 Of course, supply chains might have ultimately had greater adjustments if the Phase 1 deal reached in the fall of 2019 had been enforced. Given China abandoned it as soon as the Biden Administration took over and the Biden Administration had no interest in trying to enforce it, it is unclear if the trade war of 2018-2019 would have had more lasting consequences.

In this manner, tariffs create negotiating leverage for incentivizing better terms from the rest of the world on both trade and security terms. America would encourage other nations to move to lower tariff tiers, improving burden sharing. One can imagine a long list of trade and security criteria which might lead to higher or lower tariffs, premised on the notion that access to the U.S. consumer market is a privilege that must be earned, not a right. For example, maybe the U.S. wants to discriminate based on:

• Does the nation apply similar tariff rates to their imports from the U.S. as America does on their exports here? • Does the nation have a history of suppressing its currency, for instance via the accumulation of excessive quantities of foreign exchange reserves? • Does the nation open its markets to U.S. firms in the same way America opens its markets to foreign firms operating stateside? • Does the nation respect American intellectual property rights? • Does the nation help China evade tariffs via re-export? • Does the nation pay its NATO obligations in full? • Does the nation side with China, Russia, and Iran in key international disputes, for instance at the United Nations? • Does the nation help sanctioned entities evade sanctions, or trade with sanctioned entities? • Does the nation support or oppose U.S. security efforts in various theaters? • Does the nation harbor enemies of the United States, e.g. terrorists or cybercriminals? • Do the nation’s leaders grandstand against the United States in the international theater?

Because of the concern of the impacts of such a system on global markets, a Trump Administration may want to pursue a rate phase-in approach as described above, starting with low tariffs and only hitting the maximum 10% rate over time. Moreover, such a system is likely to begin with a small number of criteria as it is tested out, and then the criteria can grow in number.

If the system is effective over time either at raising revenue or incentivizing more favorable treatment from trading partners, it could eventually have a top tariff rate significantly in excess of 10%, that applies to a small number of countries. Similar to the domestic tax code, once the government starts carving out exclusions and deductions for various behaviors, it needs to raise rates to achieve the same revenue goals.

Such a system can embody the view that national security and trade are joined at the hip. Trade terms can be a means of procuring better security outcomes and burden sharing. In Bessent’s words, “more clearly segmenting the international economy into zones based on common security and economic systems would help … highlight the persistence of imbalances and introduce more friction points to deal with them.” Countries that want to be inside the defense umbrella must also be inside the fair trade umbrella.

Such a tool can be used to pressure other nations to join our tariffs against China, creating a multilateral approach toward tariffs. Forced to choose between facing a tariff on their exports to the American consumer or applying tariffs to their imports from China, which will they choose? It depends on the relative tariff rates and how significant each is to their economies and security. The attempt to create a global tariff wall around China would increase the pressure on China to reform its economic system, at the risk of significantly more global volatility as supply chains come under greater pressure to adjust.

From America’s perspective, if other nations choose to keep their current policies vis China but accept the higher U.S. tariff, that’s not terrible—because then, in this framework, at least they’re paying revenue to Treasury, and limiting the security obligations of the United States. Joining a tariff wall with a security umbrella is a high-risk strategy, but if it works, it is also high reward.

Tariffs and Competitiveness

Government revenue must come from somewhere, and requires some form of taxation. The characteristics of the tax code will affect overall economic growth and international competitiveness. Many in the Trump camp see them as joined. The relative cost of producing goods for export, or importing from elsewhere, can be affected by whether a nation taxes labor, consumption, capital, or trade. This argument was given explicitly for the Tax Cuts and Jobs Act in Council of Economic Advisers (2018).

Fiscal Devaluations

The literature on so-called fiscal devaluations fleshes out this idea. For instance, Fahri, Gopinath and Itskhoki (2013) show that the economic effects of devaluation in the exchange rate can be perfectly replicated either by two combinations of policies: either an import tariff and an export subsidy, or a consumption tax increase and payroll tax cut. These combinations discourage domestic use of goods and services and encourage domestic production, and result in identical economic outcomes to currency devaluations. Tax policies and currencies are two avenues for achieving a boost to competitiveness—and this equivalency helps build the intuition for currency-tariff. (Note that what is not the same in each of these policy mixes is the net amount of revenue raised.)

Because of the emphasis on competitiveness, it is unlikely that a second Trump Administration will support an increase in domestic tax rates, whether corporate or income. Its goal will be, in large part, to make America a more attractive place to invest and hire than other countries, particularly China, and higher domestic tax rates undermine that goal. Indeed, the Tax Cuts and Jobs Act of 2017 reduced in the United States’ statutory corporate rate from the second-highest in the OECD in 2016 (after Colombia) to the average (21.2% in 2021)12. Work by Chodorow-Reich, Smith, Zidar and Zwick (2024) estimated that the domestic investment of firms with mean tax changes increased by 20% relative to a no-change baseline. 13 In that sense, the preservation of low tax rates is a means of generating investment and jobs in America—and even better when financed in part by tariffs on foreign imports.

This argument extends to income tax rates as well. As long as labor supply is not perfectly elastic, an income tax will reduce the after-tax wage received by workers and require firms to offset some of the tax with higher wages. An increase in taxes on labor income thereby makes it more expensive to employ workers in the United States relative to employing workers abroad or investing in labor-saving capital. More expensive workers, all else equal, means fewer jobs relative to machines or imports.

Distortions and Optimal Tariff Rates

Economists have also spent much time studying how the tax code affects economic decisions, known as “distortions,” if they take the economy away from a first-best, efficiency-maximizing equilibrium. The economic distortions are the loss of welfare that occur beyond the revenue raised. For example, suppose a taxpayer reduces her working hours from 45 per week to 40 per week because her income tax rate increased. While she enjoys more leisure, the goods or services she would have produced in those five hours, and the salary she would have received, cease to exist and are lost to the economy forever. The “deadweight loss” or “excess burden” in this stylized example is the lost production, net of the increased leisure she enjoys and revenue raised by the government. Of course, there are many decisions that can get adjusted, not just the number of hours worked—job choice, education choice, entrepreneurship, whether compensation is in the form of cash or fringe benefits, location, and much more.

These distortions are a function of the marginal tax rate paid, not the average tax rate, since the decision whether 12 See https://www.oecd.org/en/about/news/press-releases/2024/07/new-oecd-data-highlight-stabilisation-in-statutory-corporatetax-rates-worldwide.html 13 A 20% boost resulting from a 14-point cut in statutory rates might sound small, but that is because the effective marginal rate paid by many firms was well below the statutory rate due to numerous carve-outs and extensive transfer pricing incentives which were in part eliminated via TCJA. In that sense, TCJA was a base-broadening but rate-reducing reform to the corporate tax code, and the effective reduction in marginal tax rates was much lower than the statutory reduction (on average, 7 points, per Chodorow-Reich et al).

to work those last few hours depends on the marginal and not average rate. And some of these distortions can have enormous consequences over time—for instance, if firm location decision is affected by taxes, agglomeration economies may be strongly inhibited, sharply decreasing innovation and productivity growth over the long term. The distortionary costs of taxation are convex, i.e. tax hikes are much more costly when starting from already-high rates. A one-point hike from 35% to 36% marginal tax rates is much more damaging to the economy than a onepoint hike from 2% to 3%. Costs are convex because the higher tax rates move, the more intensely households and firms adjust their behavior to avoid the tax burden.

Because marginal rates are already much higher on labor and capital income than they are on imports, the economic consequences of an increase in tariff rates might well be less problematic than an increase in income or corporate rates. For instance, Saez, Slemrod and Giertz (2012) provide a benchmark for what economists call the “marginal excess burden” of raising a further $1 of revenue. They calculate that the marginal excess burden is equal to 38% of revenue raised. To understand what this means, go back to the example of labor supply: when the government chooses to extract $1 from the worker’s salary, she reduces her work by an additional amount worth a total of 38c, net of the increased leisure she enjoys and revenue collected. By contrast, trade economists argue that for a large economy, imposing a positive tariff level is modestly welfareenhancing, up to a point. Classically, modest tariffs can improve welfare because reduced demand from the tariffimposing country depresses prices of the imported goods.14 While the tariff produces distortionary welfare losses due to reduced imports and more expensive home production, up to a point, those losses are dominated by the gains that result from the lower prices of imports. Once import reduction becomes sufficiently large, the benefits from lower prices of imports cease to outweigh the costs, and the tariff reduces welfare. That tariffs initially increase and then subsequently decrease welfare implies an “optimal” tariff rate, at which point the country has reaped all possible benefit from tariffs and a higher tariff rate reduces welfare. For a benchmark, the Handbook of International Economics chapter by Costinot and Rodriguez-Clare (2014) indicates that the optimal tariff for the United States under plausible parametrizations is around 20%. Indeed, as long as tariffs don’t exceed 50%, they are still welfare-enhancing relative to completely open trade. In other words, increasing effective overall tariffs from currently low levels near 2% will actually boost aggregate welfare in the United States. Once tariffs begin increasing beyond 20% (on a broad, effective basis), they become welfare-reducing. Investment houses are now projecting that the projected effective rate of the tariffs proposed by President Trump will jump from 2.3% to 17%, just shy of this 20% level.15

Moreover, tariffs can address pre-existing distortions due to other nations’ trade policies. The list of China’s abuses of the international trade system is long and storied, and ranges from state subsidies for export-oriented industries to outright theft of intellectual property and corporate sabotage. These distortions interfere with the discovery of comparative advantage and a free and open system of international trade. Applying corrective tariffs to address these distortions may improve overall efficiency.

Where these arguments run into trouble is when other nations begin retaliating against U.S. tariffs, as China did modestly in 2018-2019. If the U.S. raises a tariff and other nations passively accept it, then it can be welfare-enhancing overall as in the optimal tariff literature. However, retaliatory tariffs impose additional costs on America and run the risk of tit-for-tat escalations in excess of optimal tariffs that lead to a breakdown in global trade. Retaliatory tariffs by other nations can nullify the welfare benefits of tariffs for the U.S. Thus, preventing retaliation will be of great importance. Because the United States is a large source of consumer 14 See, for instance, Broda, Limao and Weinstein (2008). 15 See https://www.wsj.com/economy/trade/donald-trump-election-trade-tariffs-aed6c281 A User’s Guide to Restructuring the Global Trading System 26 demand for the world with robust capital markets, it can withstand tit-for-tat escalation more easily than other nations and is likelier to win a game of chicken. Recall that China’s economy is dependent on capital controls keeping savings invested in increasingly inefficient allocations of capital to unproductive assets like empty apartment buildings.

If tit-for-tat escalation causes increasing pressure on those capital controls for money to leave China, their economy can experience far more severe volatility than the American economy. This natural advantage limits the ability of China to respond to tariff increases.

With respect to other nations, if the Trump Administration merges national security and trade policy explicitly, it may provide some incentives against retaliation. For instance, it could declare that it views joint defense obligations and the American defense umbrella as less binding or reliable for nations which implement retaliatory tariffs. Additionally, it’s not clear whether one should view the failure of this deterrent as a bad outcome. Suppose the U.S. levels tariffs on NATO partners and threatens to weaken its NATO joint defense obligations if it is hit with retaliatory tariffs. If Europe retaliates but dramatically boosts its own defense expenditures and capabilities, alleviating the United States’ burden for global security and threatening less overextension of our capabilities, it will have accomplished several goals. Europe taking a greater role in its own defense allows the U.S. to concentrate more on China, which is a far greater economic and national security threat to America than Russia is, while generating revenue. What is clear, however, is that given all these considerations, the Trump team will view tariffs as an effective means of raising taxes on foreigners to pay for retaining low tax rates on Americans. The reduced personal income tax rates introduced by the Tax Cuts and Jobs Act are due to expire in 2026 and extending them in full without raising deficits may require raising almost $5 trillion of new revenue or debt over a ten-year budget window. Doubtless, tariffs are a big part of the answer for extending the tax cuts; revenue must come from somewhere.