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:

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.

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.