What are the economic effects of a tariff increase in a large economy

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Economic Effects of a Tariff Increase in a Large Economy

Decline in Domestic Output and Productivity

A significant body of research indicates that tariff increases lead to a decline in domestic output and productivity. Studies using data from 151 countries over several decades consistently show that higher tariffs result in economically and statistically significant reductions in output growth and productivity . This decline is more pronounced when tariffs are raised during economic expansions and in advanced economies .

Increase in Unemployment and Inequality

Tariff hikes are also associated with higher unemployment and increased inequality. The imposition of tariffs disrupts labor markets, leading to job losses and greater income disparity . This is because tariffs can make imported goods more expensive, reducing the overall demand for goods and services, which in turn affects employment levels.

Real Exchange Rate Appreciation

Another observed effect of tariff increases is the appreciation of the real exchange rate. This means that the domestic currency strengthens relative to foreign currencies, making exports more expensive and imports cheaper, which can further exacerbate the negative impact on domestic industries .

Minimal Impact on Trade Balance

Interestingly, the impact of tariff increases on the trade balance is generally small. Despite the intention of tariffs to protect domestic industries by reducing imports, the overall effect on the trade balance is often negligible . This is because the reduction in imports is often offset by a corresponding decrease in exports due to retaliatory tariffs and reduced competitiveness.

Negative Effects on Consumption and Investment

Higher tariffs act like a tax increase, negatively affecting consumption and investment. Consumers face higher prices for goods, reducing their purchasing power, while businesses face higher costs for imported inputs, leading to reduced investment in capital and innovation. This can slow down economic growth and reduce the long-term productive capacity of the economy.

Disruption of Global Supply Chains

Tariff increases can significantly disrupt global supply chains, especially in economies that are deeply integrated into global trade networks. For instance, the U.S.-China trade war led to substantial changes in supply-chain networks, increased costs for intermediate and final goods, and reduced availability of imported varieties . This disruption can lead to inefficiencies and increased costs for businesses, further hampering economic growth.

Reduction in Real Income

The full incidence of tariffs often falls on domestic consumers and importers, leading to a reduction in real income. For example, the tariffs introduced by the Trump administration in 2018 resulted in a monthly reduction of $1.4 billion in aggregate U.S. real income by the end of that year. Similar patterns were observed in countries that retaliated with their own tariffs, indicating that trade wars can reduce real income globally.

Long-Term Negative Effects on Economic Growth

In the long run, persistent tariff increases can negatively affect the productive capacity of the economy. Higher tariffs can slow the accumulation of capital, shift resources into less productive sectors, reduce competition, and interfere with technological advancements. These factors collectively contribute to a slower growth rate and reduced economic dynamism.

Conclusion

In summary, the economic effects of a tariff increase in a large economy are predominantly negative. Tariff hikes lead to declines in domestic output and productivity, higher unemployment and inequality, real exchange rate appreciation, and minimal impact on the trade balance. They also negatively affect consumption and investment, disrupt global supply chains, reduce real income, and have long-term detrimental effects on economic growth. These findings underscore the complex and often adverse consequences of protectionist trade policies.