If you’ve been following the news, you’ve undoubtedly learned that President Trump has been attempting to negotiate a new trade agreement with China. He has adopted tariffs as his primary tactic to force China to agree to terms he believes are favorable to the United States. However, China has responded in like fashion and both countries now appear to be embroiled in a trade dispute that has the potential to seriously derail an otherwise relatively strong global economy.

When President Trump announced his latest round of tariffs on May 13, the stock market plummeted. The Dow Jones Industrial Average was down by over 700 points during the day. Trade wars are not good for any economy. Nor are they good for investors. Unless the United States and China de-escalate their destructive negotiating practices, consumers and investors in both countries, and indeed the world, will suffer.

We felt a need to address this situation, because the President has been misstating the way in which tariffs work. He has, on numerous, occasions claimed that American workers will benefit and that China is paying “billions” in tariffs to the United States. This is false, as this is not how tariffs work. Let’s go back to economics 101 for a short tutorial on tariffs.

A tariff is a tax placed on goods imported by one country from another country in an effort to get the that country to agree to some change in trade practices, or to make those imports less attractive compared to domestically produced alternatives. The tax is stated as a fixed fee or as a percentage (“ad valorem”) of the value of the goods imported. The tax is paid by the importers in the country assessing the tariff. It is not paid by the exporter or the exporting country. So, in the current situation, American importers are paying taxes on goods they are bringing in from China. Manufacturers in China are not paying this tax and the Chinese government is not paying it.

Economists don’t like taxes, because they distort markets. Let’s consider washing machines, as an example. Last year President Trump placed a tariff on them at a rate that started at 20% and eventually rose to 50% by year end. So, if a washing machine cost $1,000 as it entered the United States, the tariff added $500 to the cost to the importer of that machine. The importer of the washing machine has tough decisions to make in reaction to such a tariff. The importer can pass along to the end consumer some portion of the cost of both the machine and the tariff. If the importer were to pass along 100% of the tariff and ignoring any profit markup to the importer, the machine would cost $1,500 instead of $1,000. However, the importer can probably assume that the average consumer will not be willing to pay an additional 50% for a washing machine. So, the importer may choose to absorb some of this additional cost. This practice will result in both less profit for the importer and a more expensive washing machine to the consumer. What about the tariff paid by the importer? It is paid to the United States Treasury.

Why did President Trump place a tariff on washing machines? He claimed he was attempting to protect domestic manufacturers and factory workers. How has it worked out so far? The New York Times reports that, according to researchers at the University of Chicago and the Federal Reserve, “the price of a washing machine went up by $92. Consumers bore between 125% and 225% of the costs of the washing machine tariffs. The tariffs brought in $82 million to the United States Treasury, while raising consumer prices by $1.5 billion. And while the tariffs did encourage foreign companies to shift more of their manufacturing to the United States and created about 1,800 new jobs, the researchers conclude that those came at a steep cost: about $817,000 per job.”

The researchers also found that the price of dryers also went up. Why, you might ask? Because manufacturers used the cover of a price increase for washing machines to raise the price for dryers. Manufacturers know that consumers typically buy new washers and dyers together. So, they used the price increase induced by the tariff on washers as an opportunity to raise prices on dryers. This also allowed them to absorb some of the price increase on washing machines. The researchers believe the average price increase was over 11% for each machine.

What about the cost of domestically produced washers and dryers? Interestingly, those prices went up as well. It seems that domestic manufacturers increased prices as well in an effort to raise their profits. This could be fairly easily done, because consumers don’t necessarily realize where the products they purchase are actually made. So, American manufacturers of washer and dryers, unaffected by the Trump Administration tariff, could raise prices without much notice.

What will happen if these tariffs remain? Global manufacturers and domestic distributors will shift production to other countries that are not subject to the tariffs. Yes, production will increase to some modest extent in the United States. However, the cost of the jobs associated with this increase in domestic manufacturing will come at a very steep price.

You can read an article in The New York Times for more perspective on this.

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