Tariff Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A tariff is a tax on imports. Tariffs are typically used for two reasons: to raise tax revenues and to protect domestic industries. Successive rounds of multilateral negotiations have reduced tariffs to historically low levels.

When taxing imports, governments may state tariffs as a specific tariff, an ad valorem tariff, or a combination of both tariff types. A specific tariff is a per unit import tax that is independent of the underlying value of the import, for example, a per unit tax of $10 or $20. An ad valorem tariff is a fixed percentage of the import price, for example, 5 percent or 10 percent. The final tariff, a combination tariff, has both per unit and value added components, for example $2 + 2.5 percent. The form the tariff takes has implications for how the tariff is implemented in practice, but does not affect the economic impact of the tariff. Specific tariffs, because of their simplicity, are easier to implement than ad valorem and combination tariffs. Ad valorem tariffs, because their application relies on the valuation of imports, are more difficult to implement.

Economic Impact Of A Tariff

In evaluating the economic effect of a tariff, the economics convention of comparing the equilibrium outcomes with tariffs to the equilibrium outcomes with free trade is initially adopted. If an economy is initially enjoying free trade, the imposition of a tariff will cause the domestic price of the import good to increase. Although domestic prices have increased, the post-tariff receipts of foreign producers that export goods to the home market have not increased, and as a result, total imports fall. Domestic producers, unlike foreign producers, receive the now-higher domestic price. As a result, domestic producers expand their production levels. In effect, tariffs have resulted in an international reallocation of production. The tariff has had the effect of protecting domestic producers as evidenced by the reduced competition that they face from foreign producers. The tariff has also created tariff revenues. The protection of the domestic industry has come at a cost, however, as higher domestic prices hurt domestic consumers. Overall, the welfare of the economy is reduced as the consumer loss exceeds the combination of producer gain and increased tariff revenue.

If initially an import tariff was in place and subsequently reduced and/or removed, then the effects of such tariff reductions would be the opposite of that described above. A reduction in the tariff levels would reduce the domestic price of the good, and as a result, consumers would benefit. However, it would also cause the domestic sector to contract, because the price they receive for products is now lower. Additionally, a reduction in tariffs would make the domestic market more attractive to foreign producers, and as a result, imports in the domestic market would increase. Overall, the welfare of the economy is increased as the consumer gain exceeds the combined reduction in tariff revenues and loss to domestic producers. This illustrates that reducing tariffs will improve aggregate welfare in the economy.

One exception to the welfare-improving effect of tariff reduction is in the case of a large country. When a country is “large” in international economics terms, modest tariffs may actually increase welfare. A country is defined as being “large” in an international economics context if it can change world prices for its import good due to its trade policy choices. This occurs because the large country is a major consumer of the good in question, and any shifts in its demand for the good will affect the equilibrium price.

Starting from a position of free trade, if a large country imposes a tariff, both the domestic price and the international price of the good will change. The effects in the domestic market are as previously described, with domestic prices to consumers increasing. This will cause consumer welfare to decrease. However, the effect on the world price is different than previously discussed. Given the importance of a large country, foreign producers are willing to share the tariff burden with consumers in the large country by absorbing part of the tariff. This means that the net per unit revenue to foreign producers after the tariff is lower than the free trade price. In essence, the tariff has caused the world price to fall, and the import good is now cheaper to purchase than before. This creates a benefit to consumers, as the post-tariff price is lower than it would have been otherwise, and offsets some of the consumer welfare loss. If the benefit from a reduction in the world price is more than sufficient to compensate for the net consumer welfare loss, then the tariff may actually increase welfare. When this occurs, the optimum tariff for the large country (that is, the tariff that maximizes welfare) is positive. It is possible, therefore, for a large country to lose from the removal of tariffs. Most countries are small, and therefore removing tariffs for most countries improves their welfare.

Effective Tariff

The overall economic effect of a nominal tariff depends on the tariff structure in the economy. A nominal tariff is simply the stated tariff on a product. For example, the average nominal tariff on industrial goods after the Uruguay Round of the World Trade Organization (WTO) is 3.8 percent. While 3.8 percent is the stated level of protection, the effective level of protection that industrial products receive may be different than this nominal tariff rate, as additional tariffs may have been imposed on goods at various stages of production. The economic effect of tariffs imposed on goods that are used at the early stages of the production process will be magnified, and will affect the effective tariff on goods that use these early products as inputs.

Consider a simplified three-stage production process with raw materials, intermediate goods, and final goods. The tariff structure is a simplified one, with zero tariffs on raw materials and intermediate goods, and a 5 percent tariff on final goods. The effective rate of protection on the final goods will be 5 percent, as the domestic producers of the final good face input prices that have not been distorted by trade policies. In this instance, the nominal tariff and the effective tariff are the same.

The tariff structure may be more complex, such as zero tariffs on raw materials, 3 percent tariff on imported intermediate goods, and a 5 percent tariff on finished goods. The impact of this tariff structure is twofold: the first effect is an increase in the domestic price of the intermediate good by 3 percent; the second effect is an increase in the domestic price of the final good by 5 percent. Both price increases affect final good producers. They continue to benefit from a 5 percent increase in the final good price, but are hurt by the 3 percent increase in the price of the intermediate good, which is an input in the production of the final good. The 3 percent tariff on the intermediate good dilutes the gains from the 5 percent tariff on the final good. The effective rate of protection in this case is no longer equal to the nominal rate of protection because of the transfer of some of these gains to the intermediate goods producers. In fact, the effective tariff for the final good is now lower than the nominal tariff of 5 percent. Further complexity in the tariff structure to include tariffs on raw materials will have similar effects on the effective tariff, faced at both the intermediate and final good stages.

The extent to which tariffs on intermediate goods erode the tariff protection afforded to the final good sector depends on the importance of the intermediate good in final good production, as measured as a share of input costs. When intermediate goods account for a small share of final good input costs, then the impact on the effective tariff on final goods will be smaller than when intermediate goods account for a large share of final good input cost. In extreme cases, tariffs on intermediate goods may become so burdensome that the effective tariff on the final good is negative. A negative effective tariff on the final goods would occur, for example, if the tariff on the final goods is zero percent while the tariff on intermediate goods is 3 percent.

In recognition of the forward cascading effect of tariffs, tariff structures are sometimes based on the tariff escalation principle, with lower tariffs for raw materials and increasing tariffs as the degree of processing increases. Tariff structures that are based on de-escalation (that is, higher tariffs on raw materials and lower tariffs on finished goods) may result in negative effective tariffs for processed products.

Bibliography:

James E. Anderson and J. Peter Neary, Measuring the Restrictiveness of International Trade Policy (MIT Press, 2005);
Jacques Gallezot and Vincent Aussilloux, “Collected Customs Duties: The Level of Taxation on Imports Applied by the US and the EU,” World Economy (v.31/9, 2008);
Carsten Kowalczyk, ed., “The Theory of Trade Policy Reform,” in International Library of Critical Writings in Economics, vol. 127 (Elgar Reference Collection, 2001);
Philipp J. H. Schröder, Real Versus Tariff Liberalization: A Welfare Comparison Under Monopolistic Competition (Aarhus School of Business, 2004);
World Trade Organization, “Understanding the WTO,” www.wto.org (cited March 2009).

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