Consistent with expectations, Donald Trump has amped the rhetoric on tariffs – he plans to impose 25% tariffs on products coming into the US from Mexico and Canada and an additional 10% duty on Chinese imports. The US President-elect has also threatened a 100% import tariff on members of the BRICS alliance should they go ahead with their plans of floating a new currency, challenging the supremacy of the US Dollar.
In the event that Mr. Trump holds good on his plans, it would be tempting for countries to retaliate via reciprocal tariffs on US imports. However, that may not be the best response. To appreciate that, let us understand the implications of such tariff imposition from both micro- and macroeconomic perspectives.
Economic theory tells us that tariffs drive a wedge between the producer’s price in the exporting country and the consumer’s price in the importing country, resulting in a loss of welfare, especially for consumers. Results from new generation trade models make it explicitly clear that the US itself would bear the brunt of these tariffs.
For instance, a recent study by CEPII — “the leading French center for research and expertise on the world economy” — shows that while global trade and GDP would fall by 3.4% and 0.5%, respectively, from a 10% rise in US tariffs, the corresponding decline in US trade (22.9% in exports and 17.5% in imports) and GDP (1.3%) would be far more significant.
This is not surprising in a world of regional and global value chains (GVCs), where all countries, including the US, rely on imports of parts and components from other countries, not just from China. Thus, an increase in the price of these imported intermediate inputs due to higher tariffs would raise production costs for US firms, reducing their competitiveness in international markets, and adversely affecting US exports.
Tariffs also generate dynamic inefficiencies that reduce productivity. They do so by creating a protected market and shielding domestic firms from international competition that stifles the need to remain innovative. Moreover, firms growing behind tariff walls tend to use their resources to lobby for more and longer protection, rather than on increased R&D or capital expenditure.
There would also be second-order macroeconomic effects. The ensuing rise in price level would lead to inflationary consequences for the US economy, forcing the Fed to raise interest rates. This would disincentivize domestic private investment, which would have adverse implications for economy-wide productivity, growth and employment (though this may be partly offset by inflows of foreign capital attracted by the higher rates.
With US public debt already rising to alarming levels, the rate hike would further enhance the government’s deficit, leading to a vicious circle of more indebtedness.
Of course, it is also possible that firms in China, Mexico and in other countries targeted by Trump’s tariffs absorb some of the impact of the tariff by lowering the prices of the goods and services that they produce. While this depends on their costs of production and the market structure – i.e., whether there are few or many producers of the good or service in question – there are limits to such price reduction.
Moreover, such price adjustments would inevitably erode the quality of the goods and services produced – for e.g., if the targeted firms start using low-quality parts & components in their own production to lower their costs – which again hurts the US consumer. (Note that Chinese and Mexican services would also be impacted by these tariffs to the extent that such services intensively use the targeted goods as inputs. ICT services are a case in point.)
Thus, tariffs basically shoot the importing country in the foot, which therefore does not make sense for any country, including India, to respond to US tariffs with a tit-for-tat strategy. In fact, the best response to such a tariff hike would be to buy even more US goods and services should they have the best price and quality globally.
With the resurgence in industrial policy and the US, EU and China in particular heavily subsidizing their domestic industries, targeted countries should take advantage of the lower prices that these subsidies are likely to lead to in international markets. Let us therefore use the largesse from Trump and the US exchequer to make our own industry more competitive.
(The author is Associate Professor, Finance & Economics, S. P. Jain Institute of Management and Research (SPJIMR); Views expressed are personal)
