The Cost of Tariffs on Chinese Products

Who pays for U.S. tariffs on Chinese goods?  According to some in the popular press, the answer is that the tariffs on China are paid entirely by U.S. importers, and eventually by U.S. consumers.  This answer seems to be based on the observation that U.S. importers must pay the tariff to the U.S. Customs authorities before the imported goods can cross the border.  Further, this assumes that the entire tariff is passed along to U.S. purchasers of those imports.  According to this view, a 25 percent extra tariff on all imports from China, which were valued at $540 billion in 2018, would result in tariff revenue to the U.S. government of $135 billion ($540 billion x 25%), and this would entirely be passed on to U.S. purchasers in the form of higher prices.
 
There are at least two problems with this view.  First, if the tariffs are fully implemented, imports from China would no longer be $540 billion, but in fact would be much less.  Tariffs are taxes, and if taxes raise prices to the ultimate purchasers, then these higher prices will also discourage the purchase of the taxed products.  The extent of this reduction in purchases depends on a host of factors, but the Law of Demand says that other things equal, higher prices reduce consumption.  Second, as is taught in introductory economics, the distribution of the actual burden of a tariff between importers and exporters is independent of which party is legally responsible for making the tariff payment.  Instead, the distribution of the tariff burden is determined by the responsiveness of demand and supply to price changes, the so-called “elasticity” of demand and supply.  In general, both sides will share the costs of a tariff, with the less elastic side bearing the larger share of the burden.   
  
In this regard, it is important to recognize that the tariffs under consideration are specific to goods imported from China and not a general tariff on all goods of a specific type. Because goods from other countries are not subject to these tariffs, U.S. purchasers can avoid the tariffs by purchasing similar goods from other countries, or from U.S. producers.  This substitution of goods from other countries increases the responsiveness of U.S. purchasers to price changes and will put downward pressure on the prices of Chinese imports, thereby shifting the burden of the tariffs toward Chinese producers and away from U.S. purchasers.

Finally, this substitution effect will grow stronger over time.  If the tariffs remain in place, there will be a move of production facilities from China to other countries.  Firms in China will be incentivized to move facilities to other countries, and firms already outside of China will be incentivized to expand their facilities.  The longer tariffs remain in place, the stronger is this effect.  In the end, the volume of Chinese imports would considerably decrease, and a tariff specific to China would consequently generate much less revenue to the U.S. government and impose much smaller price increases on U.S. purchasers.    

Consider an analogy to a new sales tax imposed only on goods sold in Walmart stores.  Since Walmart customers can avoid this new tax by shopping at Target and other stores, purchases from Walmart would decline, and purchases from Target and other stores would rise.  Moreover, Walmart would be under extreme pressure to match Target’s prices in order to keep its customers.  As a result, prices at Walmart would not go up by the entire amount of the increase in taxes, and Walmart profits would decline.  Finally, other stores would be incentivized to increase the size and number of stores, and Walmart stores would have shrinking sales and possibly be forced to reduce the number of stores or even to cease business.  In the long run, there would be much less tax revenue collected under the new Walmart-specific sales tax.  

None of this means that a Walmart-specific sales tax would be costless to the economy.  There is an economic cost when consumers who prefer Walmart are incentivized by the sales tax to shop at other less-preferred stores.  There is an economic cost to the higher prices that Walmart will charge to those who still shop at Walmart, and there is also an economic cost when Target charges slightly higher prices as they see an influx of consumers trying to avoid the Walmart tax.  There is an economic cost to the owners of Walmart, and to Walmart employees who will be displaced and have to seek employment at other stores or at other firms. All of these costs, both adjustment costs and lost economic efficiency, are detrimental to the economy.  But they are not calculated by multiplying the new sales tax rate times the past quantity of Walmart sales. 

How should we think of the costs to the U.S. of tariffs on China?  The immediate cost depends on the uniqueness of the goods China sells to the U.S.  If there are close substitutes currently available from other countries (e.g., then the costs will be lower as the U.S. will easily turn to other countries to purchase those goods. In addition, this substitution will put downward pressure on the prices of goods imported from China, further shifting the burden of the tariff to producers in China. 
 
If China is the only producer of a commodity (e.g., certain rare earth metals), then the immediate costs of tariffs to the U.S. are higher. However, even if China is the only producer of a good, the higher tariffs will cause higher prices and lead U.S. purchasers to buy less of the more expensive product, partially mitigating the impact of the tariff.
 
In the long run, even goods currently unique to China might have production facilities move to other countries, or new firms might open production facilities outside of China (China currently has a huge share of the market for rare earth metals, but production has occurred in other countries in the past and could be restarted, even in the U.S., if we are willing to deal with the environmental impact.) Over time there will be an increasing substitution of non-Chinese production for the goods subject to the China-specific tariff.  This movement of production facilities and rearrangement of supply chains will take time and impose real costs, but further down the road, this phenomenon will further mitigate the impact of the tariffs.
 
Make no mistake, there is an efficiency loss in all cases from imposing these tariffs.  The pre-tariff production and trading patterns, the pre-tariff supply chains, were the result of a market outcome in which firms and consumers sought to minimize their cost of producing and acquiring certain desired products. Tariffs will lead to changes in these production and trading patterns, in these supply chains, resulting in both non-trivial adjustment costs and higher product prices for U.S. purchasers.  But even after the adjustments are completed, there will be a loss of efficiency when compared to the pre-tariff situation, including reduced competition from producers in China and less efficient supply chains and production arrangements.
 

Posted: June 13, 2019 by Dennis W. Jansen, Liqun Liu, Andrew J. Rettenmaier