Jim de Bree | Economics 101: Who Bears the Costs of Tariffs

President Trump claims the Chinese are paying for the tariffs imposed by his administration. Recently an administration official said the Chinese are already lowering their prices of goods that are subject to tariffs.

For a person who prides himself on his business acumen, President Trump apparently fails to understand that tariffs cost everyone. 

To understand who bears the cost, let’s consider the following example:

A Chinese manufacturer fabricates widgets for export to the United States. The widgets cost $40 to make and the Chinese company sells them to an American importer for $70. The importer then resells the widgets to American consumers for $100. Profit of $60/widget is shared by the Chinese manufacturer and the American importer. 

The reason why widgets are made in China instead of America is because it costs more than $70 to fabricate widgets in America. 

Most goods made overseas are manufactured pursuant to a contract where the manufacturer agrees to produce a certain quantity of widgets at a pre-determined price. The importer typically does not have the ability to renegotiate the price.

The United States imposes a 25% tariff on widgets made in China. The tariffs are based on the widget’s retail value. Unless the price is changed, the U.S. Treasury will collect $25 in tariffs from the importer for every widget sold. The cost to the consumer is now $125. If the price is not reduced to compensate for the tariffs, demand for widgets will decrease and fewer widgets will be sold. That means that the importer will have more unsold widgets in inventory. In the short term, the Chinese manufacturer is unaffected because he was still paid $100/widget.

Alternatively, the importer can insulate the consumer by absorbing the $25 tariff. The importer reduces the retail price to $80, so the consumer’s cost is still $100 after the tariff. However, the importer has lost two-thirds of its profit. The reduced profit margin may not cover the importer’s overhead and it may have to reduce its payroll and other costs. Again, in the short term, the Chinese manufacturer is unaffected. 

Over the longer term, the importer will attempt to renegotiate the contract price of manufacturing the goods. At that point the manufacturer may agree to a lower price, or it may decide to sell its products to customers in countries that do not impose tariffs. It is possible that it will agree to absorb part of the tariff cost by reducing the price it charges the importer, or it may produce fewer widgets.

Tariffs are most effective in an environment that is restricted to bilateral trade. Unfortunately, for nations imposing tariffs, modern trade is multilateral; the manufacturer can sell to other countries. 

If the importer instead chooses to purchase the goods from a U.S. manufacturer, it will pay more for the goods and will likely pass on a portion of those costs to the consumer. 

The second part of the situation is retaliation. History shows that nations that have tariffs imposed on their products retaliate by imposing tariffs themselves. All of this increases the cost of goods, leading to decreased demand and an overall decline in economic activity. 

When it comes to retaliation, China has an advantage over the U.S. because a significant portion of our exports to China are agricultural products, which are sold at spot market prices. Unlike the Chinese manufacturer who has contractual protection in the short term, American farmers sell based on current market prices. If the demand for American crops plummets, they are either sold at a loss or remain unsold. Furthermore, the Chinese are free to buy agricultural products from other countries. 

China can also sabotage our agricultural exports by not inspecting them when they arrive in Chinese ports. The products spoil on the docks. Since title to the goods does not pass until after the inspection, the Chinese buyers don’t have to accept the spoiled product. 

Given the forgoing, it is hard to see how the Chinese are paying for much of the U.S. tariffs. 

According to recent research published by the Federal Reserve Bank of New York, the U.S. economy suffered monthly losses of $1.4 billion since the imposition of tariffs in 2018. 

In its May 31 analysis, the Tax Foundation, a conservative tax policy think tank, stated the following:

“If all tariffs announced thus far were fully imposed by the United States and foreign jurisdictions, U.S. GDP would fall by 0.79% ($196.66 billion) in the long run, effectively offsetting about half of the long-run impact of the Tax Cuts and Jobs Act. Wages would fall by 0.51% and employment would fall by 609,644 full-time equivalent jobs.”

If the Democrats want to win in 2020, instead of pursuing impeachment, perhaps they should consider letting the tariffs run their course. 

Jim de Bree is a semi-retired CPA who resides in Valencia.

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