Introduction

Protectionism is once again on the ballot in the 2024 US election. The choice: sharply higher tariffs—and potentially universal tariffs—under Trump, versus targeted, selective tariffs under Harris. Assessing the impact of any tariff policy on inflation and growth is challenging, given the complexity and changing pattern of global supply chains. As a general rule: the more extreme the tariff, the more stagflationary it is. We see a roughly 50% chance of a “gesture” policy, 40% of selective tariffs and a nearly 10% chance of sustained universal tariffs.

Under a universal tariff scenario, we would expect bond yields to decline and US equities to fall by around 10%, with the biggest impact on retailers, auto manufacturers, tech hardware, semiconductors, and parts of industrials. Beyond the initial risk-off shock, universal tariffs are likely negative for the US dollar. Uncertainty about the election outcome—and hence, any specific trade policy—remains high. Therefore, we discuss strategies to hedge risks.

Chapter 1

Why are tariffs an issue?

The world has embarked on what is arguably the most significant structural change in 250 years, and what economists term the “fourth industrial revolution.” Over the past decade, automation, digitization, social media, artificial intelligence, and similar technologies have altered the way economies and societies function. While investor attention is often captivated by the introduction of a new technology (e.g., the 3D printer, the computing power of the smartphone, or the connectivity of modern communication), the more serious economic impact comes from the upheaval in society.

Working practices, consumption habits, and methods of manufacturing shift, changing the demand for labor, transport, and real estate. An individual’s relative income, security, and social status all change as the economic revolution unfolds. This is great for those who find themselves on the way up. For those who find themselves on the way down in the brave new world, things are a lot less satisfactory.

Individuals who see their relative economic and social status in decline inevitably want to place the blame somewhere. While the true causes are a series of complex structural changes, these types of explanations often fall upon deaf ears. The simple solution is to find a scapegoat, but in the world of scapegoat economics, some unfortunately see foreigners—who are, by definition, alien to the domestic economy—as one of the easiest groups to blame.

This then builds economic nationalism, a specific form of prejudice politics. Politicians can then infer that by restricting actions of foreign actors, they will be able to bring about a return to better times. Economic nationalism is thus often visible through trade and capital flow protectionism, as trade is the way that foreigners are most likely to be visible to the domestic voter. It is no coincidence that polls show a majority of Americans from across the political spectrum don’t believe that the US has gained more than it has lost from trade, especially among lower-income voters (see Fig. 1).

This is a global phenomenon. Economic nationalism has been rising in Europe, Asia, and the US. It means that the issue of trade protection has become politically salient.

Fig. 1: Column chart showing the share of US voters who say the US has gained more than lost from global trade

Complexity and trade

The traditional view of global trade has evolved very little over the centuries. Many voters (and politicians) seem to regard trade in quite simplistic terms—goods are made at home from domestic materials, packed onto a ship, and sold to a foreigner.

Modern trade is almost nothing like this. Two related trends have emerged over the years. First, up to two-thirds of global trade is not taking place between separate entities, but is simply moving goods around inside companies with a global footprint. The rise of global corporations with production facilities scattered across several countries means that trade may represent moving parts up and down an internal supply chain.

In part because of this, most of the increase in global trade in goods over the past thirty years has been due to increasingly complex supply chains rather than necessarily an increase in domestic consumers’ desire to buy “foreign-made” goods. This can be easily seen with the increased importance of intermediate goods (components, essentially) as a share of overall trade.

Thirty years ago, a company might import raw materials from an external supplier abroad, manufacture at home, and export a finished product to a final consumer. Today, a company’s supply chain likely involves its product passing among different subsidiaries located in perhaps eight or ten different countries before a final sale to an end user at home. This trend created large and politically significant shifts in the location where tradable goods were produced, as well as in the associated levels of employment, even as global trade volumes rose.

These changes in global trade mean that the impact of tariffs on the global economy has evolved in recent years. The economic pain of tariffs may fall on domestic producers as much as overseas companies. It means that using past trade taxes to judge the economic impact of future potential tariffs is not very helpful.

For example, US President Nixon imposed a universal 10% “import surcharge” by presidential proclamation in August 1971, with the aim of forcing other countries to revalue their currencies against the US dollar. However, this general tariff increase (the first since the infamous Smoot-Hawley tariff of 1930) was accompanied by government price and wage controls which in the very short term prevented any domestic inflation impact.

Ultimately, the price controls were a disaster, triggering product shortages and helping to fuel a wage-price spiral when they imploded; it is unlikely price controls would be repeated today. Nixon lifted the tariff by the end of the year. That would leave current-day US prices and economic output more exposed to the effects of a universal tariff. US imports of goods were 3.4% of GDP in 1971, compared to 12.7% in 2023 (see Fig. 2). The economic impact of import taxes (i.e., tariffs) were therefore significantly less than they would be today.

President Trump’s imposition of tariffs on selected imports from China may be looked upon as a more modern example of trade taxation. The value of goods imported directly from China that are subject to tariffs has fallen by over 50% compared to 2017 levels. However, the value of these same imports from other countries has risen by more than the value that China’s imports have fallen (see Fig. 3).

The rest of the world has generally replaced China in supplying taxed products to the US. In addition, some of this shift in supply chains may represent the rerouting of China’s exports via third countries. An export from China that stops in Canada may have a maple leaf sticker applied to the side of the box and recorded as a Canadian sale to the US. Mexico, Canada, and the euro area picked up three-quarters of China’s lost market share in tariffed goods between 2018 and 2020. The complexity of global supply chains can make it difficult to identify and tax products that are small parts of a larger manufacturing process.

Fig. 2: Line chart showing that imports have grown as a share of the US economy
Fig. 3: Line chart showing that US tariffs diverted some Chinese imports to other countries

What do tariffs actually do?

A tariff is a sales tax that is applied after goods arrive in a country. The tax is paid by the domestic buyer—and tariffs are often applied with the intention of changing the behavior of domestic buyers. The buyer (importer) is generally a company, not a retail consumer. The buyer pays a higher price, either because they pay the tax that the tariff represents or because they purchase a higher priced (or conceivably lower quality) alternative. In theory, the exporter could cut prices in order to accommodate the tax burden. In practice, this rarely happens. Analysis of the 2018 US tariffs against China suggests almost the entirety of the tax was borne by US buyers.1

The nation in which a seller is located has little incentive to devalue its currency. While devaluation could offset the tariff’s effects, the tariff will increase import costs for the entire domestic economy (and increase the cost of imported components for use in export production, reducing the trade benefit). We therefore do not think of a tariff as being applied to a foreign country, like China, but as being applied to domestic buyers of goods made in China.

Inflation: As a tax, a tariff’s direct impact is on price levels. A tariff will produce a one-off increase in a product’s price. As such, the direct impact of the tariff is to raise inflation rates for a single year as the price reflects an additional tax burden. A tariff will not add to prices subsequently, although it may cause behavioral changes (wage demands, profit-led inflation, reduced competition, etc.) that produce second-round inflationary effects.

There is, however, a big difference between the price that is subject to a tariff and the price that the final consumer pays. There are two reasons for this. In the case of the US, less than one-third of US imports are consumer goods (including passenger cars). Almost 70% of US imports are inputs into domestic production—inevitably, given the role of complex supply chains in trade. A 10% tariff on a semiconductor used in a washing machine does not justify a 10% increase in the price of a washing machine.

Even for consumer goods there is a big difference between the import price level and the consumer price level. A lot happens to a good between arriving at a port (when the tax is applied) and when the consumer buys it. Costs related to advertising, domestic transport, warehousing, and retailing, not to mention profit margins at each stage, all have to be paid for—and these add to the consumer price. As a result, the import price for a consumer good may well be less than half the price paid by the consumer. Even if all of a 10% tax on a product sitting on the dockside in the Port of Los Angeles is passed through to the US consumer, on average that should represent something less than a 5% increase in the price the consumer pays at the store. To give just one example, almost a quarter of what US consumers spend on goods goes to pay for the costs (and profits) of the shop or website, and these are unaffected by the tariff.

Pricing power is also important. Where imports are intermediate goods, there is the possibility that the tariff will be absorbed by slightly smaller profit margins along the supply chain. In 2018, companies along US supply chains appeared to be nervous that they could not pass on price increases, and part of the tariff increases meant squeezed margins. If the recent inflation episode has changed the psychology of companies, passing on price increases may be more commonplace than in earlier tariff episodes. A specific, more aggressive form of this is the risk of profit-led inflation, where prices rise by more than is justified by the tariff. Consumers may think that a 10% tariff means that a 10% increase in the price that they pay is “fair” (when it clearly is not).

Perhaps the simplest way to think about the impact of a tariff—a tax on trade—is to consider the relative importance of imports to a nation’s economy. In 2023, imports of goods into the US were the equivalent of 12.7% of GDP. Had a universal 10% additional trade tax been applied to those imports, and had it been passed along supply chains to the consumer, that tariff would have added 1.3% to price levels in the US economy over the subsequent quarters.

Growth: A tariff is a tax, and tax increases are negative for economic activity because they imply consumers have less money to spend. It is, of course, possible that other taxes are cut to offset the tariff, making the tax revenue impact neutral. However, this may still be a net negative. A tariff is a sales tax, and sales taxes will often hit lower-income groups harder because they spend a higher proportion of their income. While an income tax cut may offset the revenue gains from the tariff, the distribution of the income tax cut is unlikely to exactly match the distribution of the tax increase represented by the tariff.

Tariffs may reduce the competitiveness of domestic firms through the impact on intermediate goods prices. A tax on imported intermediate goods (components like microchips) will increase production costs for domestic producers. That puts those manufacturers at a competitive disadvantage relative to foreign competitors. For example, looking at the tariffs from 2018/19, US users of components from China experienced a one-off increase in costs that Canadian users of those same components did not face. Canadian producers were given an immediate competitive advantage. Export Development Canada offered specific advice to help Canadian companies importing components from China that were subject to US tariffs for use in producing finished goods that would be exported to the US. The tariff could not be avoided completely, but as long as there was a sufficiently large difference between the component and the finished product, Canadian firms were making the same thing as their US competitors with lower-cost inputs.

Transnational companies that use imported components may switch production to foreign locations. That reduces domestic production and potentially domestic jobs. For smaller companies that do not have the option of switching locations, this competitiveness challenge will either threaten to reduce sales or alternatively squeeze profit margins.

Firms that use imported components specifically to make exports have a more complicated situation. They may be able to claim Foreign-Trade Zone status. The company effectively pretends that its factory sits outside the taxing country. If components are used to make goods for export, those components are not subject to tariff. This is not costless: As might be imagined, there is a lot of paperwork involved in this sort of process. But this can help to reduce the competitiveness damage of a tariff in a complex supply chain.

For example, in May 2024 BMW submitted a Foreign-Trade Zone request for its factory in Spartanburg, South Carolina to allow it to import components without tariff, which could be used to manufacture cars for export from the US. The exemptions would apply to a range of components from glass adhesives to crankshaft sensors.

Economic activity will also potentially be affected by retaliation from trade partners. As other countries put in place retaliatory tariffs, their own consumption growth will fall, thereby slowing global growth.

Endnotes

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