understanding tariffs and how they work

Tariffs have been big news lately, part of the news cycle that overhypes everything Trump-related for the glory of clicks and views. It’s a little crazy, and it’s a bit hard to understand everything related to tariffs, so I’m here to give you a little basic info.

A tariff is a tax, that’s the bottom line. Tariffs are levied by governments, which is why they are a type of tax, and they are levied specifically on goods of one sort or another.  Traditionally, tariffs are levied on imported goods, that is, items made outside the United States and brought into the country to be sold to Americans for fun and profit.  Another word for a tariff is a duty; while the two words have slightly different connotations when it comes to imported goods, we use them as equivalents for each other. I’ll be using tariff throughout this post.

(You can read another post I wrote about tariffs, “protective tariffs, motorcycles and the beef lobby.”)

The first tariff in US history came from the Tariff Act of 1789, and indeed it was the first law of any sort passed by the new government established by the US Constitution (also created in 1789).  The new US government needed to not just boost, but create an economy that would sustain its efforts, and they still (to a certain extent) held a grudge against England.  It’s no joke that England was an economic powerhouse in the late 18th century – the British Empire legit ruled most of the world at that point.  However, the new US government found itself needing to promote business and manufacturing at home, so that’s where the impetus for the Tariff Act of 1789 came from.

The US and UK signed a treaty in 1783 that ended the American Revolution; one of the aspects of that treaty allowed the British unfettered navigation of the Mississippi River.  This greatly benefitted the British, but did not benefit the Americans much.  The British pushed the favor by passing the Navigation Acts (in 1783), which forced non-British ships – especially American ones – to pay heavy duties (i.e. taxes) when they offloaded their goods in British ports.  The Brits followed this law up with two others that further restricted American goods getting into British hands, so the Tariff Act of 1789 was in part a retaliation against this sequence of laws enacted by the British Parliament.

The Tariff Act of 1789 required foreign ships offloading goods in US ports to pay 50 cents per ton, while US-registered ships paid just 6 cents per ton.

Here’s an easy way to understand the situation.  Let’s say you make sails, and you charge $5 for a ton of sails.  You can sell your sails in America for $6 a ton and do well.  If you make your sails in England, and ship them to the United States, your distributor/importer has to pay $6.50 for one ton of sails.  If you make sails in the US (and transport them via ship), your distributor has to pay $6.06 for their ton of sails.

boat-classic-clouds-173910There’s the kicker, then. If you, as the distributor, sell both US- and UK-made sails, you can sell them to retailers at the same price, $7 a ton.  If you do that, you make just 50 cents on the UK-made sails, while raking in 94 cents on the US-made sails.

Let’s take it a step further, though, because what retailer makes just 50 cents on something?  No, as the retailer, you’re going to sell your UK-made sails for $10 a ton. This ups your profit to $3.50 a ton, but you can justify that higher price because those sails are made in England, and of course everybody knows British ships are awesome and they have been ruling the oceans for decades, so UK-made sails command a premium for their real or perceived quality difference over US-made sails.  Raising the price of the imported sails enables you to absorb the cost of the tariff.  Get this, though – everybody knows there’s a 50 cents-per-ton tariff on UK-made sails, so you can charge $10.50 per ton and now you’re making $4 per ton in profit without anybody complaining, because they know that 50 cents is going to the government, which of course is protecting you and American business/industry.

Jump back and look at the US-made sails, though.  Sure, they’re slightly inferior quality to the premium UK-made sails, but ships gotta have sails, right?  Instead of selling them for $7 a ton, you can sell them for $8 a ton, which gives people the impression they’re still getting a deal over the UK-made sails, but now you’ve upped your profit to $1.94 per ton, and because of the $2 per ton price difference, you’re likely to sell more US-made sails than UK-made ones, which improves your overall bottom line.  You can even up the price to $8.50 a ton, which still keeps them $2/ton below the cost of the UK-made sails (profit now $2.44/ton). You can safely buy fewer tons of UK-made sails, knowing you’ll sell more US-made ones at the now artificially higher price.  Plus you can feel good for supporting US industry!

There’s some lessons in there to unpack.

  1.  Tariffs are taxes charged to import goods into a country.
  2.  Tariffs can be absorbed by the importer or passed on to the consumer.
  3.  Because tariffs artificially raise the price of imported goods, domestic goods can be priced high and still look like a bargain to the consumer.

Think about this, though: What distributor in their right mind is going to eat the cost of the tariff?  That’s not good business, especially if your margins are razor-thin, like they are for many goods.  We’re talking mere cents of profit, with businesses relying on volume to really make money.  Wouldn’t you, a smart business owner in a capitalist economy, pass the cost of the tariff straight on to your customer?  Yes, you would, because you need to maintain your margins for your business to succeed.  You were already selling your goods for as low a price as you could, so you can’t really absorb the cost of the tariff.  The importer passes it on to the distributor, the distributor passes it on to the retailer, the retailer passes it on to the consumer.

Thus, the most important lesson of all: THE CONSUMER PAYS THE TARIFF.

This is not unique to the United States.  European consumers pay their tariff costs, Chinese consumers pay their tariff costs, Indian consumers pay their tariff costs and so on, just like American consumers do.

You might be wondering who benefits from higher tariffs, or really from tariffs at all. The government levying the tax is who benefits.  They collect the tariff up front at the ports.  They collect taxes on the money made by the distributor, the wholesaler and the retailer.  They then collect a sales tax when the consumer buys the product.  The government benefits every step of the way from tariffs, and that, my friends, is the whole reason tariffs exist in the first place – no matter where you live, no matter what form of government you are under and no matter what types of goods you’re buying.

Remember that.

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