Tariffs, Trade Wars, and Policy Shifts under Trump: A Tutorial on the Global Economy and Trade

There was a kind of a cottage industry of economic studies done on the first round of Trump tariffs in his first administration, and the results were a bit mixed, although a number of the studies found that the tariffs primarily passed through to U.S. buyers. So, they’re mostly being paid by the purchasers of foreign goods in the United States.

Rich Ford: This is Stanford Legal, where we look at the cases, questions, conflicts, and legal stories that affect us all every day. I’m Rich Ford with Pam Karlan. Please subscribe or follow this feed on your favorite podcast app, and that way you’ll have access to all of our new episodes as soon as they’re available.

Just weeks before he was elected President of the United States, during a conversation at the Economic Club of Chicago, Donald Trump declared, “The most beautiful word in the dictionary is tariff. And it’s my favorite word.” And as the President-elect takes to the bully pulpit, leaders of nations threatened with new tariffs are calling Trump or flying down to  Mar-a-Lago to make their case.

To help us make sense of the fascinating world of trade, tariffs, and the global economy, we’re thrilled to have our colleague, Alan Sykes. Alan is a leading expert on the application of economics to legal problems, whose most recent scholarship is focused on international economic relations. His writing and teaching have encompassed international trade, torts, contracts, insurance, antitrust, international investment and the economic analysis of law. He’s the author most recently of a book called The Law and Economics of International Trade Agreements.

Welcome to the show, Al.

Alan Sykes: Thank you. Pleasure to be here.

Pam Karlan: Al, I think maybe where we should start is just what exactly is a tariff?

Alan Sykes: A tariff is a tax imposed at the border on goods coming across the border. So it’s just a … like a sales tax except it’s only imposed on imported goods.

Pam Karlan: So, if it’s like a sales tax, who pays it?

Alan Sykes: Well, that’s a standard kind of tax incidence question. Economics 101 would say it depends on the elasticities of supply and demand. The tax will tend to fall more heavily on the less elastic side of the market. So you have to ask to what extent can consumers find substitutes easily? If so, that makes demand more elastic and they’ll bear less of the tax on the producer side. 

You have to know something about the producer’s cost functions and their opportunities to sell in other markets to avoid the tariff. And so it’s a complicated empirical issue. There was a kind of a cottage industry of economic studies done on the first round of Trump tariffs in his first administration, and the results were a bit mixed, although a number of the studies found that the the tariffs primarily passed through to U.S. buyers, so they’re mostly being paid by the purchasers of foreign goods in the United States. That changed a little bit over time. Some of the studies found that over time, foreign sellers reduced their prices a bit.Some of the studies found that some U.S. buyers, like retailers, absorbed the tariffs rather than passing them on in full to consumers. 

So it’s actually a complicated empirical question, but there’s no question that the U.S. buyers will pay a good chunk of the tariffs, and the amount that’s borne by foreign sellers is variable depending on the sector and the circumstances and the long run versus the short run and so forth.

Pam Karlan: Yeah, so why would we have tariffs rather than an income tax or tax on sales generally, that is …what’s the theory behind why a tariff is a good form of taxation?

Alan Sykes: Well, I don’t think most people think it is a good form of taxation in developing countries historically and even some today, the apparatus to impose an income tax or a payroll tax isn’t available and so governments may depend for revenue on tariffs, which they can enforce at the border

Pam Karlan: So that’s like in the early 19th century, why would have had tariffs in the United States?

Alan Sykes: Exactly. So the U.S. federal revenue back in the founding era was largely coming from tariffs. But in the modern era, we do have the apparatus to impose other sorts of taxes. And so we would think that a non-discriminatory sales tax on goods from wherever, they are made would be a preferable economic option because that wouldn’t distort the decision over where to produce things or from whom to buy things. We might think that income taxes are a better source of revenue because they’re easier to make progressive and can be administered fairly easily without having to tax every little transaction that goes on in the economy. So there are a lot of reasons to think that other taxes are generally better for raising revenue.

Pam Karlan: So for raising revenue, that makes sense. One of the things that President-elect Trump claims is that if he imposes a tariff, it will bring manufacturing back to the United States. What’s the theory behind that and do you think that’s a persuasive theory?

Alan Sykes: Well, the theory is fairly simple. If you raise taxes on imported goods that are competing with domestic manufacturing, that will allow the domestic manufacturers to expand their output, employ more workers and raise their prices.

So they’ll be able to operate profitably on a larger scale than they would be if they didn’t face the foreign competition. Whether it works empirically or not is another question. U.S. manufacturing employment is pretty stagnant. It’s pretty much the same today as it was before COVID. So the various tariffs that we’ve seen imposed in recent years haven’t done much to expand U.S. manufacturing.

Pam Karlan: The other thing is, you know, you see some discussion about, which seems to me, both things can’t be true. Both that the tariff will raise a lot of revenue, and the tariff will bring manufacturing back to the United States. It would seem to me that, at most, it will do one or the other of those things.That is either there will be a lot of stuff brought into the country that will be subjected to a tariff, which will raise a lot of money, in which case there’s not much more manufacturing going on here. But if the manufacturing’s going on here, and so the goods that are being sold here are being manufactured here, then they won’t be subjected to a tariff, so you won’t raise any revenue.

Am I missing something there?

Alan Sykes: No, that’s right. If you had imposed a prohibitive tariff on imports, imports would be zero and revenue from tariffs would be zero. If you have a low tariff on imports, you’ll raise some revenue because it doesn’t knock them out of the market altogether, and there will be some expansion of domestic production and competition with imports, which will diminish the tariff revenue to be sure as their substitution away from imports toward domestic goods. So there’s a tradeoff there, but you could have…you could have some revenue and some growth in domestic production as a theoretical matter. As an empirical matter, the notion that tariffs are going to raise significant revenue in relation to the size of the U.S. budget is not very plausible.  I think, tariff revenue today is something like two tenths of a percent of the U.S. Federal revenue. And even with much higher tariffs we’d still be talking about small potatoes

Pam Karlan: And if we impose these tariffs on other countries, presumably some of those other countries will then start imposing tariffs on stuff coming from the United States, which I take it is … our agricultural sector is a particularly vulnerable sector?

Alan Sykes: Yeah, agriculture, other things that we kind of specialize in the higher technology area—retaliatory tariffs are–certainly we’ve experienced those with China in the recent past—and I suspect we would find retaliatory tariffs in response to new tariffs going forward. So that’s one of the reasons why, even if you are able to expand the import-competing industries somewhat, you usually find that the export industries contract and the net impact can be adverse. It’s also important to recognize that tariffs on intermediate goods can often cause manufacturing to contract.

When I was in private practice, I did a so-called safeguard case where the International Trade Commission authorized tariffs on imports of copper into the United States. But we were able to persuade the Reagan administration at that time that would actually cost the economy jobs because downstream wire and brass mills were much more labor intensive than copper mining. And we would actually shrink those industries and jobs by more than we would gain in the upstream copper industry. So there’s that dimension of it too, that you have intermediate goods subject to tariffs—that can often backfire in terms of expanding your manufacturing sector.

Pam Karlan: And if you’re an economic planner for the federal government, how do you manage to figure this stuff out? That is, what is the ideal tariff rate on stuff—zero or is it something else? How do you … how do they go about figuring that out?

Alan Sykes: As economists say, it depends a little bit on what you’re maximizing. If you’re maximizing global welfare, if you want the global economy to be as efficient as possible, generally speaking, the optimal tariff is going to be zero. Just let the markets be free, let people specialize in what they do best, and let trade be as economical as possible. It is, if you’re a large country, you have a certain amount of what economists call monopsony power in your economy, and so your consumers collectively can influence the price of what we pay at the border for things by adjusting the total quantity of our purchasers.

And in that setting, there is this thing called an “optimal tariff,”  which ends up actually benefiting the country that uses it. But it’s a beggar thy neighbor policy. It hurts foreign countries and it’s adverse to global welfare. And the optimal tariffs tend to be very small, for the most part.

Pam Karlan: So these 100 percent tariffs, for example, that Donald Trump is talking about, there’s no economic sense to doing that?

Alan Sykes: Certainly not any efficiency justification for that unless … you always have to qualify: Is there some national security concern? Is there some supply chain vulnerability to having us so dependent on Taiwan semiconductor for our commodity chips and so on?

Pam Karlan: Wouldn’t it just be banning the import of the good altogether? If you put more national security, presumably you don’t want to just say, Well, we’ll make people pay more for it.

Alan Sykes: But you might want to encourage the expansion of domestic production. And so that’s the whole idea behind the CHIPS Act. The Democratic Party tends to favor subsidies rather than tariffs, so the Democratic policy has been to subsidize chip making.

I think Trump is more of a tariff person than a subsidy person. But there are sometimes plausible reasons to want to make sure that you have domestic productive capacity in certain things, and that might involve tariffs as a protective tool. But those are going to be very specialized targeted industries where there’s real vulnerability if you don’t build up your domestic capacity. So it certainly wouldn’t be 100 percent across the board tariffs on all sorts of different products—that would not be justifiable in that framework.

Pam Karlan: That would be product-focused, not country-focused?

Alan Sykes: Exactly. So it’d be, you’d be protecting yourself against the danger of possibly a foreign monopoly emerging which is pretty unlikely in almost all industries, but maybe it’s conceivable. And you might be protecting yourself against very severe supply chain problems in the event of, say, a conflict with China. Those would be very targeted rationales for some measures to either tariff, or use tariffs or subsidies, to build a particular sensitive sector.

Rich Ford: Can I ask you a big picture question? My sense is that there had been a growing consensus probably since World War II, and you can correct me if I’m wrong, that free trade, was beneficial, not just to the United States, but to most of the world. And that it had been U.S. policy for the most part to encourage that we had things like NAFTA is a pretty dramatic example of trying to expand the domain of free trade, but that had been U.S. policy. But since Trump, some people have suggested that maybe we’re retrenching on that and we’re moving into an era in which we’re going to abandon or at least curtail the policy of free trade. Some people even noted that president Biden kept a lot of Trump’s tariffs in place, suggesting that some kind of general consensus had moved away. What’s your take on that?

Alan Sykes: Yeah, so it was …  there, there was a consensus in Washington in favor of liberal trade that consisted of centrist Democrats and traditional Rob Portman-like Republicans that were all free marketeers, and the protectionist wings of each party were not nearly so powerful. That was the highly union-connected Democrats, plus people like maybe Bernie Sanders and Elizabeth Warren on the Democratic side. And then it was just a few folks like a Pat Buchanan on the Republican side. But that started changing, I would say, even a little bit before Trump. There’s the so-called “China shock” when China joined the WTO and studies suggested that there was a big hit to manufacturing employment in the United States because of the growth of China, and the populist movement and politics that we see today is bipartisan and, it’s both Trump and Biden and their trade representatives, Lighthizer and Katherine Tai, and it’s very much more America, “America First,” American workers first, and we’re now in a situation where the United States in particular has really moved away from the consensus in favor of liberal trade, on both sides of the aisle.

So, Trump started it in a big way, but Biden preserved most of the Trump tariffs and has added to them:  100 percent tariffs on Chinese electric vehicles. That’s Biden. That’s not Trump.

Pam Karlan: Is this because people don’t understand tariffs so the government can make political claims to the public that they don’t have to pay for this? Whereas if you said we’re going to have to subsidize our industry, or we’re going to have to, provide health care that’s not connected to jobs if we want to decrease the cost of manufacturing jobs, or we’re going to have to do something else… I mean, what accounts for why tariffs are so popular? Is it just, Donald Trump, like Tony in the sound in West Side Story saying the most beautiful sound I’ve ever heard? It’s tariffs…?

Alan Sykes: I think there’s partly that I think politically Mr. Trump has always maintained that he’s going to impose these tariffs and the exporters will pay the tab, even though that’s empirically not demonstrable. In fact, it seems to be demonstrably false to a great extent. So as you say, it’s partly people don’t understand the incidence of who really pays these things. They exaggerate in their mind the impact that it’s going to have on employment opportunities and growth opportunities in the United States. They fail to recognize that every time you cut back your imports, you’re going to have effects on your exports, either through retaliation or through exchange rate. That’s you … might have noticed when President elect Trump threatened tariffs on Canada and Mexico just recently, the Canadian dollar and the Mexican peso depreciated relative to the dollar.

So all of that is, all of that is going on, and I don’t think those basic kinds of economic facts are well understood by the public, but they’re certainly, I think, well understood by most serious folks in Washington, but it’s it’s something that they can exploit politically to support the interest groups that they want to support.

The Democrats are not nearly as enthusiastic about tariffs. They prefer the subsidy route, as I said before, but industrial policy of one sort or another is a very popular thing in Washington these days.

Pam Karlan: So Al, you often hear or worry about there’s going to be a trade war. What is a trade war?

Alan Sykes: Well, a trade war is where one country, for whatever reason, decides to initiate trade measures that protect its market from foreign imports, and that begets retaliation where the countries that are affected retaliate similarly, and you end up potentially with an escalating battle of protectionist barriers, as we saw, for example, in the 1930s following the enactment of the Smoot-Hawley Tariff by the U.S.

Pam Karlan: Some people say that the Smoot-Hawley Tariff, and then the trade war that followed it, really deepened and lengthened the Depression. Is that right?

Alan Sykes: It’s debated by economic historians. There are a number of folks who have that view. There’s been some challenge to that. It was certainly perceived by the Roosevelt administration that the contraction of trade in the 30s contributed to the depth and length of the depression, as well as to the conditions in Europe that led to war. So Cordell Hall, who was the secretary of state for Roosevelt, was a big fan of liberal trade after the war on the theory that it was not only commercially valuable, but that it would bring world peace, or at least contribute to it.

Pam Karlan: And that’s because countries that are trading with each other have all sorts of other relationships. I mean, what’s the mechanism there?

Alan Sykes: I guess sort of the simple political economy story might be that you have commercial interests in countries that have an interest in keeping foreign markets open and having a stable relationship so that they can earn a nice rate of return on their business investments in their foreign operations and in their domestic export operations.

And that creates a political constituency to press each government not to engage in measures that would result in war or other kinds of conflicts that would foul up the commercial relationships on which these interest groups depend.

Pam Karlan: So if we do things like impose 100 percent tariffs on things beyond the electrical vehicles from China and the like, how would China retaliate against the United States? What would the form of retaliation look like?

Alan Sykes: I think partly it would be probably tariffs. They would target quite possibly American agriculture, as you mentioned earlier. And then it turns out China has a large chunk of the existing supply of certain kinds of rare-earth elements and minerals that are important in manufacturing, such as semiconductor manufacturing.

So they’ve already, in response to U.S. policy, banned the export of I think germanium and two or three other minerals that are not readily available from other sources at the moment.

Pam Karlan: And so what then happens is, even if we had domestic manufacturing capacity for certain semiconductors, we wouldn’t be able to manufacture them because we can’t get the raw materials?

Alan Sykes: Potentially. There are some other sources for these things, but there’s also … there’s always the question of whether you can find a way around China’s policies by nominally having the purchaser be someone other than the United States and then rerouting it somehow. But it would complicate things for sure.

Pam Karlan: And it would increase the costs, presumably.

Alan Sykes: Yes. Absolutely

Pam Karlan: …Over what they’d otherwise be…. So the other thing is, in addition to these kind of bilateral back and forth between countries, there’s an awful lot of international trade that’s regulated by multilateral, multi-country organizations. And I wondered if you might describe the ones that are most important for folks in the United States.

Alan Sykes: Yeah. Historically the multilateral trading system began, as far as international trade law is concerned, and institutions, began in 1947 with the General Agreement on Tariffs and Trade, which was negotiated at a time when the U.S. was the only big economy that wasn’t decimated by World War II. And we took the lead in starting the GATT and, over a series of negotiating rounds that lasted about 50 years, tariffs in the, among the GATT members, which steadily grew in number, steadily declined to the point that U.S. average tariff rates, which are a crude indicator of the amount of protection in the trading system–U.S. average tariff rates went from on the order of 30 something percent to on the order of 3 something percent over that 50 year period. So it was a very successful institution. And then it was subsumed into the WTO in 1994 when there was a new dispute settlement mechanism put together and services were added to the mix and intellectual property was added to the mix.

And the WTO then continued to govern global trade for quite some time, reasonably successfully, although it didn’t have breakthrough as in terms of new negotiations to speak of, but it at least maintained the status quo ante quite successfully for a long time, but then the US started to lose some cases in the dispute process on politically sensitive issues relating to anti dumping cases and subsidies cases, and some others, and in recent years, national security issues have come into the mix. The U.S. became very dissatisfied with the WTO and stopped allowing judges to be appointed to the WTO appellate body, which puts an end to definitive dispute resolution in the organization, and at the same time has gone off and imposed a lot of tariffs and done some other things in the name of national security, in the name of sanctioning China for intellectual property theft and forced technology transfer and so forth. So the U.S. Has now done a lot of things that have either been ruled by first stage arbitrators to be violations of the WTO, or that would be so ruled in all likelihood if the dispute settlement system was functioning, and so the WTO is just going by the wayside from the U.S. perspective–it’s still vital for the rest of the world. Most other countries still participate in it, respect most commitments, but the U.S. … someone like Washington trade lawyer friends would say the U.S. Is effectively withdrawn from the WTO and there’s something.

Pam Karlan: That’s something that every now and then President elect Trump suggests he might want to do.

Alan Sykes: Yeah, I don’t think he has to do it formally. He just does stuff that is against the rules and thumbs his nose at the whole system and knows that there’s no dispute settlement process to rule against him. And so that would result in sort of effective withdrawal from the WTO without the need for any sort of formal withdrawal.

So that’s one of the developments that we’ve seen since the first Trump administration that is disappointing for those of us in this field who admired the institutional architecture that had been developed in the now almost eight years since the GATT was founded. And the movement has been very strongly towards smaller scale agreements like for example free trade agreements, such as the USMCA …

Pam Karlan: Yeah, can you tell me, because I know lots of people have heard of the WTO, but my guess is most of our listeners have not heard of the MCA.

Alan Sykes: That’s the successor to NAFTA, the North American Free Trade Agreement, which was negotiated in the 80s, and went into effect, it was under George H. W. Bush administration, if I’m not mistaken, or might have been Clinton. In any event, President Trump renegotiated it and changed the name to the U.S. Mexico Canada Agreement by tightening up the standards for deciding whether something originates in North America for purposes of getting duty free preferences and so forth.

Also changed the investment provisions. But that’s an agreement just among those three countries, but it’s a very important agreement because we are each other’s biggest trading partners. Canada and Mexico are the U.S.’s top two trading partners. The U.S. is the top trading partner for both Canada and Mexico, so it’s quite a significant agreement and it is threatened somewhat by the threat to impose tariffs on Canada and Mexico that President-elect Trump has made—those tariffs would certainly violate the tariff commitments In the USMCA, although the Trump administration would argue that we’re doing it for national security reasons whhich is an exception to tariff commitments under the USMCA So it would be there would at least be the facade of legality …

Pam Karlan: Yeah, I mean, I was a little confused about his national security argument, which seemed to be mostly about tying trade to immigration and border control, as opposed to something about the trade itself. Am I missing something there?

Alan Sykes: No, I think the argument would be that unrestricted migrant flows and unrestricted fentanyl flows, that’s the way he would characterize them, are a threat to national security. And there’s a clause in the USMCA that’s very deferential to a country that invokes national security.

It basically says that it’s not justiciable. So, if a country claims national security, they are entitled to do what they want to do.

Pam Karlan: I just say that it seems like when it was being negotiated, it was presumably about the regulation of trade being connected directly to the national security interest, not we have a national security interest over here, and we have a trade interest over there, and we can use the trading system as kind of a lever for dealing with things that aren’t themselves directly about the trade.

Alan Sykes: Yeah, I completely understand the point, and I suspect that’s probably the way these national security exceptions were originally conceived. I’m not sure what was in the mind of the Trump folks when they renegotiated in the 2018-2019 window. They might have had these other things in mind at the time. But you’re right that it is that the national security argument is being used to leverage trade measures essentially as a form of economic sanction to persuade countries to do what we want them to do on other issues, and that’s probably not in … the certainly not in the original spirit of these national security exceptions, though it’s not necessarily in conflict with the text.

The text of the treaty says nothing in this agreement shall prevent either any member country from doing what it considers necessary to protect its essential security interests. So it just makes it completely non justiciable.

Pam Karlan: I mean, and that, the idea of economic sanctions is a different thing than tariffs generally, right? Economic, or … they might operate the same way, but aren’t they directed at different things?

Alan Sykes: Yeah, but as you say, they can operate the same way. Economic sanctions are a much broader class of things than tariffs. It often involves financial flows, banking sanctions, things of that nature. And we’ve used those for everybody, for all sorts of issues down through the years against various adversaries: Russia, Iran, North Korea. What’s different I guess is that we’re now thinking about or talking about using them against allies

Rich Ford: Well, thank you to our guest Al Sykes for explaining to us the implications of tariff policy for free trade and for foreign policy more generally. I’m sure we’re going to hear a lot more about this in the years to come. This is Stanford Legal. If you’re enjoying the show, please tell a friend and leave us a rating or review on your favorite podcast app. Your feedback improves the show and helps new listeners to discover us. I’m Rich Ford along with Pam Karlan.

See you next time.