Why higher tariffs won’t shrink the trade deficit

In President Donald Trump’s executive order calling for reciprocal tariffs, he said that their main purpose is to reduce the US trade deficit. Economists have long argued that tariffs have no effect on trade balances. (See this 2017 blog post.) But the data suggest an even more adverse possibility—that higher tariffs may increase the trade deficit—because countries with higher tariffs tend to have larger deficits. However, a likely explanation for this correlation is that a country’s stage of development drives both tariffs and deficits, while tariffs have little direct impact on deficits.

Most of the countries with high tariff rates are developing economies. These countries are much poorer than the United States and many find that taxing imports at the port of entry is administratively and politically easier than taxing domestic transactions.[1] Given their low levels of economic capital, many are borrowing to finance their development, which implies a negative trade balance.

Figure 1 displays a broad measure of trade balances against average tariff rates for 137 countries.[2] The data are averages over the 20 years ending in 2022, the most recent year for which tariff data are available. The United States is the gold dot below the blue fitted regression line with an average tariff rate of around 3 percent. Note that a larger negative balance is a larger trade deficit. The negative correlation in figure 1 likely arises from the effect of a country’s stage of development on both its tariff rate and its trade balance. The slope of the blue line is -0.45 and is statistically significant at the 1 percent level.[3],[4] This implies that a 1 percentage point increase in the average tariff is associated with a 0.45 percent of GDP decline in the trade balance. In other words, tariffs are associated with increasing trade deficits. Similar results are obtained using effective tariff rates, which weight tariffs for each category of imports by the value of imports in that category.[5]

The data show that even tariffs as high as 30 percent are not able to prevent countries from running much larger trade deficits than the United States currently does. The reason is that when tariffs reduce imports, they also reduce the supply of dollars that pay for imports. A reduced dollar supply to foreigners drives a higher dollar price, which makes US exports more expensive for foreigners (figure 2). The result is that imports do not shrink as much as would be expected from the tariff alone and exports shrink by an equal amount, leaving the deficit unchanged.

Although tariffs do not reduce trade deficits, they do reduce imports and exports, as well as total income. That's because they force a country to shift resources from more profitable exports to less profitable imports, as well as to services. But the long-run economic effects are also negative. By shielding producers from foreign competition, a tariff ultimately leads to less business innovation, slower productivity growth, and lower household living standards.

Notes

1. As countries develop their administrative capacity, they tend to reduce reliance on tariffs in favor of less distortionary sources of revenue. Viewed in this light, President Trump’s tariff push harkens back to the 19th century, when US administrative capacity was lower than today and tariffs provided a larger share of fiscal revenues.

2. The current account balance reflects all income received from foreigners minus all income payments to foreigners. Goods trade is the largest component of the current account, but services trade and investment income are also important.

3. The outlier with an average tariff rate of 30 percent is the Bahamas. Dropping this observation has no effect on the slope, which remains -0.45 and significant at the 1 percent level.

4. The slope using the goods trade balance is also -0.45 and significant at the 10 percent level.

5. The slope with effective tariffs is -0.28 and is significant at the 5 percent level.