The Debate On Tariffs Ignores A Very Big Issue: The Tax Wedge

The debate on tariffs ignores a very big issue: the tax wedge.

A tariff is a tax, and a tax is a wedge, an obstacle between buyer and seller. How harmful the tax wedge is, of course, depends on its size and breadth.

Let’s make this simple. Suppose there is no income tax and a person making $40 an hour wishes to buy an item that costs $200. That individual would have to work five hours to make that purchase (five hours times $40 equals $200).

Now, suppose the income tax is 50%. The would-be buyer keeps only $20 an hour after that 50% tax. This means the individual would have to work ten hours, instead of five hours, to make that purchase, thanks to the tax wedge.

Currently, the tariff discussions have focused on inflation, i.e., what the impact of tariffs will be on prices.

Overlooked is whatever impact tariffs might have on consumer prices; they will impose a wedge, a barrier to doing business. Taxes add friction to conducting business. The magnitude depends on the actual rates and how extensive they are on particular products and services, and the effect on supply chains and existing trading patterns.

That’s why the focus on inflation misses the bigger issue. Tariffs don’t necessarily raise overall prices. The cost of that $200 item may not change, but the effort required to buy it will. That means less prosperity.

Federal Reserve boss Jerome Powell misses this point with his fussing about the possible impact of tariffs on prices. Instead, he should concentrate on the friction they will impose on commerce.

Historically, the most devastating result from tariffs came from the sweeping Smoot-Hawley Tariff Act that began to wend its way through Congress in 1929, triggering the infamous stock market crash. It was signed into law in June 1930, imposing tariffs on thousands of items. The legislation triggered massive retaliations from other countries and effectively blew up the global trading system. Trade shriveled. It began what became the Great Depression, as it was followed by other big economic mistakes, particularly tax increases in the U.S., Britain, Germany and other nations. Countries resorted to competitive devaluations, what historians labelled beggar-thy-neighbor policies.

This disastrous state of affairs is why nations, following World War II and led by the U.S., began a series of agreements reducing tariffs and other trade barriers. The resulting explosion in trade was critical to the huge economic growth the world experienced after 1945.

The most immediate point to realize today is that the Smoot-Hawley tariffs didn’t raise prices. The slump in commerce led to price cuts—prices don’t go up in going-out-business sales.

Thankfully, the tariffs being enacted or proposed today aren’t yet on the scale of Smoot-Hawley. Moreover—and unlike in 1929–30—they are still fluid, still subject to change.

Nonetheless, the helter-skelter way the tariff issue is being treated leads to real concerns.

Hopefully, these are hard-fisted negotiating tactics that will yield sensible agreements and end up reducing trade barriers.

But in the meantime, remember the impact the tax wedge can have on economic growth.