What is the definition of a bad tax? If I ask enough people, I’m likely to get a range of responses, though no single answer is definitive. It’s better to speak of the hallmarks we associate with bad taxes.
People with a background in tax administration would suggest a bad tax is a tax that’s incapable of being evenly enforced, has a poor revenue yield, or is too easily avoided. By way of example, some folks regard state-level use taxes as suboptimal creations. In theory they make sense, but I’ve yet to meet anyone who has ever paid a use tax.
The field of behavioral economics teaches us that a bad tax is one to which the predictable taxpayer responses are misaligned with national economic policy. For example, we might say that a tax provision is flawed if it encourages U.S. corporations to pour capital into foreign projects to the exclusion of domestic opportunities, or encourages the hiring of foreign employees while doing nothing for domestic workers.1
Sometimes a bad tax can be identified by the things it is not, rather than the things that it is.
Those with an eye toward social justice might say that any tax not premised on the ability to pay is flawed because it makes the overall system more regressive. Climate activists will say that any tax regime that ignores our carbon footprint is lacking because it fails to address one of society’s most serious problems. Business leaders would say that a bad tax is one they can’t pass on to somebody else, which explains why we seldom hear corporate lobbyists complaining about consumption taxes, the burden of which is passed to consumers.
Here’s an addition to the list: Taxes that are disingenuous are bad taxes. Imagine a category of taxes that are pitched to the public at large as having broadly beneficial consequences, though a serious analysis reveals them to be detrimental. Perhaps we can agree that a bad tax is one that generally delivers the opposite of what it promised.
Are tariffs bad taxes?
I’m reluctant to declare that all tariffs are categorically bad. A blanket assertion feels extreme, but they undeniably have the potential to be terrible taxes. That makes it distressing when opportunistic political figures insist that “foreigners” pay our tariffs, and that higher tariffs necessarily boost the domestic economy by making imports more expensive. The abundance of evidence demonstrates that these generalizations are false.
Tariff policy has often been accompanied by crass salesmanship. The Smoot-Hawley Tariff Act of 1930 was supposed to solve the Great Depression, instead it made the crisis deeper and longer than it needed to be. More recently, we witnessed similar salesmanship when the Trump administration embraced higher tariffs as a tool for reversing so-called economic carnage. Today, we are seeing it again. Former President Donald Trump is on the campaign trail and tariff policy is once again on his mind.2
A recent story in The Washington Post claims that Trump and his advisors are contemplating a three-pronged tariff strategy, should he prevail in the November elections.3 According to these reports, the first step would be an across-the-board tariff of 10 percent applied to almost all goods entering the country. This batch of tariffs wouldn’t be retaliatory. They would come to represent the new baseline, setting the “price of admission” when foreign manufacturers seek access to the U.S. market.
Second, Trump would call for an additional tariff of 60 percent applied to goods from China. Unlike the first batch, these tariffs would be punitive in nature. Their purpose is to punish China for various economic and commercial grievances. Recall that Trump already increased tariffs on Chinese goods (from roughly 3 percent to 12 percent) during his first administration. Bumping the rate up to 60 percent might be the single largest tariff increase in modern U.S. history.
An increase of that magnitude — if it is to be taken seriously — is more about bringing the U.S.-China trade relationship to a grinding halt, and less about raising revenue from the taxation of imports. It would surely trigger a swift and equivalent countermeasure from China that would slam doors shut for U.S. exporters. One hopes that such a drastic proposition is campaign banter, intended to project the image that nobody is tougher on China.
Trump isn’t backing away from the story in The Washington Post. On February 4 he gave a television interview to Fox News during which he confirmed that a 60 percent China tariff will be on the table if he wins the election. “I would say maybe it’s going to be more than that,” Trump told Fox News’ Maria Bartiromo. What is Trump thinking here? If the gesture is symbolic, why stop at 60 percent? No tariff aimed at China can be too high!4
Third, Trump would impose a series of targeted tariffs that correspond to the “special taxes” other countries impose on U.S. goods as they enter their markets. The Washington Post article doesn’t mention the VAT, but that is likely what Trump is referring to. We know from prior experience that Trump and his advisers are routinely confused about the fundamentals of VAT. The mistake lies in their tendency to perceive a destination-based tax regime through an origin-based lens.
The three tariff proposals are a long way from becoming reality, but they’ve already drawn pushback.5 This article adds to those criticisms. The suggested tariffs would be near the top of my list of historically bad taxes. Trump’s first trade war hurt overall U.S. economic performance, contrary to the candidate’s self-congratulatory claims. That should be a persuasive argument against launching a second trade war, in the event there’s a second Trump administration. The same criticisms apply to President Biden, should he follow suit and jump on the tariff bandwagon.
Who Pays Tariffs?
There’s nothing like social media to invigorate a public debate on taxation and trade. In January, former U.N. Ambassador Nikki Haley took to X (formerly Twitter) to offer her take on Trump’s outlandish tariff proposal. Haley is the last remaining non-Trump candidate for the GOP presidential nomination:
Donald Trump wants to tax every American with a 10 percent across-the-board tariff, costing families an average of $2,600 a year. They’re already paying skyrocketing prices thanks to Biden and Trump’s inflation. We can’t afford this.6
Two days later, we received a reply from Stephen Miller, one of Trump’s advisers:
“Free Trade” is a false religion that melts minds. A tariff is not a tax on “every American.” (That’s the income tax). A tariff is a tax assessed on FOREIGN goods made by FOREIGN labor. Under a tariff system, if you make it here and build it here, you pay no tax. Simple.7 [Emphasis in the original.]
Does Miller need reminding that approximately half the U.S. population doesn’t pay income taxes — 47 percent according to his fellow Republican Sen. Mitt Romney, R-Utah. It’s entirely possible, if not probable, that more U.S. households pay tariffs (passed on through pricing adjustments) than pay federal income tax.
It’s self-evident that all U.S. tariffs are directly paid by the U.S. importer. The question is what happens next. No importer wants to soak up a tariff, which cuts into the profit margin — perhaps eliminating it altogether. Neither do the wholesalers or distributors who feature in the domestic supply chain. To the extent they can, each of these firms will pass the additional charge on to the next person, until it eventually rests with the final consumer. That’s not necessarily a retail consumer. A significant share of U.S. imports are business inputs, for which the effect of a tariff is to increase production costs.
It’s often assumed that something less than 100 percent of a tariff is passed on to domestic consumers. The thinking is that, following the introduction of a tariff, foreign manufacturers will adjust their prices downward to prevent their goods from being uncompetitively priced, and not selling at all. To the extent that occurs, it means the foreign producer is absorbing some portion of the tariff burden. It’s difficult to reach generalized conclusions about how frequently that occurs. The competitive circumstances of each import transaction differ because of the nuances of supply and demand.8
The picture that emerges from economic research is not encouraging for proponents of higher tariffs.9 One study focused on the effects of U.S. tariffs imposed between 2018 and 2019 on a narrow range of products (solar panels, aluminum, steel, and washing machines).10 They found that the entire burden of the tariffs landed on U.S. businesses and consumers, causing them to incur $114 billion in losses.
Other researchers arrived at similar conclusions, with the details of price responsiveness varying by product type. One study found that retail prices for handbags rose more quickly following the introduction of tariffs than the prices for bicycles and refrigerators.11 The rate at which tariffs are passed through to consumers can change over time. One study of U.S. steel imports found a passthrough rate of 100 percent during the first year a tariff was in force, with the rate declining in the second year of the tariffs.12 The data paints a picture in which, upon the introduction of a tariff, U.S. businesses are quick to adjust their pricing while foreign exporters are remarkably slow to adjust theirs.
It’s hard to say with ironclad precision what the tariff passthrough rate has been over the last few years. It’s not 100 percent, though it may well be close to it. So, yes, it is literally true that foreign manufacturers don’t benefit from U.S. tariffs — but that’s a far cry from saying they pay them. The evidence is clear that U.S. consumers predominantly bear the burden.
One study noted the occurrence of over-shifting, which occurs when U.S. business increase their prices by more than the amount of the tariff. For example, the authors of the study found that a $1 increase in the U.S. tariff applied to imported solar panels resulted in a $1.34 increase in retail prices.13 That suggests U.S. firms were adjusting prices not merely to preserve their pre-tariff margins, but to expand them. This raises the possibility that U.S. tariffs are partly responsible for recent inflationary pressure.
Over-shifting exhibits a crossover effect that can reach complementary product lines. For instance, it was observed that U.S. tariffs applied to imported washing machines not only caused an upward movement in retail prices ($86 per unit), but also triggered an increase ($92 per unit) in the retail prices of dryers — although imported dryers were not subject to any new tariffs at the time.14
Let’s not forget that an aggressive tariff policy can harm the U.S. economy in ways that don’t show up in retail prices. During the Trump administration, Congress approved a $30 billion bailout for the U.S. agricultural sector to compensate farmers for the sharp decline in business they suffered when China enacted its own tariffs in response to U.S. tariffs.
There’s another criterion for identifying bad taxes: You know that a tax is bad when it requires a $30 billion rescue package to make up for the economic harm it inflicted on an important domestic constituency. How big will the next bailout be if U.S. exporters are shut out of China altogether?
Conflating VAT With Tariffs
This is not the first time we’ve heard Trump threaten to retaliate against other countries for VAT regimes.15 To be clear, VAT is not a trade barrier. It is a trade-neutral consumption tax. If you consider any country with a VAT regime — which is most places not named the United States — imports and locally produced goods are subject to an identical tax rate. There is no favorable treatment for the local goods, nor any punitive treatment of the imports. Neutrality demands that their imports (including U.S. exports) must pick up the same tax.16
Trump and his advisers looked at that mechanism and mistook it for a tariff — based on the superficial similarity that a product made in the United States picks up a foreign tax charge at the point where it enters the foreign marketplace. That was especially so with Peter Navarro, the director of the U.S. Office of Trade and Manufacturing Policy during the Trump administration. In the course of providing counsel to Trump, he routinely conflated VAT and tariffs. This is happening again, with other advisers stepping in to play Navarro’s role.17 Let’s hope it stops.
Moreover, let’s hope that all our federal policymakers take note of the picture that’s emerged from an ample body of economic research. The last trade war was a failure. It hurt the U.S. economy far more than it helped. Let’s not repeat the mistake.
FOOTNOTES
1 The allowance for qualified business asset investments comes to mind because it rewards companies for making investments in tangible property held overseas. Professor Kimberly Clausing has previously referred to QBAI as the “America Last” tax provision.
2 This analysis of tariff policy is not partisan. President Biden has retained many of the Trump administration’s tariffs. If it helps to depoliticize the discussion, we should refer to them as the Trump-Biden tariffs. I’m no fan of them, regardless of attached name or party affiliation.
3 Jeff Stein, “Donald Trump Is Preparing for a Massive New Trade War With China,” The Washington Post, Jan. 27, 2024.
4 To paraphrase New York Times columnist David Brooks, we’re never quite sure whether to take Trump’s remarks seriously but not literally, or to take them literally but not seriously.
5 Erica York, “Tariff of Abominations Redux: Trump Proposes 60 Percent Tariff on Chinese Goods,” The Tax Foundation, Jan. 29, 2004.
6 Nikki Haley (@nikkihaley), X, Jan. 29, 2024.
7 Stephen Miller (@stephenm), X, Jan. 31, 2024.
8 This should remind readers of the familiar debate about the incidence of the corporate tax burden: Does it rest primarily with shareholders in the form of diminished returns on their investment, with employees in the form of reduced wages, or consumers in the form of elevated prices?
9 Alex Durante and Alex Muresianu, “Who Really Pays the Tariffs? U.S. Firms and Consumers, Through Higher Prices,” The Tax Foundation, Dec. 15, 2021.
10 Pablo Fajgelbaum, Pinelopi Goldberg, Patrick Kennedy, and Amit Khandelwal, “The Return to Protectionism,” 135(1) Q.J. Econ. (Feb. 2020).
11 Alberto Cavallo, Gita Gopinath, Brent Neiman, and Jenny Tang, “Tariff Passthrough at the Border and at the Store: Evidence From U.S. Trade Policy,” NBER Working Paper No. 26396 (Oct. 2019).
12 Mary Amiti, Stephen Redding, and David Weinstein, “The Impact of the 2018 Tariffs on Prices and Welfare,” 33(4) J. Econ. Persp. 187-210 (2019).
13 Sebastien Houde and Wenjun Wang, “The Incidence of the U.S.-China Solar Trade War” (Apr. 21, 2023) (available on SSRN).
14 Study by Aaron Flaaen, Ali Hortaçsu, and Felix Tintelnot, “The Production Relocation and Price Effects of U.S. Trade Policy: The Case of Washing Machines,” NBER Working Paper No. 25767 (Apr. 2019).
15 Robert Goulder, “Tariffs as Taxes: Trump Gets His Border Adjustment After All,” Tax Notes Int’l, Mar. 26, 2018, p. 1339.
16 The same neutrality explains why, under a destination-based VAT regime, exports must get a border adjustment. It’s a means of eliminating double taxation, because it’s understood the exported goods will pick up the VAT charge in the country to which they are being sent. Failure to appreciate this neutrality explains why some people regard the VAT border adjustment as an export-contingent tax subsidy — when it’s not a subsidy at all.
17 Navarro was recently sentenced to six months for contempt of Congress in relation to his refusal to cooperate with the congressional inquiry into the events of January 6, 2021.
END FOOTNOTES