Republicans aren’t able to contain their giddiness over their plan to slap a 20% tariff on all goods and services imported into the United States. In 2015, the total value of all imported goods, services and income payments brought into the U.S. was $3.6 trillion. Multiply this by 20% and you have the federal government collecting an extra $720 billion annually. This covers the U.S. government’s current $580 billion spending deficit, Donald Trump’s $100 billion tax cut for the rich and a good chunk of his $54 billion defense spending increase. Even better, any negative consequences of the tariff (which might cut demand for their goods and services) falls on foreigners. And, if demand for imports drops because of the tariff, then the slack will be made up by new US factories coming online with more high paying manufacturing jobs. What could possibly go wrong with this stroke of genius?

The answer is plenty. First, this plan is highly inflationary. Second, it will start a trade war and third, it will lower economic growth. This scheme, with various renditions, has been tried before. Most notably by economic basket cases like Argentina, Brazil and Venezuela.

Inflation

If you were raised after President Bill Clinton signed the General Agreement on Tariffs and Trade (GATT) in 1994, you probably don’t know what inflation is. Price inflation simply means the erosion of your buying power as prices rise faster than your wages while the value of savings plummets. People quickly learn not to save since the buying power of $10,000 is much less six months from now. Without savings, companies can’t borrow for new technology and a country’s worker productivity and relative wages fall.

Lowering and getting rid of tariffs with the GATT Agreement and opening our markets to more open trade put the final dagger into inflation in the US. At a time like now when we are at a full employment economy, too much income would be chasing too few goods and leading to inflation; open trade acts like a pressure valve. Now, goods from other nations can flow into the US holding inflation in check. Add in a 20% tariff on imports and the pressure valve becomes much less effective.

Besides upsetting the balance described above, the tariffs themselves are highly inflationary. While Republicans try to make the point that tariffs are a cost to the exporting country, that is not correct. In almost all cases, retailers will treat tariffs just like any other cost. Assuming a retailer works on a 40% profit margin (which is conservative), the 20% tariff is now a 28% increase in the retail price.

Much of economics is defining who are the winners and who are the losers resulting from a given economic policy. In this case, it is a no-brainer that the biggest losers are US consumers whose buying power will be sharply diminished by the Republican tariffs. Lower income Trump supporters will be hit disproportionately hard.

Republicans want us to believe that tariffs will make US made goods competitive, spurring a frenzy of factory building here. This is highly unlikely to happen. Building factories is an expensive long-term commitment and the longevity of Donald Trump’s Administration does not appear to be a good long-term bet. A new administration and Congress could wipe away the Republican tariffs with a swipe of a pen.

More likely, domestic competitors will simply raise their prices to the new tariff enhanced levels and reap extra profits.

Trade wars

The nasty thing about unilateral tariffs is that they don’t exist in a vacuüm. Countries hit by our tariffs will reciprocate. Just because we pick a number like 20% for our tariffs doesn’t mean other countries will use the same level. China and Japan could slap a 30% tariff on agricultural goods and deal a particularly hard blow to a vulnerable industry that also happens to comprise Trump’s main base of support.

The last time we engaged in a trade war was after the Smoot Hawley Act signed by President Herbert Hoover in 1930 that raised tariffs on over 2,000 products. Canada was the US’s biggest trading partner at the time. Mackenzie King was the Canadian Prime Minister and had cut tariffs in the 1920’s. He warned Hoover that Canada would retaliate if Hoover signed the Smoot Hawley Act. Two months after the act signing Canada raised tariffs on US goods and lowered tariffs on imports from British Empire countries, consciously giving Canadians inducements to buy from England instead of the US. Believing he had done enough to stand up to the US, King called for a general election. He was wrong. His Liberal party was crushed by the Conservatives who promised and passed even higher tariffs on US goods. This is a lesson that won’t be lost on foreign leaders as they craft their responses to the US tariffs.

Lower productivity

A nation’s productivity is generally closely correlated to wage growth. What unrestricted trade does is force a nation to focus on expanding its most productive industries and contracting the ones it doesn’t do so well in. This increases productivity and hence wage growth.

Unfortunately, as covered in many other posts on this website, the US’s reliance on huge government budget deficits that overwhelm private savings and result in behemoth Capital Account deficits negate many of the advantages we should be getting from more open trade. Nevertheless, things could be worse.

If Republicans enact their 20% tariff, things will get much worse. China is a big time buyer of US corn. If China imposes a large tariff on US grain, Chinese farmers will start growing more corn, even though they are better at growing other crops. They will also import more corn from South America and other countries that are less productive corn producers than the US. They may even find it advantageous to feed Canadian or Australian wheat to their cattle. All of these are distortions caused by the US tariffs will lower the productivity of Chinese livestock producers.

Extrapolate these costs over the entire global economy and the lower productivity will lead to slower or no growth, which is defined as a recession.  And, this is global recession we are talking about.

Summing-up

For the first time in many decades, Republicans have come up with a plan for reducing the federal budget deficit. We should commend them for this. We cannot go on indefinitely borrowing $trillions from foreign entities.

Unfortunately, their plan comes with huge costs. Make no bones about it, this proposed tariff is a mega tax increase. Rather than the actual tax increase that President Bill Clinton balanced the budget with, this tariff increase will have far-reaching negative global growth results.