Taxes on imports that are the most common form of government interference with international trade.
Trade barriers exist largely to protect domestic firms that produce goods that compete with imports, though tariffs are sometimes levied for purposes of raising government revenues. Moreover, tariffs are sometimes levied on exports as well as on imports.
A specific tariff assigns a fixed monetary tax per physical unit of an imported good, whereas the ad valorem (that is, value-added) tariff is levied as a constant percentage of the monetary value of the imported good.
Preferential tariffs and most-favored-nation (MFN) treatments are some common types of tariff instruments. Preferential duties are tariffs applied to an import according to its geographical source; a country that is given preferential treatment pays a lower tariff. MFN status is a misleading term because it implies that a country is getting special, favored treatment over all other countries; in fact, the term means the opposite— nondiscrimination in tariff policy. Countries strive to receive MFN status to “graduate” from being subject to nonfavorable treatment.
The motives of modern governments in restricting imports are varied. Some common motives include a desire to protect the domestic producers of the import-competing good, a need for food or military security, a response to political pressure, a wish to reduce consumption of the good, an effort to reduce imports to avoid balance of payments problems, and a need to raise revenue.
There are many reasons that a country restricts trade, and tariffs have long been used to do this. Classical economics taught the benefits of free trade. During the eighteenth century and at the beginning of the nineteenth century, tariffs were used primarily to raise government revenue. The taxing of imports is probably the easiest existing means by which a government may obtain income. In the 1840s, the lessons of the classical economists, who taught that economic efficiency is enhanced by eliminating tariffs, started to be applied in their home country, England. Even the tariffs that helped English agriculture were abolished. England continued its course toward free trade and from the 1850s to World War I it operated as a free-trade country. Other European countries, especially France and Germany, followed England’s path and reduced already low tariffs in the 1860s. World trade grew at an extremely fast rate during this period.
Soon, however, the demand for a more protectionist policy developed in response to the introduction into the European continent of inexpensive grain from the United States and Russia. This new source of grain was made possible by railways, steamships, and innovations in agriculture. These developments, in conjunction with the depression of 1873 to 1879, the longest and deepest period of stagnant trade the world had yet known, were the main reasons behind the protectionism of the 1870s.
During the period between the world wars, in particular the 1930s, tariffs and other trade barriers were increasingly employed. Since World War II, the trend, especially among leading industrialized countries, has been toward trade liberalization. Thanks to the multiple rounds of multinational negotiations of the General Agreement on Tariffs and Trade (GATT) (succeeded by the World Trade Organization in 1995), many trade barriers have been abolished and the average level of tariffs has fallen, but protectionism has not been eliminated. Nontariff barriers and new methods of protectionism continue unabated.
To understand why tariffs have been a frequently used policy instrument, it is helpful to analyze how they affect the economy as a whole. Using tariffs to protect the domestic market helps some and hurts others.
The concepts of consumer surplus and producer surplus are used to measure the welfare effect of a tariff. As market prices rise, consumer surplus falls and producer surplus increases. The ad valorem tariff on a product causes the domestic price of this good to increase, which increases producer surplus and reduces consumer surplus. Thus producers benefit and consumers do not, since they pay higher prices. At the same time, the government gains by collecting the tariff on each unit of the new level of imports. If there remains a part of consumer surplus that is not transferred to anyone, it is called the “deadweight loss.” The net cost to society of distorting the domestic free-trade market price is called the “deadweight loss” of the tariff.
If a country is small and thus is subject to fixed world prices, tariffs will reduce the gains from trade, thereby reducing national welfare by altering relative prices and changing quantities transacted. The conclusion that tariffs are harmful for a small open economy assumes that there are no distortions in the economy. If there are distortions, tariffs could be used to offset these distortions and thereby increase welfare. This possibility is an application of what is known in economics as the theory of the second best.
Export taxes and import tariffs are equivalent in that they tend to raise the relative domestic price of imports and lower the relative domestic price of exports. Both tend to shift resources out of export industries into import-competing industries. Many observers argue that countries should restrict imports by tariffs and simultaneously encourage exports by subsidies. This contention is not true. The two proposed policies have exactly opposite effects and would therefore tend to cancel each other. The most extreme form of protective tariffs is a tax that eliminates imports, called a prohibitive tariff.
Although for a small country tariffs almost always have a negative effect on trade, a large country may be able to exploit its monopoly power on world markets by using tariffs to gain favorable terms of trade for itself. However, this power is greatly undermined by the likelihood that other countries will retaliate. The noncooperative scenario of tariff imposition and retaliation is unlikely to benefit any country. The probable outcome is that the volume of world trade will be reduced without a significant gain for any country. Gains from trade are lost because of the reduction in world trade.
Another important point related to tariffs is the distinction between the nominal tariff rate on a good and the effective tariff rate. The nominal tariff rate is more commonly known as the country’s tariff schedule, whether it is an ad valorem tariff or a specific tariff that can be converted to an ad valorem equivalent by dividing the specific tariff amount per unit by the price of the good.
When the effect of a tariff is examined, it is assumed that the tariff is the only tax that directly affects costs and prices of the good in question. This is true only when the production of goods does not require imported inputs or requires inputs that are freely traded internationally. However, most commodities are produced with the use of intermediate goods that are themselves subject to tariffs. Thus, a tariff on imported steel, for example, would raise costs and lower output in the automobile sector even if there were a protective tariff on cars. In general, manufacturers are better off as tariffs rise on imports that compete with their outputs and worse off as tariffs rise on their imported inputs. The term “effective protection” refers to the fact that all such tariffs need to be taken into account in computing the net protective effect of the tariff.
Enterprise resource planning (ERP) is defined as the percentage of change in a sector’s value added. Value added per unit of output (V) is the difference between the price of a final good and the cost of purchasing intermediate inputs. For example, if the price of an automobile is $10,000 and the cost of acquiring the steel, leather, glass, rubber, and other inputs needed to produce the car is $7,000, the value added is $3,000. In this case, the value added is 30 percent of the gross value of the car. Since the ERP is the percentage of change in the value added, it can be written as: (Value added under protection – value added with free trade)/Value added with free trade.
To simplify, it is plausible to assume that the steel is the only intermediate input in car production ($7,000) and let us suppose that a 20 percent tariff is imposed on imported cars (the price of the car is still $10,000). The domestic producers of cars respond to the tariff by raising their prices by the same amount (20 percent in this example), to $12,000. With no tariff on steel, the domestic value added thus rises to $5,000 ($12,000 – $7,000), and the ERP becomes 66 percent: ($5,000 – $3,000)/$3,000. What is interesting here is that the 20 percent nominal tariff on the final good raises the effective tariff from zero to 66 percent. But if the same amount of tariff is imposed simultaneously on imported steel, this protection will fall. The domestic price of a car will increase to $12,000, but the price of its input (steel in this ex ample) will also increase to $8,400 as well, which gives $3,600 value added. The ERP will be 20 percent: ($12,000 – $8,400)/$3,000. In this case, the effective rate of protection equals the nominal rate. Finally, if the tariff on the imported steel is increased to 50 percent, the value added will be $1,500 ($12,000 – $10,500) and the ERP will be –0.5 percent: ($1,500 – $3,000)/$3,000. Thus, it is possible for the tariff on inputs to be high enough to reduce effective protection for the final good relative to free trade.
Regarding the ERP, it is possible to draw the following conclusions: if the tariff on the output exceeds the tariff on the input, the effective rate of protection is higher than the nominal tariff; if the tariffs are equal, the effective rate of protection is equal to the nominal tariff; and if the output tariff is lower than the tariff on the input, the effective rate of protection is less than the nominal tariff and may even be negative.
Because all countries have many different tariff rates on imported goods, it is generally a problematic issue to determine the average tariff rate from this variety. One measure of a country’s average tariff rate is the unweighted average tariff rate, which is the simple average of all tariff rates of a country. If there are two goods and the tariff rate of good A is 10 percent and the tariff rate of good B is 20 percent, the unweighted average tariff rate is 15 percent. The alternative technique is to calculate a weighted average tariff rate. Each good’s tariff rate is weighted by the importance of the good in the total bundle of imports. If the tariff rate of good A is 10 percent and a country imports $500,000 worth of good A, and if the tariff rate of good B is 20 percent and a country imports $200,000 worth of good B, then the weighted average tariff rate can be found as follows: [(0.10) ($500,000) + (0.20) ($200,000)]/($500,000 + $200,000) = 0.12 (or 12 percent).
Elfi Cepni
See also: Free Trade; Mercantilism.
Appleyard, D.R., and A.J. Field. International Economics. Boston: Irwin, 1995.
Markusen, J.R., et al. International Trade: Theory and Evidence. New York: McGraw-Hill, 1995.