Why the Economic Effects of Taxes (Including Tariffs) Matter

Policymakers have many ways to impose taxes and raise revenue, and each type of taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. comes with different trade-offs. Two tax systems that generate the same amount of revenue but rely on different types of taxes can have different effects on the economy.

At the Tax Foundation, we illustrate the trade-offs of different types of taxes with our General Equilibrium Model. The model estimates how tax policy changes affect the returns to capital and labor, how capital and labor change in response to changes in after-tax returns, and how changes in capital and labor grow or shrink overall output.

When we model a change in tax policy, the estimated effect on economic output is not a reflection of the amount of revenue raised or lowered. Instead, the economic impact is a reflection of how the change in tax policy alters the after-tax return to capital and/or labor and incentives to invest and work on the margin.

When we examine the impact of tax policy changes on American incomes (as measured by GNP), we operate under the assumption that the US is a small open economy, meaning that a change in US government borrowing is not large enough in relation to the total pool of global savings to meaningfully alter interest rates. Rather than producing a “crowding out” effect, changes in revenues produce changes in American incomes by increasing or decreasing interest payments owed to foreigners on US debt. Changes in revenues also affect our projections of the debt-to-GDP ratio.

For example, consider a newly imposed carbon taxA carbon tax is levied on the carbon content of fossil fuels. The term can also refer to taxing other types of greenhouse gas emissions, such as methane. A carbon tax puts a price on those emissions to encourage consumers, businesses, and governments to produce less of them. . We model a carbon tax as an excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. (a narrowly targeted consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. ). Consumption taxes, including excise taxes, create a wedge between the amount of money a person earns from labor and how much consumption a person can afford after tax, effectively reducing real after-tax wages. The reduction in real after-tax wages reduces incentives to work and thus leads to a reduction in hours worked and economic output. Likewise, a carbon tax would increase prices of (and reduce demand for) carbon-intensive goods, reducing real after-tax wages, hours worked, and economic output. We use the same method to estimate the economic effects of tariffs (another form of a narrowly targeted consumption tax), modeling them as an excise tax.

Using this method, we have estimated that the current 2018-2019 trade war tariffs would reduce long-run output in the United States by about 0.2 percent. Empirical studies on the 2018-2019 tariffs so far, using different types of general equilibrium models, have found effects on US output ranging from -0.17 percent to -0.50 percent.

Economists find a negative economic effect from tariffs because tariffs are not a special type of tax that can boost net economic output. Tariffs raise revenue for the government (like any other tax) and shift demand toward domestic industries that produce the protected goods, but that shift represents a reallocation of activity and a redistribution of income—not a net expansion.

If I must spend $3 or $5 or $200 more for a tariffed good or a domestically produced good, that could be $3 or $5 or $200 more for the domestic producer—and it is $3 or $5 or $200 less for me to save or spend elsewhere. While some of that higher cost is captured by the government in the form of tax revenue and by protected industries in the form of higher prices on both existing and new sales, some economic welfare is lost in the process—tariffs lead to losses above and beyond their benefits as investment and activity flow to inefficient producers and as some consumers are priced out of the market.

Some taxes create more economic losses than others, either by falling on more mobile factors of production (like capital) or by causing greater distortions along some other margin (like, in the case of tariffs, inviting foreign retaliation). In an article reviewing the economic effects of the trade war so far, economists Pablo Fajgelbaum and Amit Khandelwal note that these “welfare effects appear small relative to GDP, but this does not mean that the distortions due to tariffs are small . . . the US-China tariffs have a marginal value of public funds (MVPF), defined as the ratio of real income costs of a policy to its revenue benefit, of (minus) 1.2-1.5. This implies that the tariffs are particularly costly relative to many other public policies.”

Tariffs have a net negative impact. Yes, they divert business toward protected domestic producers, but they generate losses for consumers and unprotected businesses of a greater magnitude. For instance, recent tariffs on steel and aluminum led to annual production increases worth $2.8 billion for protected firms but led to a larger $3.4 billion annual average in production losses for downstream industries. Elsewhere, estimates have shown that while tariffs can save jobs in protected industries, they do so at very high costs (e.g., about $650,000 per steel job saved). That is crucial information for policymakers to have when deciding whether to impose tariffs.

Finally, if policymakers want to use the revenues generated by a tax increase for other purposes, that may have an additional economic effect of its own—but it does not erase the economic effect of how that revenue was raised in the first place.

When it comes to tariffs, for example, nearly all the new tariffTariffs are taxes imposed by one country on goods imported from another country. Tariffs are trade barriers that raise prices, reduce available quantities of goods and services for US businesses and consumers, and create an economic burden on foreign exporters. revenue raised under the Trump administration was used to bail out farmers and ag producers harmed by retaliatory tariffs. We’ve also modeled the estimated effects of Trump’s new tariff and tax proposals and compared the trade-offs of each tax policy change for economic output.

Estimating the economic effects of different types of taxes informs policymakers about the trade-offs of raising revenue in a given way. How that revenue is spent may have additional impacts. But mixing the impacts can misguide policymakers seeking efficient ways to raise revenue.

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