The Art of the Tariff

Most Misunderstood

Everyone not living under a rock has probably heard the news by now: Trump is implementing tariffs.

Despite the LinkedIn posts insisting that the tariffs will raise prices so high that your children will starve-and that he is doing so because he hates you, your family, and this country—surprisingly, there is more to the story.

For those who only consume CNN & MSNBC (hopefully none of you) or know nothing about tariffs, they essentially serve three potential functions.

The first is to promote protectionism.

In layman’s terms, the idea behind tariffs is to make foreign imports more expensive by applying a tax so that domestically produced goods become more competitive. The main reason why foreign inputs are considerably cheaper than their domestic counterparts is due to the discrepancy in labor costs.

Once these domestic goods become more competitive, this produces a flywheel effect—domestic goods see increased demand, leading to higher demand for domestic labor, potentially reversing the effects seen in towns like Flint, Dayton, and Detroit, which have been decimated by free trade agreements.

The most notable of these agreements, often referenced by Trump, is NAFTA—the North American Free Trade Agreement.

Negotiated under George H.W. Bush and implemented under Bill Clinton, the bill permitted free trade between the three North American countries, immediately incentivizing companies in the automobile, textile, and electronics industries to relocate factories to Mexico.

Job losses in states like Michigan, Ohio, and Pennsylvania began almost immediately, and wages stagnated as blue collar workers were now competing against lower paid Mexican labor.

There’s no coincidence why Trump flipped those states in the 2016 election.

In this case, the goal of re-implementing tariffs is to shift companies’ incentives back to manufacturing in the US rather than shipping jobs abroad.

The second function of tariffs is to serve as a tool for negotiations on the international stage.

A perfect example happened not too long ago when the Trump administration decided to place duties on a variety of Canadian goods.

Canada, mistakenly thinking they have any type of leverage, decided to impose a 25% surcharge on electricity exports to US states like Michigan, Minnesota, and New York.

Little did they know they were messing with the wrong guy.

Trump immediately threatened to raise tariffs on Canadian steel and aluminum imports from 25% to 50% in addition to tariffs on Canadian automobiles.

Unsurprisingly, Canada walked back their decision.

Another example was in 2019 when Trump and Mexico were in a heated battle over illegal immigration, as he was pressuring Mexico to do their part in preventing migrant caravans from crossing into the US.

Trump threatened a 5% tariff on all Mexican imports, increasing by 5% every month of inaction until it reached 25%.

Given 80% of its exports go to the US, Mexico had no other option but to acquiesce to our demands within days.

The third, and arguably most important, function is to decrease the tax burden and pave the way for substantial tax cuts.

What most people don’t realize is that income tax in America is relatively new; from the founding of the country to 1913, income tax didn’t exist and tariffs provided most of the government’s revenue.

Although a 3% tax on incomes over $800 was signed into law to fund the Civil War, it was swiftly repealed in the early 1870s, just a few years after the war had concluded.

The first tariff was the Tariff of 1789, as tariffs of roughly 5-10% were placed on a handful of goods to pay off revolutionary war debt and fund the new federal government.

27 years later, the first protective tariff was introduced to protect American industries after the War of 1812 by taxing British imports of textiles, wool, iron, and more.

Over the next handful of decades, tariff policy varied, as there were eras of high tariffs, like the late 1820s to protect northern industries, and low tariffs, like the 1840s that saw free(ish) trade become more popular.

Time is Money

Why I’m skeptical about the efficacy of Trump’s tariff gameplan simply comes down to one thing: time.

Tariffs are tricky and the reality is that it’s a long game. And if there is one thing we know about human nature, it’s that people are impatient.

More specifically, the long game is this: in the short run, prices may increase, with the severity depending on numerous factors. In the long run, it is neutralized by the decrease in taxes that are ideally implemented due to the increased revenue brought in from tariffs.

In other words, best case scenario is there will be other deflationary pressures that minimize inflation rates that will potentially lead to the win-win-win of the long term inflation rate hovering around 2%, lower tax rates, and higher domestic output and labor productivity.

Now, will all of that happen within the next 10-20 years? Probably not. Best case scenarios rarely happen.

The most realistic impediment to this is prices rise too much, too fast, the Trump administration may give up on the plan, killing the plant before it could sprout.

With tariffs, there seems to be some level of inevitability with regards to price increases given that the US inputs tend to be more expensive than its foreign counterparts as discussed before.

However, what most people don’t discuss is that Trump implemented tariffs on a wide variety of goods in his first term and was able to keep the average inflation rate under 2% during his presidency.

In an ideal world, the effects of Trump’s tariffs this time around would mirror his first term.

But, because of life’s unpredictability, it could also mirror the Tariff of 1890.

After an immediate jump in inflation, the public expressed their dismay by voting out Republicans in the proceeding elections.

Republicans quickly lost their majority in the house, having the number of seats reduced by nearly half from 171 to 88. In the 1892 presidential election, Benjamin Harrison lost to Grover Cleveland, giving Democrats the Senate, House, and Presidency.

In 1894, the Cleveland administration passed the Wilson-Gorman Tariff which lowered duties across the board. They also attempted to implement a 2% income tax, but it was quickly struck down as unconstitutional in Pollock v Farmers’ Loan and Trust Co.

The context for the Tariff of 1890 was tariffs becoming political in the sense that Democrats became anti-tariff after Cleveland devoted his entire 1887 State of the Union Address to attack the use of high duties.

Because of this, when Benjamin Harrison was elected in 1888 and gained control of both congressional chambers, Republicans felt like it was their duty (no pun intended) to maintain their loyalty to high tariffs.

William McKinley, the chairman of the House Ways and Means Committee, was in charge of drafting the new tariff bill.

When Donald Trump was discussing tariffs with his good friend Joe Rogan, he called McKinley the “tariff king,” stating that the US was “the richest” and “had so much money, we didn’t know what to do [with it].”

While it seems like this is just another case of Trump hyperbole, he is actually spot on; both Democrats and Republicans both agreed that the surplus was so large, they had to find a way to quickly decrease it.

In this day and age where people don’t blink after hearing we are nearly $40 trillion in debt, it is shocking, to say the least, that the problem was that they literally brought in too much revenue.

It was problematic because consumers and business would perceive the surplus as evidence they were being overtaxed.

Additionally, there were concerns that large surpluses would create temptations for pork-barrel spending where politicians would funnel excess funds into unnecessary projects.

Kind of like spending $20 million to create a gay version of Sesame Street for kids in Iraq to promote “inclusion” and “mutual respect.”

And we wonder why the Middle East hates us.

I digress.

Democrats thought that the only way to decrease revenue was to decrease the tariff rate.

Pretty intuitive.

The Republicans, on the other hand, believed that increasing the tariff rate would decrease the demand for imports and thus decrease revenue.

This debate perfectly parallels contemporary tax debates, with liberals aiming to increase revenue by increasing tax rates and conservatives, citing the Laffer Curve, arguing that decreasing tax rates increases spending and investment, leading to higher output and thus more revenue.

With regards to both debates, there doesn’t necessarily seem to be a “right answer,” but rather one option being more suitable in certain contexts or situations relative to the other.

The Republican tariff argument eventually won out and the Tariff of 1890 was signed. However, before in-depth analysis on the effects of revenue could be executed, prices had risen too sharply and briefly Republicans lost their political power.

This scenario could potentially happen to Trump in his second go-around.

One thing that definitely doesn’t help him is his never-ending beef with the media.

It is a tough battle to say the least, as to say the media, with an emphasis on mainstream media, is powerful is an understatement.

Its power has been slowly decreasing over the past five years or so, but it is still a formidable force nonetheless—it literally shapes reality for most people.

Trump’s battle is uphill because any minor hiccup that occurs along the way will be reported nonstop, as they will ensure that every family in America knows that, hypothetically speaking, automobile prices have increased 5% over the past 6 months.

On the other hand, any positive effects, that will likely take time to accumulate, will be purposefully ignored.

Trump’s best bet is to implement tax cuts relatively soon so that it coincides with any potential price increases to neutralize its effects rather than wait for substantial tariff revenue to pour in.

Trump floated the idea of abolishing income taxes altogether, with the implication that the revenue generated would approach the roughly $2 trillion collected annually.

This isn’t very realistic, but it is important to lay the groundwork for a potential plan to significantly slash income taxes, as it is most people’s largest expense every year.

If it wasn’t for those sneaky bankers covertly meeting in Jekyll Island, maybe we wouldn’t be in this situation right now.

But that’s a story for a different day.

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Thanks for reading and until next time.

P.S. Until further notice, memos will be on a biweekly (once every two weeks) schedule.

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