Writing at the Hoover Institution’s Defining Ideas publication (“Clearing the Air on Tariffs and Deficits,” 24 April 2025), co-blogger David Henderson mentions two plausible arguments for a non-zero tariff. One of those is within an optimal tax regime:
One other intellectually respectable argument for tariffs is that they are part of an optimal tax structure. Our federal government taxes many things: individual and corporate income, capital gains, commodities like gasoline, etc. How can we be sure that a positive tax rate on imports is not part of an optimal tax system? We can’t. We do know that the deadweight loss, which is the overall loss from the tax minus the gain to the government, is proportional to the square of the tax rate. For example, doubling a tax rate quadruples the deadweight loss. So, it could be true that reducing the top marginal tax rate on income from its current 37 percent to, say, 35 percent, and replacing it with a 5 percent tax on imports could reduce overall deadweight loss.
I want to expand on David’s discussion and discuss what I think is a unique aspect of tariffs that makes them more than just some other tax. But first, it is worth using this opportunity to dispel a common myth about free markets and free trade. Free markets do not mean zero taxes (including tariffs). Rather, free markets to me mean non-distortionary taxes. In other words, taxes should seek to raise revenue in as neutral a manner as possible. Any taxes will have some distortionary effects, to be sure, but the goal is to minimize them as much as possible. To put it in Adam Smith’s words (emphasis added):
All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord…The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of the society (Wealth of Nations, Book IV, Chapter IX, paragraph 51, pg 687).
Smith would go on in Book V (Chapter 2) to lay out his maxims of taxation, which would (in his theory) lead to minimal distortions:
- taxes should be proportional,
- taxes should be certain and not arbitrary,
- taxes should be levied at a time convenient to the payer to pay it, and
- taxes should be contrived to take as little as possible.
(To this last point, he adds protective tariffs as a clear violation of this maxim).
So, to wrap up this digression quickly: free markets do not imply no taxes. A government can co-exist with a free market. Likewise, tariffs can co-exist with free trade. What makes taxes and tariffs bad is when they are distortionary and non-neutral. That is: when they attempt to direct the economic activity of people.
Now, back to the main topic: tariffs are unique among taxes.
The vast majority of taxes are purely domestic. However, tariffs are taxes imposed on imports. Thus, they are international. With domestic taxes, how they might be perceived by other governments is irrelevant (unless you have a leader who doesn’t understand the tax, as when they believe that a VAT is an export subsidy). However, tariffs can be seen as a political threat even when not intended as such. It’s possible, then, that another country’s government retaliates, thus rendering a tax that would otherwise be optimal suboptimal.
Indeed, this threat of retaliation has long been discussed as a fundamental problem of optimal tariffs. In his 1987 article “Classical and Neoclassical Roots of the Theory of Optimum Tariffs,” Thomas Humphrey notes that even initial theorizers of the optimum tariff (such as JS Mill) mentioned that a major failing was other countries retaliating (see page 27).
Thus, a theoretically optimal tariff may be practically suboptimal if it is misinterpreted by other governments. The same threat does not exist with domestic taxes.
In a slightly different context, Edwin van de Haar writes of a security dilemma among countries (emphasis added):
In a world devoid of a supreme authority, all states face a security dilemma (Booth and Wheeler 2008). This means that they cannot count on the existence of a stable and peaceful order, even if such an order would be best for general human well-being. There is always the threat of a state, or a group of states, taking advantage of the absence of a global government. The security dilemma is therefore existential. States need to take care of their own security, first and foremost militarily, if they want to survive. Leaders and elites can never be certain about the intentions of leaders of other states, even when they have no intention of harming any other state. In the same vein, weapons that are procured purely for self-defence can be seen as offensive by others. Perceptions matter a lot in a world of uncertainty (Human Nature and World Affairs: An Introduction to Classical Liberalism and International Relations Theory, pg 78).
Consequently, a nation building its military for self-defense could accidently put itself at a greater threat of invasion if the build-up is misunderstood by other governments.
We can see the same dilemma with tariffs; call it a tariff dilemma. A tariff may be part of an optimal tariff scheme, but if it is misperceived by foreign governments as an aggressive action, such an optimal tariff could invite retaliation, making the optimal tariff suboptimal. As is often the case with such policies, we subsequently see increases in rent-seeking and lobbying as domestic firms try to get subsidies or protections from these retaliations, consequently adding more distortions into the system. [1]
Taking into account all these political distortions, it may be the case that the optimal tariff is, indeed, 0%. To build on David’s example quoted above, absent retaliation, a 5% tariff with a 35% top marginal tax rate may be optimal absent tariff retaliation. But, if there is retaliation, then it may be the case that the 37% with no tariff is actually optimal.
At the end of the post, David wonders why the Trump Administration hasn’t tried to justify tariffs as part of an optimal tax system:
Surprisingly, I have not seen any of Trump’s economists make this case. Maybe that’s because to do so would be to admit that tariffs are taxes and that taxes impose costs on those who are taxed. Is it just possible that Trump wants his supporters to be as ignorant of the cost of tariffs as the MAGA dairy farmer in upstate New York was?
Since David has written those words, the Administration and its allies have started to admit that tariffs do impose costs, although the messaging is inconsistent. And I do not disagree with his assessment either. There is always an incentive to obfuscate the costs of political projects.
But let me propose another reason why the “optimal tariff” discussion hasn’t come up: the Trump Administration is openly and shamelessly mercantilist. The repeated attacks on trade deficits indicate the Trump Administration’s tariff scheme is focused on distortionary political goals, not any sort of optimal taxation.
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[1] On a related note, Dom Pino writes that lobbying is up some 277% over last year because of tariffs. The man who wanted to “drain the swamp” is making it deeper
READER COMMENTS
Rob Rawlings
May 21 2025 at 3:35pm
One other case for tariffs that David does not mention is when they are used to counter a subsidy given by a foreign government to its domestic producers. This (arguably) could be used to justify tariffs on some Chinese goods.
Jon Murphy
May 21 2025 at 5:13pm
Yes, that is a possible argument. I do not think such tariffs optimizes things: from the US perspective, it would actually reduce welfare. From a global perspective, you’d be countering one distortionary action (subsidy) with another distortionary action (tariff). First-best would be to repeal the subsidy. There are other issues as well (eg: what counts as a subsidy?), but yes, some do argue for tariffs that way.
Rob Rawlings
May 21 2025 at 6:25pm
Yes, I also would not support tariffs proposed for that reason – they almost certainly would fail to achieve their stated goal and instead add more distortions to the global economy.
Thomas L Hutcheson
May 22 2025 at 12:40pm
Why would a foreign subsidy be a reason to place a tariff on the subsidized item?
nobody.really
May 21 2025 at 3:36pm
Thanks to Jon Murphy (and David Henderson) for this thoughtful exposition of tax policy. I largely share this view–provided that we’re discussing finding the optimal way to tax to finance government expenditures.
But taxes can be used for other purposes, too–and the goals for those taxes are not necessarily the same as for taxes designed to raise revenues. Often taxes are designed to distort behavior–that is, change behavior relative to what people would have done in the absence of the tax. For example, Henderson noted that some taxes (including tariffs) may be intended to protect certain domestic industries related to national defense by discouraging domestic consumers from doing business with foreign competitors. Likewise, an excise tax is designed to discourage other types of behavior. If Jon Murphy were to show legislators that their policy of imposing high taxes on cigarettes was distorting (in this case, lowering) the consumption of cigarettes, I expect they’d be pleased, because that would be the purpose of the tax.
Thomas L Hutcheson
May 22 2025 at 12:43pm
But if a domestic industry deserves to receive more revenue for its output than it receives from selling in an untariffed market, the way to achieve that is with a subsidy, not a tariff.
Warren Platts
May 22 2025 at 8:17am
No. Not at all. This is why these discussions are so frustrating: you’re not addressing the Trump Administration’s argument at all. That’s because the Trump Administration is protectionist, not mercantilist. Until you understand the difference between the two, you really have no business commenting on either.
FYI mercantilism seeks to promote export-led economic growth by running big trade surpluses of mainly manufactured goods. That is, they depend on foreign consumption to drive their production. This further requires the work force to be “competitive” — i.e., poorly paid relative to their labor productivity.
Protectionism, on the other hand, seeks to promote fast growth through domestic consumption. In contrast to mercantilism, this requires high wages for workers. Thus protectionism cautions a high-wage, developed economy such as the United States to avoid the globalist, free trade race to the middle — and massive trade deficits in particular when there is no shortage of capital. Not only does this stuff reduce wages and employment, it slows down overall economic growth. Under protectionism, trade still happens, but it is not emphasized: we will still need imported coffee & tea, bananas & pineapples, and champagne & international tourism. But manufactured goods should be mostly “homespun,” as Keynes put it when he was in a protectionist mood. The long run importance is that a vibrant manufacturing sector will drive future technological innovation that will increase productivity — and technological innovation is the only means for long run GDP/capita growth. Moreover, protectionism has no desire to run massive trade surpluses the way China & Germany do. That said, USA should probably run a modest trade surplus just because we’ve been in the hole for so long. That could be done by balancing the goods trade and letting our services surplus reduce the NIIP.
Jon Murphy
May 22 2025 at 9:51am
While I appreciate you trying to explain to me the field I am supremely competent in, a close reading of your comment shows that you are making a distinction without a difference.
I highly recommend you read the relevant literature (such as what I linked to) and reconsider your argument.
nobody.really
May 22 2025 at 12:39pm
I’m grateful to Jon Murphy and others on this blog for the info they provide me, free of charge, on various topics. I regret only that I cannot absorbe it more efficiently.
If beggers may be choosers, I’d be even more grateful if someone would like to provide additional exposition (or link to past exposition) addressing the distinction (or lack thereof) identified by Warren Platts. As I understand it, he argues that Trump is willing to forego the comparative advantages of international trade in order to turn the US into a gated community of rich people doing business with rich people–a policy Platts distinguishes from merchantilism. I find that description of Trumpism compelling, and the distinction novel–and Murphy’s reply makes me think that I’ve missed something here.
I’m chagrinned to imagine Murphy shaking his head in discouragement that his students have failed to graps so elementary a point as this. Such are the burdens of the professor, even one who is not paid by his students….
Jon Murphy
May 22 2025 at 2:30pm
In my last paragraph in the blog, you’ll see a link to the CEE entry on mercantilism. It’s quite thorough and you’ll see the distinction Mr Platts is trying to draw is one without a difference. He is merely describing a particular facet of mercantilism, not something uniquely different from it.
Warren Platts
May 23 2025 at 7:15am
I read that article. It is far from comprehensive and she makes the same mistake that you do: using ‘mercantilism’ and ‘protectionism’ interchangeably. Until you understand the difference, you can never have a proper understanding of Smith’s Wealth of Nations because he himself makes the distinction clear: half the book is a screed against mercantilism, yet Smith was not against judicious protective tariffs if they removed what you call “distortions into the system” or cushioned China-shock level shocks to workmen while raising desired government revenue at the same time. Cf.:
Or:
Indeed, if you want to stump a free trader, ask her why Smith took the job of Scottish Commissioner for Managing and Causing to be Levied and Collected His Majesty’s Customs, and Subsidies and other Duties in that part of Great Britain called Scotland, and also the Duties of Excise upon all Salt and Rock Salt Imported or to be Imported into that part of Great Britain called Scotland. They never have answer. But once one realizes that Adam Smith was what I call a mild protectionist, it makes perfect sense.
Similarly, consider Alexander Hamilton’s Report on Manufactures, the founding document of American System protectionism. Was Hamilton’s Report a warmed over version of Mum and Walpole? Of course not! Hamilton’s Report on Manufactures was as much a rejection of mercantilism as was Smith’s Wealth of Nations. Cripes, half the reason the Americans rebelled was because of Great Britain’s mercantilist exploitation of the American colonies! Granted, Hamilton was aware of Smith’s work; they were contemporaries after all. But people seem to forget that Smith’s economic philosophy wasn’t implemented until nearly a century passed after 1776. Therefore, it is mistake to conceive of Hamilton’s Report as mainly an explicit rejection of free trade because no one practiced free trade in the early 19th century.
One should ask: What does protectionism seek to protect against? Is it free trade per se? No! Protectionism was originally conceived — and still is — as protection against predatory, beggar-thy-neighbor mercantilism.
Again, if you want to understand the difference between mercantilism and protectionism, just look at their respective treatment of workmen’s wages. Mercantilists want low-wages in order to in order to increase profits (aka savings) and to be “competitive” and thus drive exports. Protectionists seek high wages in order to drive domestic consumption. Thus, perhaps ironically, protectionism shares with free trade ideology the emphasis on consumption; the difference is that free trade zealots tend to forget that workers are producers in addition to being consumers. It’s true that driving down working class wages will reduce the price of goods and services for the laptop class: that’s the one thing that free trade ideology shares with mercantilism, and indeed is the main reason free traders seek to trade with mercantilists: it drives down wages, thereby lowering the price of consumer goods. However, reducing the purchasing power of the working class slows down overall economic growth. Moreover, there is little incentive to invest in new labor-saving devices (aka automation) that increase labor productivity when it’s easier to throw cheap labor at any problem. Therefore, protectionism ultimately seeks to save the laptop class from itself.
Jon Murphy
May 23 2025 at 12:04pm
Again, while I appreciate you are trying to explain to me a topic I am supremely qualified in, your argument would be far more persuasive if you could provide some sort of authoritative citation rather than relying on your own authority.
Jon Murphy
May 22 2025 at 10:04am
One thing I will say:
While the Trump Administration is openly mercantilist, as is some of his base (eg the “fix trade deficits come Hell or high water” crowd), I am not sure Trump himself is. It’s not clear to me he has a guiding ideology. He seems to be guided by one simple mantra: “I am the dealmaker.” Tariffs are a means to make deals (no matter how bad they are or whether they clash with other stated goals) and nothing more.
I mean, he has the understanding of a mercantilist, but I’m not sure it’s his ideology.
Jose Pablo
May 22 2025 at 2:36pm
He seems to be guided by one simple mantra: “I am the dealmaker.”
This observation is absolutely accurate.
He seems to believe that he is personally buying from and selling to other governments or countries as counterparts, and that he can extract additional value from these transactions through his supposed deal-making prowess. The tariff threats and the back-and-forth become more comprehensible when viewed through this lens, otherwise, they appear entirely nonsensical.
All of this, of course, rests on a deeply flawed understanding of what is actually being given or gained through trade.
Inevitably, this mindset flattens the complexity of reality: some American individuals, cities, counties, or even states may indeed run trade surpluses with the rest of the world. But all of that, the nuance, the detail, the unseen layers, vanishes in the simplistic worldview of the “negotiator-in-chief.”
The same logic extends to his approach to international conflicts: it is less about any guiding ideology and more about creating opportunities to showcase his supposed ability to strike a deal.
Ultimately, it is all about a personality trait more than about a political or trade philosophy.
Thomas L Hutcheson
May 22 2025 at 12:48pm
If it were desirable to be running a trade surplus be a net capital exporter, the way to achieve it would be reducing fiscal deficits and taxing consumption, not income, policies I’d like to see on economic growth grounds.
José Pablo
May 22 2025 at 6:17pm
A big “if”
Warren Platts
May 22 2025 at 1:48pm
Regarding Adam Smith, he was not against tariffs per se (he was against mercantilism). Moreover, he thought that tariffs could reduce distortionary effects when taxes are assessed against to domestic producers. From Wealth of Nations:
For example, in the USA, domestic producers in import competing industries are punished with corporate income taxes on profits, whereas foreign producers are rewarded with tariff-free access to the U.S. market (at least pre-Trump). Thus in this case Smith would recommend a counter-veiling tariff such that the foreign producer is not privileged over the American producer.
Smith’s logic extends to externalities in general. For example, heavy industry can be both dirty and dangerous. Hence the U.S. has onerous environmental, health and safety regulations — for good reason I might add. The result is the costs of mitigating these externalities are baked into the price of Made-in-USA goods. Indeed, if such externalities were accounted for globally, it would turn out Chinese products would be hardly cheap enough to justify their shipping costs; the reason Chinese goods are “cheap” is because they dump waste and dead animals into rivers, pollute the atmosphere, pump out CO2 as if it’s going out of style, have such crappy working conditions that the Foxconn plant that assembles Apple Iphones have suicide nets, and employ outright slave labor in forced labor camps in Xinjiang.
Therefore, by rights, following Smith’s logic, Trump should impose in addition to the 10% revenue-raising tariff and the 20% fentanyl tariff (not nearly enough considering the trillion dollar economic losses that result), there should be a 10% environmental tariff, a 10% labor standards tariff, and a 10% carbon tariff on Chinese goods: 60% altogether. Such a tariff would be fully consistent with Adam Smith’s economic philosophy.
Jon Murphy
May 22 2025 at 2:32pm
You’ve repeated your point here multiple times over the years and, despite all the times being shown you fundamentally misunderstand Smith’s argument and the current state of US taxes, you continue to repeat it as though nothing has been said. It’d be far better if you could actually interact and address those factual issues with your post rather than merely repeat them umprompted every two months or so.
Warren Platts
May 23 2025 at 7:40am
Smith said, “It will generally be advantageous to lay some burden upon foreign industry for the encouragement of domestic industry, when some tax is imposed at home upon the produce of the latter.” “Some tax” is pretty vague and would seem to be inclusive. Therefore, I ask you why you think that Smith would conclude that a 21% U.S. corporate income tax does not count as a burdensome tax imposed upon the produce of U.S. producers? For that matter, why would you think that the U.S. payroll tax rate of 15.3% on workers’ wages not also a burdensome tax imposed upon the produce of U.S. producers? Is it because the corporate income tax is not a consumption tax? Why should that make a difference? Was Smith thinking exclusively of what we’d call VATs today? Why would you say that? And after all, since Value-Added = Profits + Wages, if we tax profits and wages instead of value-added, what’s the difference?
And as for VATs, I think we can agree with the Econ 101 principle that the consumption tax burden tends to be shared with both consumers and producers. And thus when the producer is a foreigner, the government can extract so-called “terms-of-trade” gains; that is, the government gains the full tax revenue of the import tax without having the full cost of that tax borne by the home consumers. Thus, precisely because a VAT doesn’t “discriminate” against imports, it’s actually a better beggar-thy-neighbor policy than plain old tariffs! (You can draw out a Marshallian supply-and-demand diagram to prove this is true.) Trust me, the Europeans are fully aware of this principle, even if you Americans are not.
Jon Murphy
May 23 2025 at 1:21pm
Let’s accept your claim at face value. Note that the entire post is about how such “strategic” use of tariffs can backfire. It’d be far more constructive if you address the argument rather than pretend nothing has been said.
David Seltzer
May 23 2025 at 6:51pm
Jon: In the same vein, weapons that are procured purely for self-defence can be seen as offensive by others. Perceptions matter a lot in a world of uncertainty. Thucydides’ History of the Peloponnesian War observed that Athens’ military build up, instilled fear in Sparta, which made war certain. I suspect retaliatory tariffs are an international trade example of the Thucydides Trap.