The Costs of Protectionism

Ronald Reagan, in his presidential farewell address, touted the accomplishments of the American economy during his time in office by saying, “American industry became more competitive and at the same time we summoned the national will to knock down protectionist walls abroad instead of erecting them at home.”

Today, some thirty-six years later, another Republican president is telling us that protectionism through tariffs is the answer. Tariffs are terrible policy. They are inflationary, acting like a regressive tax that hurts those at the lower end of the economy the most. They do something good government should never do – pick winners and losers. They stifle competition and innovation. And they make the world a more dangerous, less predictable place.

President Trump was elected to a second term largely because Americans were tired of years of post-pandemic, high inflation. He promised to bring down prices and make it a little easier for people to get by. But those who need the most help getting by are exactly those that will be hurt the most by tariffs. I think by now we all know that the country the tariff is imposed upon doesn’t pay the tariff to U.S. Customs and Border Protection, nor does the foreign manufacturer. Instead, the importer here in America does, passing what it can on to the consumer through increased prices. Clearly that is inflationary. Reagan described inflation as “the cruelest of all economic exploitations of the poor and the elderly.” He was correct; inflation acts like a regressive tax, hurting those at the bottom end of the economy the most.

A regressive tax is a tax in which the more money subject to taxation, the lower the rate becomes. The example I think about is social security tax, in which an employee pays 6.2% of their wages up to a cap of $176,100 in wages. That means that an employee earning $50,000 pays 6.2% on all their wages whereas someone earning $10,000,000 pays 6.2% only on the first $176,100 in wages. That millionaire’s $10,918.20 in social security tax equates to an effective tax rate of just 0.1%.

So why do I say that tariffs are a regressive tax? Well, let’s look at those same two Americans. The first already spends all of his income on goods and services during the course of a year, and perhaps even goes out onto his credit cards a bit. That means all of his income is already spoken for, so any increase in the cost of goods because of tariffs (or inflation) means he necessarily has to consume less goods. Our millionaire, on the other hand, most likely spends just a fraction of his income within the course of the year, saving and investing a large percentage of it. So while the goods he buys are also subject to cost increases due to tariffs, there is no potential reduction in the amount of goods he can consume. His savings and investments might be marginally decreased, but that’s all.

Americans fundamentally believe in fairness. And regressive taxes or anything that operates like them such as tariffs are fundamentally unfair. Income tax, on the other hand, is fundamentally fair. We may strongly dislike that there is waste in government or disagree on what services should be provided by government, but fundamentally I believe that Americans see a progressive tax code as fair. After all, the government’s revenue system should be designed with a veil of blindness; the designer should build the system not knowing whether he will be the school teacher or the tech billionaire, and build a system that is fair to both.

I recently saw a chart that showed American individual income compared to the rate of US tariffs from the 1930’s (the repeal of the ill-conceived Smoot-Hawley tariffs) through today. Certainly there are other contributing factors, but it is remarkable how income has grown as tariffs have decreased. Free, efficient markets unleash earning potential.

The argument proffered for imposing tariffs is that it will bring back a golden age of American manufacturing. There are many problems with that argument, not the least of which is one that I as an owner of several manufacturing business over the last 30 years can personally attest; hiring enough manufacturing labor in this country is very difficult. In fact, today only 8% of our non-farm employment is manufacturing. Eighty-six percent is in the service industry and those jobs pay on average far more than manufacturing. Then there is the uncomfortable truth that 100% of us can benefit from lower priced goods but only a small percentage would benefit from more domestic manufacturing jobs. When the average consumer goes to Walmart for a window fan, the choice of an American made one or a foreign made one - with or without a premium due to tariffs - is typically an easy one.

The other argument for tariffs is that we have large trade deficits with many countries. We are the largest economy on the planet and we are voracious consumers. It just may take the world to satisfy that appetite. So I don’t understand the concern here. We have surpluses in some sectors and deficits in others. Consumers go where they get the best bang for the buck. That is free markets. And it is good.

So what about the effect of tariffs on the American business community? Well in the short run any of us as a business owner might want protectionism so that our products are more desirable than a foreign competitor’s. But market forces determine which businesses flourish and innovators typically succeed. And here is another uncomfortable truth - friction of some sort is a prerequisite for innovation. No innovation ever occurred without the force of need or incentive of reward. And a market in which a company is shielded from competition provides neither friction nor incentive. Companies without competitors don’t need to innovate to retain customers, so they rarely will.

Even if tariffs were the correct tool to encourage businesses to bring manufacturing back to America, business executives would need to believe that those policies would be in place for long enough to make the cost of transition worth their investment. How in good conscious, knowing the capriciousness of this president, could they spend the capital to bring manufacturing back to the US when it is just as likely that the current administration isn’t convinced of its own course or that the next administration will have divergent views. Most business leaders will understandably take a wait and see approach. This uncertainty, in and of itself, has sizeable economic and opportunity costs.

Our president is too cavalier in his assessment that there may be short term discomfort because of his policies. Too many Americans and too many small businesses are too close to the line between success and failure. And they were promised things would get a little easier, not a lot harder.

So what of the impact to our country itself? We have already seen, in just the few months that President Trump has been threatening tariffs, that specific industries and companies have lobbied the government for exemptions and special treatment. Enter the lawyers, the lobbyists, the special interests, the businesses seeking to weaponize tariffs against their competitors, and all the accompanying potential for corruption. It is precisely this potential for corruption – and government picking the winners and losers – that made an income tax a far more predictable and fair measure of raising revenue for our federal government.

To those who say some industries are a national defense priority and need tariff protection, I would say okay perhaps some of that makes sense. But where is the line and who draws it? I would also encourage them to take a breath. First, we have allies (if we don’t scare them off). And second, have a little bit of faith in us. Before WWII we were making 3,000 planes a year. By the end of the war, we made over 300,000 with a bomber being produced every 63 minutes! And then there is how quickly we scaled up medical device and vaccine production during the Covid pandemic. We don’t need to make everything here to make everything we need in an emergency.

Frankly I think part of the desire to manufacture more goods at home is a kneejerk reaction to the disruptions caused by the Covid pandemic. Certainly, we had disruptions. But employees were sitting at home and not standing on plant floors, regardless of the country in which the particular business was situated. Perhaps a wiser path forward, instead of wasting time and resources on tariffs and building more plants here at home, might be to smooth out the supply chain with more predictable foreign policy, spend hard on educating our children, and invest more in infrastructure for shipping, ports, and greener ships and trucks.

What gives me the most pause about tariffs, or any policy that lacks consensus, is that political party control will change before we ever get to the long-term benefits envisioned by the policy. We will bear the short-run disruption for nothing. This is particularly concerning with tariffs as they take no time to implement, but because of retaliatory tariffs, they take years to unwind. This is why, as Reagan eluded to, taking steps to tear down unfair tariffs is a far better course than retaliating or imposing tariffs of our own.

Consumer spending is almost 70% of America’s GDP. And the single biggest driver of consumer spending is consumer sentiment. If consumers feel bullish on our economy, they spend. If they feel bearish, they don’t. Often this creates a self-fulfilling prophecy whereby feeling bullish leads to strong economic results where none were warranted and feeling bearish causes the very recession we were worried about. Tariffs are bearish. Disruption is bearish. Uncertainty is bearish. And because tariffs are collected on spending, not income, less consumer spending means less government revenue. It just makes little sense and risks jeopardizing our soft landing.

My last point on the domestic policy side is that there is no doubt part of the administration’s desire for these tariffs is to make it easier for them to extend the Trump tax cuts or to even reduce income taxes further. But at the risk of sounding a liberal, this lowers fair progressive taxes by increasing unfair regressive taxes. It switches where the burden is placed, picking winners and losers.

So we have talked about the effect of tariffs on the individual, on businesses, and the country. All that is left is to discuss the global ramifications. For the record, I am an unapologetic capitalist and globalist. I believe free markets are efficient and efficient markets ultimately lift everyone up. And because history has shown us that economic change usually precedes social change, free markets influence the world in the direction of freedom, justice, and human rights. Oppressed citizens of other countries exposed to western culture typically drive changes for the good in their countries. And Americans buying goods manufactured in other nations create economic opportunities for citizens of those nations that, among other things, keeps us safe (because those with economic opportunity are less likely to be radicalized) and limits illegal immigration (because those with a good life don’t risk all in search of a better one).

Certainly, there are countries that are bad actors. China’s state-owned enterprises and penchant for stealing intellectual property is unfair competition. And even among good actors there are trade issues to be addressed. For example, the EU is a harsher regulator than we are. But part of the solution to these issues cannot be to impose scurrilous tariffs on our friends. It simply isn’t what one does to their neighbors. The EU was our largest trading partner last year, in both directions. What good can be achieved by putting tariffs on them and driving them into the arms of other trade partners?

With our current foreign policy, tariff threats, backing away from alliances, and general unpredictability, our allies are having conversations without us. They are forming alliances that don’t include us. And what is worse, our allies and our competitors are starting to open channels of communication for the first time in years. Yesterday, it was reported that China, Japan, and South Korea have begun economic talks for the first time in 5 years to explore freer trade between them. The impetus for these talks…the uncertainty of US trade policy and pending tariffs.

There is an interesting thing about a bully. They behave as if no one will have the guts to punch them in the nose. But invariably someone does, and the bully shrinks away. It seems the entirety of the global community, be it our neighbors, our allies, or our trade competitors, all stand ready to punch us in the nose with retaliatory tariffs. What good are tariffs if they are matched? It adds no net revenue for anyone, yet it consumes resources for all to administer.

Some say all this tariff talk is for show. It is our President’s way of negotiating. His intention is to close borders, restrict the flow of fentanyl, and ensure the eight percent of workers we do have in the manufacturing sector have access to good jobs. These are all laudable goals. But just how far can tariffs go to accomplish those goals when the other party at the negotiating table can simply reciprocate?

The last warning I would give on trade is that the US currently benefits from the US dollar being the global currency. Fifty-four percent of global trade is invoiced in USD and 59% of currency reserves are held in USD. But with the formation of new economic alliances, the increase in our government using financial sanctions, and a perception of increased political uncertainty, will that last? If it doesn’t, having $36 trillion in debt looks even scarier if we ever have to borrow in a currency we can’t print.

President Reagan said something else in his farewell address. He said “…watch closely. And don’t be afraid to see what you see.” I am watching closely, and to me it appears that tariffs are needlessly protectionist, will inflict short-term pain without ever seeing the long-term benefit, and are designed in part to shift the burden to those who can least afford it.