Tariffs have dominated discussions around the global economy in recent months, following the U.S. government's decision to raise tariff rates around the world. According to standard economic theory, tariffs protect domestic industries that compete with imports, helping to increase employment in those sectors. However, they also tend to hurt domestic consumers by raising prices in those industries.
A country can, in some cases, improve its overall welfare through carefully designed tariff policies - particularly if those tariffs influence world market prices. But things become far less clear when other countries respond with retaliatory tariffs. In such cases, a tariff war may reduce the welfare of all the trading partners involved.
Although tariffs may support domestic industries that compete with imports, applying tariffs to inputs can make exports more expensive by driving up production costs. This means the exporting sector of the tariff-imposing country may end up worse off.
The U.S. government has suggested that higher tariffs could encourage foreign firms to invest directly in the U.S. (through foreign direct investment, or FDI). While tariffs on finished goods might indeed prompt some foreign producers to set up operations in the U.S. to avoid those extra costs, the reality is more complex.
For example, if foreign producers face different tariff rates depending on where they operate, they might choose to relocate to a third country, rather than the U.S. Tariffs on both inputs and final goods could also discourage FDI by making it more expensive to produce in the U.S.
Uncertainty over how long tariffs will remain in place may further affect FDI decisions. If firms aren’t confident tariffs will last, they may delay investing, hoping that future tariff cuts will allow them to keep producing in their preferred locations.
This policy approach can also affect the FDI decisions of producers from the tariff-imposing country. For instance, a domestic firm planning to invest abroad to serve both the home market and international customers may find such an investment less attractive if tariffs make it costly to export back to the home country. That said, this isn’t the only possible outcome.
Alternatively, the firm might choose to invest in a different foreign country - perhaps one facing lower tariffs - and use that base to supply both its domestic and international markets. Another strategy could involve investing in the most preferred foreign location for serving global demand, while maintaining a separate plant at home for the domestic market. Although this setup brings some production back home, it may limit opportunities for cost savings through economies of scale.
There are also potential environmental concerns. If higher tariffs attract investment from firms with more polluting technologies, this could result in environmental harm unless mitigated by effective regulation. On the other hand, very strict environmental policies might discourage such investment by raising local production costs.
The impact on innovation is more ambiguous. On one side, greater protection in final goods markets can boost profits and support R&D. On the other, if input tariffs raise production costs, profits may decline, potentially reducing the incentive to innovate. The net effect isn't always straightforward.
Higher barriers may also influence labour movement and trade relationships. While they can create jobs domestically, they may also cause job losses in partner countries, possibly increasing migration to the tariff-imposing country. At the same time, trade may be diverted away from the imposing country or redirected to partners facing lower tariffs. This kind of trade reshuffling doesn't always guarantee that imports come from the most efficient global suppliers.
Finally, increased tariffs may prompt multinational firms operating across borders to adjust internal pricing - a practice known as transfer price manipulation - in order to reduce their tariff burden. While this may benefit the companies involved, it can also erode tariff revenues for the country imposing the duties.