What are tariffs and how do they work?

With the Trump administration talking about raising tariffs on U.S. trading partners, there are a lot of questions out there.

What is a tariff?

A tariff is a tax on imported goods. Typically, the tariff is a percentage of the value of the import.

What is the purpose of a tariff?

Governments levy tariffs for a variety of reasons. One is to raise revenue. Another is to protect domestic industries from foreign competition. And tariffs may also be used to punish foreign nations for unfair trading practices or other reasons, such as human rights violations.

Who bears the cost of the tariff?

Legally, the importer pays the tariff. But there is a difference between who legally bears the cost and who ends up paying for it. Typically, foreign producers raise their selling costs to make up for at least some of the cost of the tariff, passing it along in part to their customers. How much of the tariff consumers end up paying depends on how strong demand is for the good and the availability of substitutes from the U.S. and other nations not subject to the tariff. The stronger demand is, and the fewer alternatives are available, the more of the tariff final customers end up paying. In addition, the value of the foreign currency relative to the dollar may weaken in response to the tariff, reducing the price in dollar terms to offset it. This would also make U.S. exports to the other country more expensive in the local currency.

What are some of the benefits of tariffs?

Tariffs can protect domestic industries from competition. In particular, tariffs can allow a country to gain a foothold in an industry that another country dominates. While tariffs may support domestic employment in the affected industries, across all industries employment effects are negligible. Tariffs can also strengthen a country’s bargaining power; the Trump administration has used the threat of higher tariffs to encourage U.S. trading partners to act on policy priorities such as immigration.

Tariffs are a source of tax revenue, and can allow for cuts in other taxes when revenue increases due to higher tariffs. In addition, companies located in other nations end up paying at least some of the tariff revenue.

What are some of the costs of tariffs?

First, importers may not be the only ones to raise prices in response to tariffs. To the extent that tariffs reduce demand for imported goods, this gives domestic manufacturers more pricing power and allows them to raise the prices they charge their buyers.

Higher prices due to tariffs lead to lower demand for the good and lower sales. Also, higher tariffs mean consumers have less money to spend on other goods and services, reducing overall demand in the economy.

In addition, tariffs can raise prices for U.S. industries that use imported goods. Many U.S. manufacturers include imported components in their products, while others buy imported goods to use, such as services firms that use computers and telecommunications equipment. These companies may raise their prices in response to higher input costs from tariffs.

Plus, our trading partners may respond to tariffs by restricting U.S. exports to their countries, either through tariffs of their own or other barriers, such as import quotas. These retaliatory actions reduce demand for U.S.-produced goods and can weigh on economic activity.

How important are imports and exports to the U.S. economy?

In 2023, goods imports accounted for 11% of U.S. GDP, with the eurozone, Mexico, Canada and China each making up about 14% to 16% of goods imports. Exports made up 7% of GDP in 2023.

There are also imports and exports of services, which are not generally subject to tariffs. This services trade includes travel (travel from abroad to the U.S. is an export, U.S. travel overseas is an import), entertainment (such as U.S. films shown abroad, which are an export), and financial services. Services imports were 3% of GDP in 2023, while services exports were 4%.

How will the Federal Reserve respond to tariffs?

The Federal Reserve is concerned about the impact of tariffs on inflation. One of the central bank’s goals set by Congress is stable prices, which the Fed defines as 2% inflation. By raising prices to consumers, tariffs would cause higher inflation. However, the Fed’s response will depend on whether this increase in inflation is temporary or permanent. If tariffs cause a one-time jump in prices, but then inflation (the rate at which prices increase) quickly reverts to its pre-tariff level, the Fed could choose to ignore the temporary pickup in inflation.

Alternatively, if tariffs cause inflation to move higher for an extended period of time, perhaps because higher tariffs lead to larger increases in wages that in turn keep inflation elevated, the central bank could decide to tighten monetary policy, raising the federal funds rate (the Fed’s key short-term policy interest rate) in an effort to slow economic growth and cool off inflationary pressures in the U.S. economy. In his news conference on Jan. 29, Federal Reserve Chair Jerome Powell said the Fed would wait and see what tariffs are implemented and what their impacts on inflation and economic growth turn out to be before adjusting monetary policy in response.

Gus Faucher is senior vice president and chief economist of The PNC Financial Services Group. He shares his insights on the regional economy each month.