Can Trump replace Income Tax with
Tariffs?
No, and trying would be regressive and
harm economic growth.
In the list of untested policy ideas from Trump, scrapping the
federal income tax and replacing it with revenues from sky-high
tariffs on imports is one of the most harmful.
For starters, it would cost jobs, ignite
inflation, increase federal deficits, and cause a recession.
It would also shift the tax burden away from
the well off, substantially increasing the tax burden on the poor and
middle class.
If pursued, this policy would antagonize US
allies and partners, provoking worldwide trade wars, damaging global
economic welfare, and undermining national security.
It would also likely destabilize the global financial system. |
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For Instance:
The poor pay over 10% of their income to SALES TAX
compared to 5.4% for the rich. = REGRESSIVE
To be sure, when Trump vents before friendly audiences, one has to
take it with a large grain of salt.
But a partial substitution of tariffs for income tax revenues is
nearly inevitable under a Trump presidency.
He has repeatedly proposed increased tariffs, including a 10 percent
across-the-board tariff on all trading partners as well as 60 percent
or higher tariffs on goods from China.
He has also called for extending the Republican
Tax Scam of 2017, which is due to expire
2025, a step that could
easily cost as much $5 trillion over ten years.
And Trump has suggested further cuts, particularly on the corporate
side.1
The dangers of these specific actions are outlined in a recent policy
brief
here.
But let’s take Trump seriously, because it
can be dangerous not to.
Exactly how far could Trump take the logic of replacing income taxes
with tariffs? |
Can Tariffs replace Income Tax?
Simply put, no.
Tariffs are levied on imported goods, which totaled $3.1 trillion in 2023.
The income tax is levied on incomes, which
exceed $20 trillion;
the US government raises
about $2 trillion in individual and corporate
income taxes at present.
It is literally impossible for tariffs to fully replace
income taxes.
Tariff rates would have to be implausibly high on
such a small base of imports to replace the income tax, and as tax rates rose,
the base of imports itself would
shrink as imports fall,
making Trump’s $2 trillion goal unattainable.
A recent
Peterson Institute policy brief calculated that revenues from Trump’s 10%
/ 60% tariff proposals would total about $225 billion per year in current
dollars.
This figure is certainly an overestimate because it does not account for
lower economic growth due to the inevitable
economic shocks caused by retaliation against US
exporters and the losses
suffered by the import-dependent manufacturing
sector.
Exporters would also be hit by an appreciating dollar,
as discussed below.
For the assumed import response to the tariff, the rate that maximizes tariff
proceeds is 50 percent, and tariff revenues peak at about $780 billion. 3 When tariff rates increase beyond the
peak of the curve, tariff revenues actually fall, since the negative effect of
reduced imports outweighs the higher tariff rates.
At the revenue-maximizing tariff rate of 50%,
customs revenue peaks at about $780 billion, less than 40% of what
income taxes bring in
Again, this analysis ignores negative effects on economic growth, which would
be dramatic with a 50% across-the-board
tariff rate, reducing revenues substantially.
Another consideration that comes into play is that the United States already
raises
about $50 billion from tariffs on imports.
That amount reduces the revenue potential of new tariffs relative to figure 1.
In addition, a tariff as large as 50%
would create very large distortions in Americans’ economic activity
(moving resources away from sectors where the United States has a comparative
advantage and toward sectors where it is less efficient),
while increasing tax avoidance and evasion (including shopping abroad,
smuggling, lobbying government officials for exemptions, etc.).
What if tariffs are pushed to the limit?
As a thought experiment, let’s continue to ignore growth effects and assume
that a sum of $780 billion from tariffs each year could finance a large income
tax cut. 4
What would be the consequences of such a fiscal shift?
- First, while one could debate the merits of switching from an income to a
consumption tax base, tariffs are a particularly distortionary form of
consumption tax.
Because they only tax imports, tariffs shift the production in the US economy
away from things it does well (e.g., export goods like airplanes and light
trucks) and toward goods in which the United States has no comparative
advantage (e.g., clothing and furniture).
- Second, even a straightforward consumption tax has important effects on
the distribution of the tax burden, since poorer
households save very little and consume more traded goods as a share of their
income than do richer households, who save far more and consume relatively few
traded goods as a share of their income.
In a
recent policy brief, we showed that tariff burdens are therefore starkly
regressive, even as they make all households
worse off.
Imagine Trump pushes his policy to the maximum, raising $780 billion in
tariff revenue and cutting income taxes by $780 billion, in proportion to the
current income tax burdens of individuals and corporations shown in
Cronin (2022).
This policy experiment appears revenue-neutral, but it would actually
lose revenue because of the contractionary
consequences of such high tariffs, which we do not model.
Some have argued that the increased consumption tax burdens might be worth it to
workers who benefit from an industrial renaissance due to the protection of high
tariffs.
Yet neither the economics nor experience supports this
view.
The US economy is already at full employment, so expanding production
in tariffed sectors inevitably draws resources away from other sectors in the
economy.
This process makes the US economy less efficient,
as activity moves toward sectors where productivity and wages are typically
lower.
At the same time, new shocks will be introduced by
the inevitable retaliation by US trade partners
alongside the massive disruption to supply chains
that 50% tariffs would entail.
As multiple studies show, the first round of Trump
tariffs harmed both job growth and industrial
competitiveness. 5
The dollar’s exchange rate would rise, hurting US exports
A less well understood but no less important consequence of these changes
is the effect on the dollar’s exchange rate.
A range of macroeconomic models predict that permanent tariffs on US imports
would cause the dollar to strengthen in the foreign exchange market.
Trump has touted the idea that tariffs will reduce the
US trade deficit.
However, a stronger dollar would add
to the trade deficit by making US exports of
goods more expensive abroad and making
foreign production relatively cheaper.
With a 50% tariff, the dollar’s appreciation could be massive—a
substantial fraction of the huge tariff hike. 6
The dollar’s appreciation after a generalized US tariff increase is
necessary to maintain equilibrium in global goods markets.
In its absence, there would be an excess supply of foreign goods (and an
excess demand for US goods) because a US tariff switches US residents’
demand from imports to American goods.
However, a stronger dollar raises the relative international price of US
goods, encouraging global consumers and firms to shift
away from US exports and toward the products of their own countries.
This shift helps to restore the global balance between supply and demand.
Trump’s tariff and tax ideas are a dangerous, backward move to the 19th
century
Trump’s latest musings may be just that—musings.
But his statements show he is serious about shifting the revenue base from
income to imports, building on his prior record of substantially higher
tariffs and large, regressive tax cuts.
Leaving aside his dreams of replacing the income tax, his concrete tariff
proposals enunciated so far would affect more than $3 trillion in trade,
nearly 10 times the trade targeted by his China trade war.
By contrast, while President Biden has kept most of Trump’s tariffs, his
recently announced new tariffs affect only $18 billion in trade, less than
1/150th of the trade Trump’s proposals would target.
Biden’s trade policies are more narrowly targeted at particular strategic
aims rather than an embrace of tariffs writ large.
This all-out embrace of higher tariffs is dangerous.
It is bad fiscal policy, since tariff revenues will
fall far short of Trump’s tax cutting ambitions, and switching the
fiscal burden from the income tax toward tariffs harms
most Americans, benefiting only those at the
top of the income distribution.
Beyond these fiscal effects, high tariffs are likely to worsen
macroeconomic imbalances, harm exports, diminish
economic growth, and create new economic shocks, including higher inflation.
When the 16th Amendment to the US Constitution
was ratified in 1913, the United States moved from a public revenue model
based on tariffs to one reliant on a graduated income tax.
Not only did this make the tax structure more progressive, it also opened
the US economy and positioned the country for the global leadership role it
would assume in the following century.
Trump’s ideas about tariffs and taxes return the United States to the 19th
century, a backward move that is dangerous and
regressive. |
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But it is not the end of the story.
In response to Trump’s tariffs, foreign central
banks would feel compelled to cut their interest rates to offset the
loss of exports to the United States, also driving dollar appreciation.
Anticipating this outcome, global investors would immediately bid up the
dollar’s value as they all move to add dollar assets to their portfolios.
Those moves, in turn, will make US exports yet more
expensive abroad, reducing the global demand
for them even more.
This destructive cycle would further dampen the
increase in US aggregate demand due to US residents switching from imports
to (more expensive) substitutes produced at home.
That US consumers and businesses would face higher
prices than before the tariff, despite a stronger dollar, would
further constrain consumption and investment.
To be sure, the federal government could try to offset negative demand
effects by lowering taxes on individuals and businesses, but the relief
would be only partial because of the distributional effects discussed above
that favor well-off high-saving households.
As for Trump’s professed goal of reducing the US
trade deficit, these factors make such an outcome uncertain.
To address persistent trade deficits, the
Trump administration might then turn to capital import
taxes, as some on his team have suggested.
This is a bad idea that would
dramatically lower investment, growth, and innovation,
as argued
in a recent commentary
Unlike the United States, most countries experiencing currency
appreciation benefit from a lower price of imports, which are typically
invoiced in major foreign currencies, predominantly the dollar.
But the United States does not enjoy that advantage because almost all of
its imports are
invoiced in its own currency , the
dollar.
As a result, the US price level would not benefit from a sharp, immediate
fall in import prices resulting from the dollar’s strength, so the
inflationary impact of a big tariff increase
would be severe, and especially severe given
that the United States is currently at full employment.
Foreign suppliers might lower their dollar prices in time, but such
responses would occur slowly. 7
These problems would be compounded if, as is likely, US trade partners
retaliated with tariffs of their own.
An IMF
study focusing on a more limited tariff
increase than the one Trump is proposing—a tariff increase of 20 percent on
goods from East Asia only—
projects that US GDP contracts by more than a percentage point in a
scenario with retaliation by trade partners.
Based on that finding, Trump’s far more ambitious tariff proposals could
spark a generalized trade war and severe
stagflation at home and abroad. |
Notes
1.
For news articles on these proposals, see
here and
here.
2.
The tariff lowers the value of imports, which is the tax base for the tariff, as
both consumers and firms reduce import volumes.
While the literature examining the prior experience with the Trump tariffs did
not show any decline in foreign supply prices, it is also possible that foreign
suppliers would lower prices to preserve market shares in the United States.
If some imports are invoiced in foreign currency (which they are overwhelmingly
not for the United States), any appreciation of the dollar (to be discussed
below) would also lower import prices and therefore nominal imports.
3.
Some aspect of this Laffer curve calculation under a constant import sensitivity
are no doubt unrealistic.
In particular, imports are unlikely to disappear entirely at a tariff rate of
100 percent.
As an alternative, if we use an import sensitivity of 2 from a semi-log
specification, revenues still peak at tariff rates of 50 percent, but the tariff
revenue is lower at the peak (just shy of $600 billion).
Imports would decline more rapidly at first, but more slowly as tariffs reached
extreme levels.
4.
Since tariffs implemented by executive action would not be scored by official
scorekeepers, the administration may also claim that tariffs raise more revenue
than they do.
We are ignoring that issue at present, although it is likely to be an important
political economy dynamic.
5.
See David Autor, Anne Beck, David Dorn, and Gordon Hanson, 2024,
Help for the Heartland? The Employment and Electoral Effects of the Trump
Tariffs in the United States,
Working Paper 32082, Cambridge, MA: National Bureau of Economic Research;
Aaron Flaaen and Justin Pierce, 2024,
Disentangling the Effects of the 2018-2019
Tariffs on a Globally Connected US Manufacturing Sector, Finance and
Economics Discussion Series 2019-086, Washington: Board of Governors of the
Federal Reserve System; Kyle Handley, Fariha Kamal, and Ryan Monarch,
forthcoming, “Rising Import Tariffs, Falling Exports: When Modern Supply Chains
Meet Old-Style Protectionism,” American Economic Journal: Applied Economics;
Katheryn N.
Russ and Lydia Cox, 2020,
“The Trade War Has Cost 175,000 Manufacturing
Jobs and Counting,” Econbrowser, September 19; Katheryn N.
Russ and Lydia Cox, 2020,
“Steel Tariffs and US Jobs Revisited,”
EconoFact, February 6.
6.
The original theoretical reference on tariffs and exchange rates is
this
one.
For recent empirical support, see
this panel study as well as
this paper focused on the United States.
Another recent paper focuses on the Trump
administration’s China tariffs and finds that they caused a small dollar
appreciation (as well as a depreciation of the yuan).
However, the China tariffs were far from the tariffs on all imports
that Trump is proposing now.
The latter would have a much more systematic effect on the dollar’s foreign
exchange value.
Large-scale models also point to
comprehensive tariffs leading to currency appreciation, perhaps on the order of
half of the overall tariff increase.
7.
Tariffs in the Trump administration led mostly to commensurately higher prices
paid by US residents rather than to foreign suppliers lowering their prices.
See, e.g., Pablo D. Fajgelbaum, Pinelopi K. Goldberg, Patrick J. Kennedy, and
Amit K. Khandelwal, 2020, “The Return to Protectionism,”
Quarterly Journal of Economics 135, no. 1: 1–55; Pablo D. Fajgelbaum,
Pinelopi K. Goldberg, Patrick J. Kennedy, and Amit K. Khandelwal, 2020,
update to Fajgelbaum et al.(2020); Pablo D.
Fajgelbaum and Amit K. Khandelwal, 2022,
“The Economic Impacts of the US–China Trade
War,”
Annual Review of Economics 14, no. 1: 205–28; Mary Amiti, Stephen J.
Redding, and David E. Weinstein, 2019,
“The
Impact of the 2018 Tariffs on Prices and Welfare,” Journal of Economic
Perspectives 33, no. 4: 187–210; Mary Amiti, Stephen J. Redding, and David
E. Weinstein, 2020, “Who’s Paying for the US Tariffs? A Longer-Term
Perspective,” AEA Papers and Proceedings 110 (May): 541–46; Alberto
Cavallo, Gita Gopinath, Brent Neiman, and Jenny Tang, 2021,
“Tariff Pass-Through at the Border and at the Store: Evidence from US Trade
Policy,”
American Economic Review: Insights 3, no. 1: 19–34; Aaron Flaaen, Ali
Hortaçsu, and Felix Tintelnot, 2020,
“The
Production Relocation and Price Effects of US Trade Policy: The Case of Washing
Machines,” American Economic Review 110, no. 7: 2103–27; and
Sebastien Houde and Wenjun Wang, 2023,
The
Incidence of the US-China Solar Trade War Rochester, NY.
Data Disclosure
The data underlying this analysis are available
here [zip]. FIGURES 1 & 2
1
Here, we use the same technique as in the policy brief to consider
revenue but ignore the negative “offset” effects on revenue elsewhere in
the system, since we assume the tariff increases are paired with equal and
offsetting income tax cuts.
Using the same standard import-sensitivity of 1 (which assumes that a 10
percentage point increase in tariffs reduces imports by 10 percent),
figure 1 shows the resulting tariff Laffer curve; we also illustrate other
import sensitivities in the figure.2
However, if such a policy were enacted, the distributional
consequences, without considering growth effects, are shown in figure 2.
The consequences of this shift are dramatic.
Under such a scenario, the bottom quintile loses 8.5 percent of their
after-tax income with no offsetting income tax cut.
The middle quintile loses about 5 percent on net, with a small
compensating income tax cut that is insufficient to compensate for a
larger tariff increase.
The top quintile loses 4 percent of income to the tariff increase but is
compensated with a 6 percent tax cut, coming out 2 percent ahead.
The top 1 percent nets an 11.6 percent increase in after-tax income.
FIGURE 2
Tariff revenue Laffer curves for different
elasticity assumptions, annual revenue, billions of dollars, 2023
At the revenue-maximizing tariff rate of 50 percent in figure 1, tariff
revenues are less than 40 percent of what income taxes bring in.
SOURCE
https://www.piie.com/blogs/realtime-economics/2024/can-trump-replace-income-taxes-tariffs
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