International trade represents massive opportunities for businesses. Tapping into foreign markets could mean accessing cheaper options or new goods that could expand your offerings. Or you could start selling to new audiences abroad, increasing your customer base and untapping potential revenue.
But the opportunity it represents doesn’t come without its costs.
Some imports and exports come with tariffs, which increase the price of doing business abroad, potentially turning an opportunity into a costly endeavor.
Understanding tariffs helps you decide whether going international is beneficial or not. With our guide, you’ll have the info you need to start your planning.
What are tariffs?
Tariffs are taxes that are imposed on imported goods and services. The purpose of these taxes is to increase the prices of imports, making them less desirable to local consumers.
When something gets imported, it goes through a customs process where the item is classified and valued based on what it is and where it came from. The customs officials then impose the tax, which is paid by the importer.
It’s less common, but tariffs are sometimes imposed on exports. Tariffs on exports are imposed to try and keep goods and services within the country rather than send them to foreign buyers.
How tariffs work
Tariffs are typically calculated in one of two ways:
Ad valorem tariffs are calculated as a percentage of the imported good’s value. If a shipment has a value of $1,000 with a 10% ad valorem tariff, the tariff cost would be $100 (1,000 x 0.10).
Specific tariffs are fixed-fee taxes that are imposed on some measurement, like quantity or weight. If someone imports 100 pounds of goods with a specific tariff of $5 per pound, the tariff cost would be $500 (5 x 100).
In some rare cases, tariffs are calculated both ways, meaning they have a fixed-fee tax and a percentage of value tax. These are called compound tariffs.
For example, a country could impose a compound tariff on cocoa beans with a $5 per pound and 10% of value rate. If a purchase of 100 pounds of cocoa beans costs $1,000, the total tariff cost would be $600: $500 from the specific portion and $100 from the ad valorem portion.
The evaluation and imposition of tariffs happen as goods are brought into the country. It’s the responsibility of the importer to then pay the tariffs. However, in most cases, businesses pass on the cost of tariffs to their consumers by increasing the prices of products and protecting their margins.
Different types of tariffs
Tariffs are commonly defined by their purpose, and these are the most common examples.
Protective tariffs
Protective tariffs are designed to protect local industries from foreign competition by making foreign products more expensive.
If a nation has a large textile industry with the price of fabric typically being $10 per ream, but demand has fallen due to the introduction of a foreign competitor priced at $8 per ream, the government could impose a tariff to maintain a domestic competitive advantage, protecting the local industry.
The purpose is to maintain demand for locally produced goods, which helps sustain gross domestic product (GDP) levels and employment.
Revenue tariffs
Revenue tariffs are imposed to generate income for the government, often to fund a specific project.
For example, the government may need to fund improvements to its harbor infrastructure through which many imports arrive. Imposing a temporary tariff on all imports could fund the project, with the tariff being removed once it’s completed.
While protective tariffs are targeted, revenue tariffs are open-ended as they aren’t intended to affect specific products or industries.
Retaliatory tariffs
Retaliatory tariffs are imposed in response to another country’s imposition of tariffs or changes in trade policies. The thinking is that if a trade partner is aiming to reduce imports, then the country needs to make moves to increase local consumption and offset the losses.
The imposition of retaliatory tariffs is often an indication of broader trade disputes, with further developments having dramatic effects on trade activity.
Anti-dumping duties
Anti-dumping duties are a specific type of protective tariff that targets goods being “dumped” by foreign producers in the domestic market at below market costs.
Dumping is considered to be penetration pricing or predatory pricing, a strategy of selling below market value to reduce retail prices and eliminate competitors. Once competitors are priced out of the market, the foreign producers create a monopoly and can increase prices back to or above expected levels.
Why do governments impose tariffs?
Different types of tariffs are imposed for different strategic reasons.
Protecting domestic industries
If foreign producers can provide a good or service for cheaper than domestic producers, consumers will move towards the more cost-effective option. But this has adverse effects on the local industry as its demand drops.
The effects of local production demand dropping impact business owners, employees, and taxation.
By imposing a tariff on foreign products, governments can artificially inflate their prices to give local alternatives a competitive edge.
Generating tax income
Tariffs have been used historically as a source of government funding. These tariffs could be used to fund specific projects, initiatives, or for general use within a government.
This is less common in the modern age, with free trade agreements implemented to protect imports from tariffs and taxation.
Supporting infant industries
A country may look to develop a new production sector that is already established abroad. For example, they may look to start producing electronics, which would have to compete against the historically dominant China.
During an industry’s “infancy,” its efficiency would be low, and costs would be high. To support its development, the country would impose tariffs on those types of products and give locally produced goods a competitive advantage, despite the higher costs.
Reduce dependency on foreign suppliers
When a nation is dependent on a trade partner for essential goods, like pharmaceuticals, it’s at risk of losing access to those goods with a change of foreign relations, policy, or disruption of industry.
Imposing tariffs on those goods promotes the production of those goods locally. In the example of pharmaceuticals, this could mean maintaining access to essential medicines or equipment if there is a disruption with the foreign supplier.
Protecting domestic consumers
While tariffs often result in consumers paying higher prices, they are sometimes introduced to protect consumers from cheaper, substandard imports.
In some cases, the lower price for the foreign product comes with a lower quality product. If that lower-quality product takes over a larger portion of the market, it could price out higher-quality alternatives.
The introduction of a tariff is intended not only to make the cheaper foreign alternative on par with domestically produced goods, but to make it on par with higher quality products that are of greater value to consumers.
Gaining political leverage
Tariffs are often used as a negotiation tactic in international relations. Retaliatory tariffs are tactically deployed to hurt foreign industry and give nations an upper hand in negotiations.
In these cases, tariffs aren’t imposed for purely economic reasons, but as a political tool to influence policies and agreements.
Advantages and disadvantages of tariffs
Tariffs aren’t objectively good or bad; rather, they have tradeoffs that impact different groups. These can be either advantages or disadvantages, depending on who you are and how you participate in the economy.
Advantages
- Tariffs protect domestic jobs: By keeping production domestic, businesses employ local citizens in manufacturing sectors, increasing job availability and employment.
- Generating government income: Tariff collections often fund public sectors and infrastructure without directly taxing citizens.
- Encouraging local consumption: Consumption of domestically produced goods stimulates local economies, but it also reduces the reliance on costly and environmentally disruptive supply chains.
- National security: Reducing the dependence on foreign-produced goods ensures access to those goods or services in the instance of an international conflict or supply chain disruption.
Disadvantages
- Higher consumer prices: Businesses typically pass on tariff costs to consumers, increasing prices and reducing their purchasing power.
- Reduced efficiency: By reducing competition in the marketplace, domestic producers aren’t as incentivized to improve the efficiency of their operations.
- Limited product selection: Tariffs can stop the importing of certain goods or producers, which reduces the options available to consumers in the marketplace.
- Skewed resource allocation: Investment that’s forced into protected industries could have higher economic returns if invested in a more productive sector.
The economic impact of tariffs
The effects of tariffs are complex and nuanced. Some tariffs are imposed for short-term purposes, while others can cause short-term disruption for long-term growth. To understand the economic impact of tariffs, let’s break down their effects from four different perspectives.
The impact of tariffs on businesses
Businesses that import goods directly pay tariffs on their shipments. For any businesses that use imported components, their product costs immediately rise.
You’ll see the effect on your inventory costs or cost of goods sold, driving up per-unit production costs and cutting into margins. Businesses usually change their pricing strategy as a reaction, increasing prices to maintain profitability.
That is, unless the business can find a more cost-effective domestic provider. This could mean reevaluating vendors and finding new suppliers.
Protected domestic producers often benefit from tariffs as they face higher demand, increasing sales and employment levels.
The impact of tariffs on consumers
If a business is affected by tariffs, it’s very likely that it will increase prices to pass those costs onto consumers. As consumers face higher prices across sectors, their purchasing power decreases.
The counterargument is that domestic employment is protected by tariffs. This could result in lower unemployment rates and higher GDP, indicating better societal economic wellness.
As the domestic industry improves, it’s expected that earnings would increase or prices would normalize, returning purchasing power to its previous levels.
Tariffs and inflation
Tariffs increase the cost of imported goods, and when the prices of goods increase, it can lead to higher rates of inflation. This doesn’t mean tariffs always lead to inflation, but they can contribute to inflationary pressures.
The extent to which tariffs influence inflation depends on multiple factors:
- The breadth of the tariffs: How many goods or industries are affected by the tariffs
- The magnitude of the tariffs: How high is the tax rate on imported goods, and how much it influences prices
- The competitive costs of domestic alternatives: The difference in cost between the foreign good and the domestically produced alternative
- The reaction from foreign producers: The willingness of foreign suppliers to drop prices in reaction to the tariffs and maintain their market share
Simply put, a broader tariff will have more of an impact on prices (and inflation) than a specific or specialized tariff that affects limited goods.
Long-term implications on domestic and global economies
Tariffs can be economically disruptive in the short term, but have long-term benefits. Introducing a tariff can completely reshape a domestic industry, increasing investment and employment in domestic production while reducing dependency on trade partners.
However, these adjustments take time. The uncertainty that they create in the immediate future can be incredibly disruptive, impacting consumer confidence and business investment.
Tariffs aren’t inherently good or bad. It takes time for them to realize their full impact, and the long-term benefit could outweigh the short-term disruption. What’s important for businesses is knowing how to adapt in the short term to weather the impacts and potentially reap the benefits down the line.
Who pays tariffs?
Tariffs are paid directly by importers. When they bring a shipment into the country, it’s reviewed by the customs authority, and they receive a bill for the owed amount.
However, the economic burden of tariffs ultimately gets shared across different parties in the supply chain and ultimately the consumers.
In competitive markets where consumers are price-sensitive, it’s likely the importer who absorbs the bulk of the tariff costs, as increasing prices would impact sales volumes. But, if the business has enough of a position in the market and consumers aren’t price sensitive, prices increase and pass the cost onto consumers.
It also depends on how readily accessible domestically produced alternatives are. If a business can find a domestic alternative at a comparable cost, it won’t have to pass the costs onto consumers. If there aren’t alternatives and they’re stuck paying the tariffs on foreign-produced goods, they’re stuck bearing the burden of the tariff.
An example of this dynamic is the imposition of steel and aluminum tariffs under Section 232. The 2018 introduction of Section 232 imposed a 25% tariff on steel and a 10% tariff on imported aluminum.
While steel and aluminum production in the US increased, creating an estimated 8,700 jobs in the steel industry, the higher costs adversely affected industries that used these materials, including the automotive, construction, and manufacturing industries.
The most affected by the aluminum tariffs were packaging companies, like those producing cans for soft drinks. The costs faced by producers were ultimately passed on to consumers, which you can see in the costs of canned beverages tracked by the Federal Reserve Bank of St Louis.
Even though steel and aluminum aren’t seen as direct-to-consumer products, the increase in those costs did affect the prices of everyday goods to consumers.
How to stay informed and prepared for tariffs
Given that tariffs have significant impacts on a business’s operations and profitability, it’s of the utmost importance to stay informed on any changes.
Some resources to follow include:
- The U.S. International Trade Commission database for current rates and special provisions
- The Office of the United States Trade Representative for announcements on trade actions, investigations, and negotiations
- U.S. Customs and Border Protection for guidance on compliance, tariff classifications, and administrative procedures
Being proactive helps minimize the potential disruption tariffs can have on your business. Take the following steps to keep yourself prepared:
- Analyze your supply chain: Identify any products that could be impacted by high tariff rates and look for alternative sourcing options domestically.
- Use scenario planning for tariffs: In your financial forecasting and budgeting, plan for a scenario where tariffs could impact your operations.
- Diversify your supplier base: Having suppliers in different countries provides flexibility if one is suddenly impacted by tariffs.
- Maintain strong supplier relationships: Having a good relationship with a supplier could help you negotiate more favorable terms if they’re affected by tariffs.
It’s difficult to predict when tariffs could be imposed or at what rate. The best option you have available is to diversify such that you’re not overreliant on one supplier. Not only is this best practice to prepare for tariffs, but it also helps in the case of supply chain disruptions or other economic disruptions.
Tracking costs to understand the impact of tariffs
Want to make better decisions about international operations? Then you need to take steps to understand your costs.
With BILL Spend & Expense, you get automated expense management and budgeting tools that help you spend smarter. Cost controls and expense reporting cut down on the manual labor required to break down how you’re spending money, supercharging your efficiency and freeing up time to analyze the numbers.
Explore our interactive demo or request a walkthrough to see our platform in action.
