Rethinking the Optimal Tariff Theory

Import tariffs—taxes imposed on imported goods—are typically enacted to protect a country’s domestic producers, but economists have long debated how much of this protection comes at the expense of domestic consumers through higher prices. In “Tariff Incidence: Evidence from Sugar Duties 1890-1930,” Douglas Irwin finds evidence of an interesting and substantial asymmetry in the market’s response to tariff policy changes, depending on whether the duty rate is increasing or decreasing. He finds that while the burden of a tariff increase is passed on to both domestic consumers and foreign producers, a reduction in tariffs only benefits domestic consumers.

The optimal tariff theory argues that a country that is a large importer of a particular commodity can shift the economic burden of an import tariff from domestic consumers to foreign suppliers if the country has monopsony power in the market—the country is a primary buyer from many competing suppliers. This monopsony power results in a supply that is relatively inelastic or insensitive to price changes, which forces exporters to lower their pre-tariff prices when facing a tariff increase in order to maintain the same supply level and allows importing countries to capture revenue that exporters previously received.

Despite over a century of theoretical debate on the incidence of tariffs, sound empirical evidence on who bears the burden of trade tariffs is sparse. Because data on import prices are often aggregated and averaged across a variety of products, each of which could be subject to a different tariff rate, it is difficult to discern the individual impact on prices of a particular tariff change. However, Irwin is able to sidestep this difficulty by using a highly unique set of data on weekly fluctuations in domestic and tariff-exclusive import prices of raw cane sugar in New York City. Fortuitously, these prices were recorded during a 40-year period in which the US made abrupt changes to tariff legislation resulting in clear and direct shifts in pricing at the same time that the US constituted a large importer of sugar, comprising 20-25 percent of the annual global consumption.

Irwin’s findings show that in the two months leading up to a US tariff increase there was a dramatic increase in import prices and volume of up to 200 percent, but demand fell sharply and remained depressed for several months immediately after the rate increase had taken effect. This fluctuation suggests that domestic purchasers, such as sugar refineries, bought abnormally large amounts of imported sugar in anticipation of the tariff increase. In contrast, after a tariff reduction, there was surprisingly no increase in import prices, and thus no symmetric effect on demand. Irwin explains that this difference is a result of the long-term nature of tariffs; these policy changes are assumed to last for the foreseeable future. A permanent price increase would therefore trigger a surge of buying, while a permanent price decrease could be taken advantage of at any point in the future.

In the aftermath of a tariff increase, a higher domestic price and a lower tariff-exclusive import price implied that domestic consumers and foreign exporters shared the incidence of the policy change, at an estimated 40-60 split, respectively. Conversely, a tariff reduction yielded no increase in import prices, but domestic prices dropped until they reached the same level as import prices, passing the benefit of the reduction entirely to domestic consumers.

It is reasonable to conclude that because there is no increase in import prices following a tariff reduction, countries that are large importers of a commodity could potentially lower or eliminate their tariff rates without reducing their terms of trade (the level of imports that a country can purchase per unit of exports). Similarly, large importers may be able to improve their terms of trade by increasing tariff rates, thereby forcing other countries to lower the price of goods they sell to those countries. These implications of Irwin’s findings add a layer of complexity to the optimal tariff theory and should be considered in the ongoing US policy debates surrounding trade liberalization and the restructuring of the Farm Bill.

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Article Source:  Tariff Incidence: Evidence from Sugar Duties 1890-1930, Irwin, NBER, 2014