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Donald Trump just set the world on fire by starting a global trade war. The U.S. effective tax rate just hit its highest rate since the early 1900s.
This is a massive bet by the president, who hopes to protect specific industries in the U.S. and eventually generate enough tax revenue from tariffs to replace the income tax.
These are lofty goals, and I doubt they will actually work. There is a good chance this policy will result in a global recession, but more on that in a bit.
First, I think it is important to explain a tariff and how it works. Then, its potential repercussions will be easier to understand.
What Is A Tariff (Simple Overview)?
In its simplest definition:
A tariff is a tax on imported goods. When a good is shipped into a country, the receiving country adds a tariff cost at the border.
The importer (not the exporter) pays the tariff but then will pass along the cost to the consumer. Of course, the importer is a company (not a country), so they have to pay the tariff to the government on the value of those imported goods. The goal of this is to make foreign goods more expensive to incentivize consumers to buy domestic goods instead.
How Tariffs Increase Prices
Let’s look at an example. Let’s say that BMW exports a car from Germany to the U.S. at a price of $50,000. The tariff rate for that car is 20% (which is the actual rate to take effect on April 9). When the car arrives at the border, the U.S.-based BMW dealer will have to pay $10,000 to the U.S. government.
The BMW dealer will not want to eat the $10,000 cost. Instead, they will pass along this cost to the consumer so they can continue to make a profit. The $50,000 car now will have a price tag of $60,000.
If you were car shopping and considering this BMW versus an American-made vehicle (priced at $55,000), the American-made car suddenly looks more appealing, encouraging you to buy locally.
This same principle applies to just about every product that we import—food, computers, phones, clothes, etc.
Why Do Governments Use Tariffs?
Governments use tariffs on imported goods for a number of reasons, but the primary reason is to protect local industries. Tariffs can also help domestic companies compete against cheaper foreign-made products, protect jobs, and reduce dependency on foreign nations in critical sectors, such as national defense.
The Catch: Drawbacks of Tariffs
At first glance, tariffs sound appealing—create jobs, protect national interests, and reduce the income tax? Yes, please.
But, of course, it’s not that simple.
Higher Prices: As mentioned in my earlier example, tariffs are simply passed along to the consumer. This is highly inflationary, which will most affect lower and middle-income families. Everyone has a baseline cost to meet basic needs (food, housing, etc.), but high-income individuals can absorb rising prices much more easily than those on a fixed income. A universal increase in prices across the board is far more devastating to someone making $50K/year than to someone making $500K/year, especially when they are trying to pay for those basic needs.
Another aspect of rising prices is that even American-made goods are likely to see an increase in prices. This is because many, if not most, domestic goods rely on foreign imports of some kind.
American-made cars are rarely entirely built in the U.S. Most are assembled from parts that are sourced from around the globe. Ford may have its engine built in Mexico, its transmission built in Japan, and its wiring harness built in Vietnam. The final assembly might happen in the U.S., but the supply chain stretches across the globe.
Even the raw materials that go into a vehicle depend heavily on foreign sources. If you buy an EV, the lithium might come from Chile or Australia, the rare earth elements from China, and the aluminum from Canada.
In short, we live in a global economy. Disentangling this is nearly impossible.
Less Choice: When fewer foreign products are available, consumers have fewer choices. This reduces competition and, over time, can make domestic companies less competitive. With limited pressure or incentive to improve, these companies will not innovate. They will grow stagnant. They will not find ways to lower their prices. And they will cease to try to drive efficiency. Think of how the DMV operates (no competition) and apply that same logic to corporate America. No bueno.
Retaliation: Other countries may impose their own tariffs in response. Shocker. We are starting to see this play out in real-time. U.S.-based companies that sell their goods to foreign nations will now be at a disadvantage. Here is a stat to provide some perspective: 41% of the S&P 500’s revenue came from abroad. American companies rely a great deal on the rest of the world for revenue growth.
Trade War: We are seeing retaliation back and forth today. This is a trade war, and no one wins. Consumers will have to pay higher prices and will have fewer choices.
Trump’s Tariff Idol—McKinley
President Trump has been talking about tariffs for years—decades, even. I shared this NYT article a few months ago, but it’s worth sharing again.
And as many already know, Trump idolizes William McKinley, the OG tariff king.
In the late 1880s, before William McKinley was president, he was a Republican representative and Chair of the Ways and Means Committee. He believed that tariffs would support economic growth in the U.S.
As such, he passed the McKinley Tariff bill, which raised tariffs sharply, averaging 50% on imported goods. It was designed to protect American industries from foreign competition by making imported goods more expensive.
It didn’t work. It raised consumer prices (inflation) and caused a public backlash. In the 1890 midterms, the Republican party lost heavily—100 seats. This defeat ranks as the third-largest in congressional history since the Civil War.
I bring this up because we may be heading down a similar path. Tariffs can be easy to sell politically, but their real-world effects are usually higher consumer prices, less competition, and slower growth. The public will notice—and it will show up in the election results.
Tariff Formula
A few days ago, I wrote about the details of President Trump’s proposed ‘reciprocal’ tariffs. The numbers are large, and the idea is that these tariffs would be half of what other countries are currently charging us, with a global floor of 10%.
The official formula for calculating the “reciprocal” tariffs, as published by the U.S. Trade Representative, looks pretty complicated at first glance.
However, some sharp people quickly found out that this formula is not complicated after all.
The formula is actually pretty straightforward. The formula is calculated as:
The formula takes our trade deficit (meaning we buy more stuff from that country than what they buy from us) and divides it by total imports. It is simply a percentage rate, not a tariff.
This formula has a few concerning aspects. First, it doesn’t consider any tariffs in place—none. Second, it instead places the biggest tariffs on the countries running the biggest trade surpluses.
Take Indonesia, for example. We have a $17.9 billion trade deficit (meaning we import $17.9 billion more goods from them than we export to them). They export $28 billion worth of goods to us. $17.9B / $28B = 64%. The Trump Administration claims that this is the tariff rate Indonesia charges us. This is completely false and utterly wrong. This is a nonsense number. Regardless, we are now implementing a 32% tariff in ‘retaliation.’
How To Prepare For the Trade War
The trade war is here whether we like it or not. I have no idea how this is going to play out or what the full ramifications are going to be. Is Trump using this to get countries to the negotiation table? Does he really believe that tariffs can replace the income tax? Who knows. However, I can say with certainty that this, too, shall pass.
Just as it seemed that the world was falling apart in March 2020, there are echoes of that same feeling today. There is panic in the air, and people are surprised by the quickness of this selloff. It doesn’t feel great. However, the panic will subside at some point, and we will get through this.
If you’re an investor, now is not the time to overreact. History has shown us that reacting to short-term selloffs with long-term money is a losing strategy. Be sure that you are allocated correctly. Be sure that your investment philosophy is sound. Do this before you do anything else. If you have extra cash on the sideline, maybe now is the time to begin thinking about buying a dip.
Also, if you have an Amazon cart full of products that you’ve been thinking about buying, maybe now is the time to do so.There is a really good chance that these prices will increase, especially if those goods are imports. To that point, some domestic companies might raise the prices of their goods and blame it on tariffs. We’ll find out soon enough.
The big picture: this isn’t the first time a president has been aggressive with their trade policy, and it won’t be the last. These moves will have unintended consequences, and they will not play out as intended. So, take a breath and stay grounded.
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