Tariffs and Trade

Exploring what tariffs are and how they impact global trade while examining what India should do as trade becomes more restrictive globally

The weeks that went by were tumultuous for international trade and politics. Almost immediately after returning to office, the President of the United States, Donald Trump, charged tariffs on imports from Canada, Mexico, and China and threatened tariffs on Indian products. Interestingly, perhaps fearing US tariffs, the Government of India reduced tariffs on multiple products in the latest budget.

In this article, we look at what tariffs are, what they do to trade, whether they are good or bad, and what India should do going forward.

What are Tariffs?

Tariffs are taxes imposed on imports of goods to a country. The US has imposed a blanket 10% tariff on all imports from China. This means that a Chinese smartphone costing $100 in the US market will now become $110.

Because imports become costlier, tariffs are said to shift consumer preferences towards locally made products. Tariffs are therefore used as a protectionist measure - to protect local industries from foreign competition by artificially increasing the costs of foreign goods.

India also imposes tariffs. Consider the tariff rates India has been following since 1991 in the graph below:

From peak tariffs pre-1991, we have gradually reduced them in a push toward greater globalization. Before the recent reduction, our tariff rates were increasing after 2018. Along with tariffs we have been using more and more non-tariff barriers such as import limits, rigorous licensing systems, local content requirements, anti-dumping duties, etc. A WTO report claimed India as the 2nd largest user of non-tariff measures in 2023.

There are significant costs to tariffs (and non-tariff barriers) as they create 2 significant problems for countries imposing them - tariffs increase the costs of companies dependent on imports, and they increase prices for consumers.

Increased Cost to Importing Companies

It is important at this juncture to understand the dynamics of trade. We often talk about trade as something countries do with each other. But the fact is that countries do not trade, rather it is the people who trade with their counterparts in other countries. Moreover, they do it not because they are forced to, but do it voluntarily because trade benefits them.

When we analyze the commodities being traded, we see that majority of them are intermediate goods that companies buy to add value and produce finished goods. For example, India is the third largest importer of crude oil. However, much of the crude oil that is imported is refined and exported by Indian companies making India the seventh-largest exporter of refined petroleum products as per the Ministry of Petroleum and Natural Gas.

So when the US or India puts tariffs, it damages companies that do this value addition and are import-dependent. The intermediate products they require will suddenly become costly and/or low quality. So while protectionism and tariffs may help a few companies, they also damage certain other companies.

Consumers Pay More

Tariffs and protectionism also impact consumers. Consumers are thinking human beings who want to maximise their benefits. They usually do not pick products because they like China or the US. Rather, they select products that give them maximum value with their money. With tariffs, products that would have been available to them at low costs will now become expensive.

When we think deeper about it, the extra costs due to tariffs may be easier to manage for a middle-class or rich person. However, the poor will have to spend more of their limited income. Through tariffs, countries therefore protect local companies at the cost of consumers, disproportionately impacting the poorer ones.

When Are Tariffs Warranted?

There may be situations where tariffs are a necessary tool at the Government’s disposal. We discuss two such possible cases here.

Case 1 - National Security

Suppose country A is purposefully selling products at low prices to damage the manufacturing industries of country B. This may be a scenario that merit tariffs. There is a national security angle here as manufacturing industries are vital, especially in case of a war where you have to make equipment to be used in warfare.

China has been pursuing such strategies, called dumping, wherein commodities like steel are being exported at very low costs to India. This prevents the Indian steel industry from growing and affects them in the long term. India has been countering this by using anti-dumping duties on commodities.

Case 2 - Support Sunrise Industries

Another case where tariffs may be warranted is to support nascent industries within the country that have high potential. For instance, India may need to provide incentives for emerging semiconductor industries within the country considering its strategic and economic significance. If there are companies from China or US that sell cheap semiconductors preventing Indian semiconductor industry from growing, it may merit a tariff.

While these cases may justify tariffs, there is an inherent risk that local companies will induce pressure or influence Governments to make needless tariffs. Tariffs in one sector will also create demands for other sectors as each industry has an incentive to protect itself from international competition. Therefore, tariffs are to be used sparingly and that too after discussions with all stakeholders concerned. Furthermore, incentives to local or emerging industries will be better done through subsidies or similar mechanisms that does not impact consumers or import dependent companies.

Also, it is evident that blanket tariffs on all commodities, such as those imposed by the US do not fall into either case and can be categorized as a protectionist measure that will harm consumers and importing industries.

Trading Benefits All

One of the greatest learnings economics brings concerning trade is how it benefits all participating parties. Russel Roberts brings it out through his two-part essay (Part 1 and Part 2). Consider the graph below depicting the growth of trade (on the y-axis) compared with growth in GDP per capita (on the x-axis) from 1945 to 2014. We see that countries with growing trade tend to have growing GDP per capita too.

This has been validated by Frankel and Romer in their study which says that “one percentage point in the ratio of trade to GDP increases income per person by at least one-half percent”.

Another curious factor to consider is that countries that import more are also countries that export more (think of India’s oil imports and exports). There is a correlation between the two in the modern global value chains. No country can magically minimize imports and increase exports. All countries need each other, and targeting imports will also impact exports.

Human progress has indeed benefited from trade. International politics and nationalisms of the day must not stand in the way of free and mutually beneficial trade.

Tariffs - Way Forward for India

A tariff war is indeed brewing and the US may charge tariffs on India. In such a situation, what should we do? Should we charge retaliatory tariffs? Or should we continue the precedent of reducing tariffs that the latest budget has set?

For one, tariffs as we suggested will impact consumers and importing industries. Even when a country has charged tariffs on our exports, we should not create a vicious cycle where our people and industries are impacted. To reduce trade deficits and increase our exports, we must focus on improving the competitiveness of our industries and create a favourable situation for them to be global champions. Easing export procedures and creating policies that improve our industries should be the priority rather than controlling imports.

The Indian Government’s decision to cut tariffs at a time when there is a looming global tariff war is a pragmatic and proactive step. It is in the right direction and should be continued as we go forward.

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