The Effects of Tariffs and Trade Barriers in CBO’s Projections

Posted by
Daniel Fried
August 22, 2019

In the Congressional Budget Office’s newly published economic projections, higher trade barriers—in particular, increases in tariff rates—implemented by the United States and its trading partners since January 2018 reduce the level of real (that is, inflation-adjusted) U.S. gross domestic product (GDP) by roughly 0.3 percent by 2020. The tariffs raise domestic prices, thereby reducing the purchasing power of domestic consumers and increasing the cost of business investment. The tariffs also affect business investment by increasing businesses’ uncertainty about future barriers to trade and thus their perceptions of risks associated with investment in the United States and abroad. In CBO’s projections, the economic effects of the tariffs wane after 2020, as businesses make adjustments to their supply chains to mitigate the costs associated with the tariffs.

CBO published those projections yesterday in An Update to the Budget and Economic Outlook: 2019 to 2029. The projections incorporate the assumption that U.S. tariffs imposed by the Administration and in effect as of July 25, 2019—as well as retaliatory tariff increases on U.S. exports implemented by other countries since January 2018—will remain in place through 2029, the end of the period covered by the projections.

What Tariffs Have Been Imposed?

Since January 2018, the United States has imposed tariffs on 11 percent of goods imported into the country, measured as a share of the value of all U.S. imports in 2017. Some of those tariffs apply to imports from nearly all U.S. trading partners, including tariffs on washing machines, solar panels, and steel and aluminum products. A few countries are exempted from certain tariffs. For example, Canadian and Mexican imports were granted exemptions from the tariffs on steel and aluminum products. Other tariffs affect only imports from China, covering about half of U.S. imports from China and targeting mostly intermediate goods (items used for the production of other goods and services) and capital goods (such as computers and other equipment). 

In response to those tariffs, U.S. trading partners have retaliated with their own tariffs on U.S. products. As of July 25, 2019, retaliatory tariffs had been imposed on 7 percent of all goods exported by the United States—primarily industrial supplies and materials as well as agricultural products. 

How Do the Tariffs Affect the Economy?

In CBO’s projections, the tariffs affect U.S. economic activity in several ways. First, they make consumer goods and capital goods more expensive, thereby reducing the purchasing power of U.S. consumers and businesses. Second, they increase businesses’ uncertainty about future barriers to trade. Such uncertainty leads some U.S. businesses to delay or forgo new investments or make costly adjustments to their supply chains because changes in trade policies might affect the costs of their operations. Third, they prompt retaliatory tariffs by U.S. trading partners, which reduce U.S. exports by making them more expensive for foreign purchasers. All of those effects lower U.S. output. In the other direction, U.S. consumers and businesses are expected to replace certain imported goods with goods produced in the United States, which would offset some of that decline in output. In addition, tariff revenues, by reducing the deficit, increase the resources available for private investment.

On balance, in CBO’s projections, the trade barriers imposed since January 2018 reduce both real output and real household income. By 2020, they reduce the level of real U.S. GDP by roughly 0.3 percent and reduce average real household income by $580 (in 2019 dollars). Beyond 2020, CBO expects those effects to wane as businesses adjust their supply chains. By 2029, in CBO’s projections, the tariffs lower the level of real U.S. GDP by 0.1 percent and the level of real household income by 0.2 percent. Those estimated economic effects are small because the value of imports subject to the tariffs is less than 2 percent of the value of all goods and services purchased by U.S. consumers and businesses. Imposing higher tariffs on a wider array of items would have larger economic effects.

How Uncertain Are CBO’s Estimates of Those Effects?

CBO’s estimates of the economic effects of the tariffs implemented since January 2018 are uncertain for many reasons. Because broad tariff increases in developed economies have been rare in recent history, existing empirical research sheds little light on how businesses and consumers in the United States and its trading partners might respond. The estimated short-run effects on trade and prices are uncertain because it is difficult to predict how foreign exporters might adjust their prices in response to the tariffs and associated changes in the value of the dollar. Similarly, it is difficult to predict the extent to which domestic importers will pass along the increase in costs to their domestic customers. The magnitude of the long-run effects on investment is also uncertain because it is difficult to project how changes to tariffs and businesses’ concerns about further changes to trade policies will affect long-run investment by companies that rely on global supply chains. 

If future trade policy were to deviate from the assumptions incorporated into CBO’s projections, economic growth and other variables could differ considerably from what CBO projects. For example, if the tariffs led to new trade agreements that lowered trade barriers between the United States and its trading partners, domestic inflation would probably decline, trade flows and investment would rise, and GDP growth would probably be faster than projected. If those agreements also established stronger protections for intellectual property among U.S. trading partners, U.S. corporate profits and investment in research would probably increase. Conversely, if trade barriers rose further, domestic investment and output would probably be weaker than projected.

Daniel Fried is an analyst in CBO’s Macroeconomic Analysis Division.