Optimal Tariffs: New Insights
Optimal tariffs are much higher than we thought
This spring, economists Oleg Itskhoki from UCLA and Dmitry Mukhin from the University of Wisconsin-Madison are revisiting a significant yet controversial question in international economics: when should tariffs be imposed? Their findings, grounded in complex mathematical discussions, reflect the current financial landscape of the global economy, which is somewhat surprising and could even relate to the trade policies of the Trump administration.
Their essential argument is quite straightforward. Even in a well-connected and globalized economy, countries like the U.S. could potentially benefit more from higher tariffs. When considering global capital flows, currency fluctuations, and external assets, the common belief in favor of free trade begins to weaken and, at times, the reverse may hold true.
The figures they present are striking. In a model with balanced trade, the research suggests that the ideal maximum tariff for the U.S. could be as high as 34%, while revenue-maximizing rates may spike up to 80%. However, when adjusted to reflect the real economic circumstances of the U.S.—such as trade deficits and a substantial amount of foreign debt—the “optimal” tariff rate actually drops to around 9%. It’s still considerable, yet it indicates that the economic justification isn’t as strong as some might think.
What brings about this shift, according to the authors, are the “assessment effects.” Tariffs tend to strengthen the dollar, which, in turn, decreases the dollar value of American foreign assets. So, some benefits gained from trade terms could be countered by impacts on the U.S. international investment position.
No Significant Retaliation
Interestingly, the real-world implications of their findings might extend beyond what the authors explicitly claim. The theoretical framework they utilize relies on the idea of symmetrical retaliation, a type of Nash Equilibrium. However, the history over the past six years paints a different picture. The U.S. has enacted tariffs on numerous countries, including China, the EU, and Japan, but rather than escalating tensions leading to a trade war, we’ve often seen negotiations or accommodations instead.
For instance, Japan has entered into bilateral agreements, the EU has resumed trade discussions, and even China has committed to large purchases following lengthy negotiations. India, facing recent tariffs on discounted Russian oil imports, has responded with diplomacy. Many models envisioned a full-blown tariff war, yet that hasn’t occurred.
Such realities can change the underlying mathematics. As Itskhoki and Mukhin point out, the worst outcomes in their model arise from retaliation. However, if trade partners choose to accept tariffs and offer concessions instead—like reducing their own trade barriers or promising investments—the benefits from U.S. tariffs could be much greater. While the authors haven’t modeled these secondary benefits, they would likely improve trade conditions while requiring lower tariff rates for a balanced trade, enhancing U.S. revenue.
In simpler terms, if tariffs act more as negotiation tools rather than permanent measures, and succeed in garnering valuable concessions, their foundational logic would seem to gain further support.
The Political Nuance
Moreover, there are political and legal intricacies that add depth to this discussion. Ideally, production and export subsidies would effectively boost employment in tradeable sectors like manufacturing. However, in practice, such subsidies can be hard to implement and are politically sensitive or even restricted by trade agreements. Tariffs, on the other hand, are straightforward, enforceable, and recognized under U.S. trade laws. Managed trade agreements that include investment and purchase commitments create an effect similar to subsidies—not merely financial transfers, but through diplomatic means.
Modern Trade Theory
The importance of Itskhoki and Mukhin’s insights lies not just in their conclusions, but in how they frame the discussion. Rather than viewing tariffs as relics of a past era, they propose that tariffs can function as macro-financial instruments with predictable outcomes on trade balances, exchange rates, and international investment positions. Their research provides a significant counter-narrative to the dominant view that portrays tariffs as inherently detrimental.
To clarify, their paper is careful. The authors recognize that their calibration is an estimate, and factors like sector friction and long-term dynamics are beyond their scope. They also point out that results can vary based on assumptions regarding asset composition and currencies. Nonetheless, the broader takeaway is clear: the tariff debate warrants a more nuanced and updated economic analysis.
With Donald Trump likely returning to the White House and tariffs re-emerging as a focal point of U.S. trade policy, Itskhoki and Mukhin’s work may provide a robust academic defense of that approach. Existing tariffs have often prompted negotiations rather than retaliation. What followed were trade agreements, investment promises, and targeted purchase commitments—all types of concessions likely to amplify the projected benefits of their model. Viewed through this framework, Trump’s tariff policy wasn’t a departure from sound economics; instead, it represented practical applications of theoretical principles that the field is beginning to embrace.
