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It appears that within the span of 4 days, we have harkened back to the days of the study of Political Economy. We are observing in real time the impact of differing global trade viewpoints. Unfortunately, it is nearly impossible to understand the nuances of the differences in preferences are in a tweet, TikTok video, or a 30 second soundbite.
Economics, in its simplest terms, is about the study of preferences relative to a cost. Should I buy that really expensive car for $80,000 or should I buy a $40,000 car and invest the difference? Which would be more valuable to me? There is no correct choice, but a preference.
Let’s drive this simple question into tariffs. Tariffs are just a tax. Plain and simple. They tax the movement of goods in and out of a country. No more, no less. Today we are examining them as if they are good or bad. Let’s pose the question: are taxes good or bad? They are necessary to fund all the government that the citizens of the US have voted for.
Where is the best place to get the tax to run the country? Here is where we get into the preference. Should we tax goods that we import, should we tax the income that we generate, capital gains that we realize; should we tax property that we own? All these tax schemes have different incentive structures. Incentives drive behavior. Things that we tax, we generally get less of. Individuals are incentivized to reduce their exposure to taxes whenever possible.
In the United States, we have had income tax for a very long time. The first tax was collected in 1913. It is ingrained in our economy and, while hated by many, it funds a great deal of our country. It also incentivizes citizens to limit their income (reported, anyway) to minimize their overall tax burden. There is an entire industry devoted to tax planning. Is this the most efficient way to fund our government?
In Europe, they use a VAT to increase the funding of their government. In 2022, they generated over €18.2 billion in VAT fees. There is much disagreement over whether an income tax versus a sales tax is the more efficient tax scheme. You could say it all comes down to politics.
Is a tariff an efficient mechanism to fund our government? It really depends on what you want to incentivize. As a “free trader” I would never suggest a tariff. It puts up barriers between countries’ trade and obstructs the free flow of goods to the most efficient use of capital. Then why have tariffs ever been implemented? In the past, it was mostly to protect domestic industries. An underdeveloped country could not develop an industry if there are other countries that are developed and can produce products cheaper, better and more efficiently. You would leave the emerging markets in poverty for a very long time.
Take, for example, a country that wants to create a manufacturing industry that makes BBQ grills. Starting from scratch, they’d struggle to compete with companies like Weber, Traeger, or Char-Broil. So, to protect their burgeoning market, they will tariff all BBQ grills coming to their country, so the domestic grills would be cost competitive. This is a common justification for tariffs in emerging economies. And as an aside, they might be able to raise funds through the tariff to fund their new industry.
Ok, but why would the US, clearly the most dominant economy in the world, want to create a tariff scheme? The answer comes in incentives. Incentives drive behavior.
Let’s first understand the tax. A tax is a tax. No more, no less. An academic would say that a 20% tariff would increase the product price by 20%. In an academic world, that is correct. In the real world, practitioners would see it much differently.
Imagine you sell into the United States for $1.00 per unit. If the US increases the tariff by 20%, you will need to sell your product for $1.20 per unit. The problem is no one would buy it for $1.20 per unit. If your profit margin was 30%, could you discount the price and still make a profit? Would you? Should you? Is there another country that you could sell your product to at $1.00 per unit? Should you change markets?
The tariff is starting to get more complicated.
What happens if, as a result of the new tariff regime, the US dollar declines relative to the Euro? Could you now sell your product at a currency-adjusted price of $1.00 per unit and have the tariff built in?
Let’s get more complicated. What if the elasticity of demand is not 1 to 1? Elasticity of demand is a calculation that determines how much of a product you would buy at a certain price. A simple example is that of oil. The US consumer must buy oil at any price to use in their lives. Everything in the US is based on oil. If prices go up, the US consumer generally pays it.
Let’s turn to electronics. If an iPhone is $1,500 before tariffs and $3,500 after tariffs, how frequently would you upgrade? Will that impact demand? Will Apple have a strong incentive to manufacture the iPhone cheaper? If the iPhone could be made in Kansas for $2,000, would Apple change manufacturing locations?
These are some of the complications of tariffs. But remember, a tariff is just a tax, no more, no less. So, if you keep the tariff, and all of its pros and cons, but you lowered the US income tax by an equal amount, what is your net impact on the US consumer? In an academic world, you should be indifferent. They should balance each other out on a dollar-for-dollar basis. In a practitioner world, however, it is not that simple. There are people in the US that are impacted by income taxes differently than tariffs (the products that they buy.) This is the messy world we live in today.
So, let’s get down to the details. What are the pros and cons of the tariffs that we see:
Pros of Implementing Tariffs
- Boosts Revenue: Tariffs could generate significant government revenue, with estimates ranging from $600 billion annually to $2.8 trillion.
- Protects U.S. Industries: May shield domestic industries from foreign competition, potentially creating jobs in manufacturing.
- Encourages Domestic Production: Could transform the U.S. into a producer rather than a consumer nation, revitalizing the private sector and reducing reliance on imports.
- Negotiation Leverage: Seen as a tool to pressure trade partners into lowering their own tariffs or making concessions.
- Long-Term Manufacturing Growth: Might lead to more domestic manufacturing over 15 years and bring production of critical goods in-house.
- Economic Rebalancing: Could lower asymmetrically tariffs from trading partners and trim an oversized public sector.
Cons of Implementing Tariffs
- Higher Consumer Costs: Increases in prices for households, with estimates of $1,800 to $3,400 per year, making everything more expensive.
- Economic Risks: Risks a GDP drop, a 35% chance of recession, or broader economic slowdown.
- Job Losses in Import Sectors: Could harm jobs tied to import-dependent industries.
- Market Instability: Spooks markets, reduces liquidity, and shifts consumers into austerity mode, with skepticism about excessive tariff levels.
- Trade War Potential: May provoke retaliation from other countries, escalating into trade wars.
- Short-Term Pain: Immediate higher prices and reduced consumer activity might outweigh long-term gains.
The Timeline
As a study of a Political Economy, we need to address the timeline as to when this “experiment” will need to be course corrected. The next Congressional election is November 3, 2026. In this election all 435 Congressional Seats will be up for grabs, in addition to 33 Senate Seats. If the current administration does not see positive economic results from their “tariff play” the electorate will speak and speak loudly. Currently there are very tight margins for control of both the House and Senate. Any small movement could change the balance of power in Congress. That would drastically reduce the ability of this administration to accomplish anything in the second half of the presidential term.
It’s possible the electorate may only tolerate economic disruption for 9–12 months before demanding change. As such, we believe that we will see significant change to the economic landscape for the better, or course correction for a more stable global economy in this political timeframe.
With that as the backdrop, what actions can and/or should be taken?
First, if you are still working and have a 401k, then increase the amounts going into the 401k. Focus on small caps and large cap growth. These are the two asset classes that have been hit the hardest and are starting to look inexpensive.
Second, as we referenced in our Market Update on Friday, Roth conversions are going to make a lot of sense with depressed asset values.
Third, be patient. As I write this, the market has seen a 4% market swing due to rumors about deals that are being made as we speak. Going from cash to equities makes sense in this market. Swapping equities for equities can be very challenging with rapid swings. That is something that we want to stay out of the way of.
As always, let us know of any questions you may have.
-Sean
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