U.S. tariff policy has historically shifted among competing goals: providing revenue, protecting domestic markets and opening foreign markets to domestic producers. These goals are unlikely to be achieved simultaneously. Modern models applied to the U.S. reveal that tariffs can enhance consumer welfare via terms-of-trade gains, a costly externality on foreign partners, but only if those partners don’t retaliate. Thus, potential consumption gains for U.S. households and businesses depend on policy choices and strategic responses from trading partners.
Tariffs are an economic policy tool that attempts to balance competing goals such as raising government revenue, protecting domestic industries by restricting market access and enforcing international trade reciprocity.
However, historical evidence from the U.S. shows that achieving these three goals simultaneously is typically not feasible, requiring policymakers to prioritize one or two of them. This prioritization has historically shifted in response to varying economic and political contexts.
Understanding how tariffs affect the economy is crucial for informed policy analysis. Research reveals that tariffs can increase government revenue but only to a certain extent. In the U.S., maximum revenue is achieved at a universal 70 percent tariff rate if no other country reacts. That level declines to 30 percent if other countries respond with reciprocal tariffs.
A 25 percent tariff can enhance domestic consumption if revenue is rebated and terms of trade shift favorably, offsetting some of the import price increases. However, this advantage disappears if retaliatory tariffs are imposed, emphasizing the need for careful balancing when designing any tariff policy. In the 2018–19 tariff episode, targeted tariffs appeared to cause economic distortions across sectors and countries by altering the relative prices of goods. This illustrates the complex and varied effects of such policies.
Tariffs and government revenue
Tariffs have historically served three main purposes: generating government revenue, protecting domestic industries and facilitating (non-discriminatory) foreign market access. Collectively, these objectives are known as the three Rs of tariff policy: revenue, restriction and reciprocity. As detailed by Dartmouth professor Douglas Irwin, U.S. tariff policy has shifted its focus among these goals over time.
Originally, tariffs were the federal government’s principal source of income, particularly before the implementation of modern income and payroll tax systems. Throughout the 19th century and into the early 20th century, customs duties were the primary contributors to federal revenue. This reliance was largely due to the lack of alternative federal income sources, making tariffs a central element of U.S. tax policy by necessity.
Efforts to diversify U.S. government revenue sources began in 1862, during the Civil War, to fund war expenses. Those efforts coincided with the introduction of excise taxes as a major income source. The constitutional basis for federal income taxation was solidified with the ratification of the 16th Amendment in 1913, the same year the Federal Reserve was established to stabilize the banking system and ensure a secure monetary system.
The introduction of payroll taxes in 1935 under the Federal Insurance Contributions Act during the Great Depression aimed to fund Social Security (the Social Security Bill was also signed into law in 1935), further reducing fiscal dependence on tariffs. These alternative revenue sources were significantly scaled up during World War II. Since then, the federal government has primarily relied on individual income and payroll taxes for funding, with only a marginal contribution from customs duties.
Tariffs and protectionism
Historically, the “restrictive” R of tariffs has fulfilled dual roles: protecting nascent domestic industries and combating unfair trade practices such as dumping, the practice of exporting goods at artificially low prices to seize market share or undercut competitors. These protective measures were common during periods of economic nationalism and mercantilism when governments actively defended domestic producers. Over time, however, tariffs also became strategic tools in negotiating improved trade conditions and furthering other international policy objectives.
By the late 19th century, tariffs were applied to a declining number of imports, and their importance as a government revenue source waned, especially following the introduction of universal income taxes in 1913. Despite protectionist spikes—the last of which in the U.S. was the Smoot-Hawley Tariff Act of 1930, which likely worsened the Great Depression—the trend of diminishing reliance on tariffs persisted.
After World War II, the U.S. pushed for greater global economic integration, moving from high, targeted, country- and sector-specific tariffs to reciprocal trade agreements, leading to the establishment of the General Agreement on Tariffs and Trade and later, the World Trade Organization.
Underlying this strategic shift toward lower tariffs was the belief that liberalizing trade would result in sizeable shared global economic benefits, commonly referred as gains from trade, fostering economic growth and ushering in a new era of globalization. The transition was also supported by the development of a more predictable rules-based international trade system, along with declining transportation costs, advancements in shipping containerization and other technological improvements that helped establish global supply chains and deepen economic integration.
While global tariff rates have generally remained low, the U.S. and other nations occasionally employ targeted, strategic tariffs on specific sectors or countries to address economic challenges or to support negotiations. Until recently, most trade barriers tended to be non-tariff, ranging from national security concerns and regulatory differences in consumer protections to language barriers and the time costs associated with shipping.
Tariffs and foreign trade
Persistent U.S. trade deficits began in the post-Bretton Woods era. These deficits raise questions about potential underlying U.S. economic weaknesses or, conversely, reflect the strength of an economy capable of attracting foreign investment to finance high levels of consumption and investment.
Tariffs in this context add complexity to the discussion. Proponents argue that tariffs protect faltering domestic industries and reverse trade imbalances by curbing imports and boosting local production. They often present these measures as crucial for defending against unfair foreign competition (dumping) or as part of a broader strategy for re-industrialization and reshoring through import substitution.
Critics counter that tariffs increase costs for businesses and consumers, potentially disrupting deeply integrated global supply chains. Moreover, they argue tariffs hinder U.S. domestic investment financed by foreign savers, ultimately constraining economic growth. Historically, tariffs have not consistently rectified trade deficits. During both the gold standard period in the first half of the 20th century and the Bretton Woods era, the U.S. experienced prolonged periods of trade surpluses despite substantial variations in tariff rates, challenging the idea that tariffs alone can effectively address trade imbalances.
The role of tariffs in trade and re-industrialization policy in the U.S. is contingent on broader structural shifts, including uneven sectoral productivity growth and evolving consumption patterns. Chart 4 illustrates this evolution in the U.S., showing how technological advances initially boosted agriculture’s productivity, allowing labor to transition to more productive manufacturing industries.
As these manufacturing industries matured, automation decreased the need for labor even as output grew. Over time, rising incomes shifted consumer expenditures from necessities to manufactured goods and ultimately to services. This phenomenon is described by Engel’s law: As income rises, the share spent on food declines, a pattern that increasingly also applies to manufactured goods in high-income economies. This shift into services consumption, coupled with relatively slower productivity growth in the service sector, led to a gradual increase in both service employment and output.
As the U.S. manufacturing sector grew and sought new markets to leverage economies of scale, American trade policy shifted. Initially focused on keeping foreign competition out, the policy gradually moved toward opening access to foreign markets for domestic manufacturers, fostering greater trade reciprocity. The U.S. began to experience persistent trade deficits precisely after manufacturing peaked in the 1960s, as the economy increasingly shifted toward services and became more dependent on imported goods consumption.
Research by University of Minnesota’s Professor Timothy J. Kehoe and colleagues links sectoral productivity disparities and shifts in consumption to foreign borrowing associated with persistent trade deficits, suggesting the decline in manufacturing employment is largely due to productivity differences rather than trade imbalances alone. This implies that even if the U.S. corrects its trade imbalance, employment in the goods-producing sector may continue to decline. Today, however, the increasing tradability of services introduces a new and dynamic dimension of international engagement worth considering.
The terms of trade mechanism
Another aspect to consider regarding tariffs is how they change terms of trade, defined as the ratio of export prices to import prices. This relative price describes how much a country can import and consume for each unit it produces and exports. If the terms of trade improve—meaning the value of exports rises relative to imports—a country can acquire more goods from abroad for each unit produced and exported, thereby benefiting domestic consumers. Large countries such as the U.S. are generally not price-takers in international markets and can influence their terms of trade, even through tariffs. Thus, as shown by MIT professor Arnaud Costinot and UC-Berkeley professor Andrés Rodríguez-Clare, U.S. tariffs can adjust the relative prices between domestic exports and foreign imports, affecting both the external competitiveness of U.S. producers and also the pass-through of tariffs into U.S. consumer prices.
Consider, for instance, the U.S. imposing a 10 percent tariff on sneakers from Mexico, which were originally purchased duty-free for $100 a pair. Given the availability of similar products from other countries and the U.S. as the primary export market, Mexican producers might feel compelled to reduce the pre-tariff price to $95 to regain some competitiveness amid the reduced U.S. demand from higher after-tariff prices. This price adjustment is typically achieved through several means: lowering real wages or other production costs and tightening profit margins. Additionally, potential currency depreciation triggered by decreased demand for Mexican pesos as dollar-denominated export revenue declines can help offset some of the tariff’s adverse effects on Mexican producers by propping up U.S. demand.
After a 10 percent tariff is introduced, the total cost of a pair of sneakers to U.S. consumers rises to $104.50, which is below the anticipated $110 if pre-tariff terms of trade had remained. Additionally, the U.S. Customs collects $9.50 from the tariff, which could be refunded to consumers, effectively reducing their expense back to $95—cheaper than the pre-tariff price of $100. This results in a net benefit for U.S. consumers through improved terms of trade, but at the expense of Mexican workers who may face wage cuts and job losses. While the U.S. can manipulate terms of trade through tariffs, this acts as an externality for trading partners such as Mexico, imposing economic burdens they did not choose and cannot control.
The economic impact on U.S. consumers depends on how the U.S. government redistributes the tariff revenue through mechanisms such as tax cuts or direct refunds to consumers. The overall effect on U.S. consumers hinges on balancing potential real income losses from higher prices against the gains from tariff revenue. This terms-of-trade mechanism demonstrates that tariffs have complex impacts beyond trade and industrial policy, with significant fiscal and redistributive effects.
The Laffer curve of tariffs
The potential for generating additional tariff revenue for the government hinges on how import values respond to tariff changes. While imposing tariffs may initially boost duty revenue—offsetting any reduction in import volume—excessively high tariffs can drastically decrease import volumes, eventually leading to a revenue decline. This phenomenon is depicted by the revenue-maximizing tariff Laffer curve, which identifies an optimal tariff point for maximizing duties.
However, the revenue-maximizing tariff rate may not coincide with the rate that maximizes domestic consumption. That requires accounting for terms-of-trade effects (balancing real income losses for consumers against tariff revenue increases for the government) into an alternative consumption-maximizing Laffer curve.
For the U.S. Laffer curve calculations, it is assumed that all tariff revenue is rebated back to consumers. With unilateral and uniform tariffs imposed by the U.S. across all sectors and trading partners, research by SMU associate professor Michael Sposi and colleagues indicates U.S. consumption-equivalent customs duties peak with a tariff rate of just over 70 percent. Their estimates are derived from a model that considers trade in intermediate and final goods and services among all 50 states and the seven largest U.S. trading partners. By contrast, to enhance U.S. consumption by more than 0.5 percent, a more moderate tariff increase of about 25 percent is optimal.
In scenarios of reciprocal tit-for-tat retaliation, any U.S. tariff increase beyond 1 to 2 percent would reduce U.S. consumption by depressing domestic real wages through decreased global demand for U.S. products and more restricted access to foreign markets.
Some economists advocate increasing tariffs by more than the optimal 25 percent consumption-maximizing increase—and even beyond the 70 percent revenue-maximizing increase, while still generating equivalent amounts of government revenue. They push for higher tariffs as an industrial policy aimed at bolstering domestic manufacturing through import substitution. However, imposing significant tariffs could provoke retaliatory actions from trade partners, potentially escalating into a trade war and causing widespread economic damage that could negate any consumption gains for U.S. consumers. In fact, under retaliatory scenarios, U.S. consumers will face consumption losses except at very low tariff rates of around 1 to 2 percent or less (like those prevalent for much of the post-World War II era).
Interestingly, in scenarios of 25 percent tariff increases with tit-for-tat retaliation from all trading partners, Mexico experiences a consumption loss of 1.6 percent and Canada a loss of 1.1 percent. These losses soften the more severe negative impacts expected in the absence of retaliation, which are about 1.8 percent for both countries. These figures suggest that, unlike the conventional view for small open economies, retaliation is not always self-defeating and might alleviate some of the losses for United States–Mexico–Canada Agreement (USMCA) countries from the U.S. tariff hike. That’s in part due to the countries’ status as large and deeply integrated trading partners of the U.S. and the assumption of a coordinated global response.
Even under those conditions, however, there exists a threshold beyond which sufficiently high U.S. tariffs render universal retaliation more damaging than no retaliation at all. Moreover, achieving such a coordinated response is difficult, making unilateral retaliation less attractive than a negotiated trade deal or accommodation. This scenario echoes the lessons of the Smoot-Hawley Tariff era and similar protectionist policies of the 19th century, which also incurred substantial economic costs. Trade wars tend to result in losses on all sides, underscoring the dangers of escalation.
The distributional impacts of tariffs
Even under the most favorable scenarios for the U.S., tariff increases have uneven impacts across the country, resulting in clear winners and losers. These effects are shaped by factors such as education, employment status, geographic location and the economic profiles of individual states.
For instance, a hypothetical unilateral 25-percentage-point increase in tariffs on all sectors and all countries without retaliation could shift U.S. consumption patterns, ranging from a 0.8 percent decrease to a 2.3 percent increase across states, with an average national consumption gain of more than 0.5 percent. States that rely on import-dependent sectors such as mining may benefit from reduced foreign competition, which boosts local market share. Conversely, states with export-driven industries, particularly those in the Northeast, the East Coast and parts of the Midwest, might suffer from decreased global demand and higher costs for intermediate goods.
Retaliatory tariffs further complicate trade dynamics, leading to an overall decrease of almost 1 percent in U.S. consumption. Again, the impact of a 25-percentage-point tariff increase with retaliation is unevenly distributed across states, with those more reliant on exports experiencing the sharpest declines (nearly 3 percent). However, even under those conditions, some states may still increase consumption by more than 2.5 percent in the face of retaliation. This scenario underscores the differential effects of tariffs across U.S. states, highlighting the significant regional disparities in how trade policies impact local economies.
Where do we stand now?
Before the 2018–19 trade war, U.S. tariffs were relatively stable and low, averaging about 2 percent on a trade-weighted basis. The highest tariffs were predominantly in the textiles and agriculture sectors, which experienced higher average rates than other industries. Due to the North American Free Trade Agreement, updated to the USMCA in 2020, Canada and Mexico were largely exempt from these higher tariffs.
Conversely, U.S.-produced goods faced significantly higher tariffs abroad, particularly in emerging and developing countries. Despite USMCA exemptions, U.S. agricultural and food exports still encountered high tariffs in Mexico and Canada, with exceptionally steep tariffs—exceeding 50 percent—in China. This disparity highlights the challenges U.S. exporters face in international markets.
The trade war escalated anew in March 2025, with the U.S. applying a 25 percent tariff on goods from Canada and Mexico, later adjusted to exclude USMCA-compliant items, and intensifying tariffs on Chinese imports by 10 percent and then up to 20 percent.
Additionally, in April 2025, the U.S. applied a uniform increase of 25 percent on steel and aluminum for all trading partners. Subsequently, a new tariff schedule was introduced with higher rates targeted at countries running large bilateral trade deficits with the U.S.
The resulting import-weighted average tariff increase was estimated at 41 percentage points; but, under a subsequent reciprocal tariff policy, only about half of those increases were implemented, with changes ranging from no adjustments for Canada and Mexico to an additional 34 percent increase for China while applying a minimum 10 percent tariff across the board. These increases, while not uniform across countries, approximate on average the earlier examined flat 25 percentage point rise.
(Shortly thereafter, however, a 90-day pause on tariff hikes above the 10 percent minimum was granted to facilitate negotiations, resulting in a first agreement with the U.K., while retaliatory tariffs from China escalated sharply but have since been scaled back amid renewed trade talks.)
The response from most affected countries in terms of retaliation remains uncertain, as does the application of exemptions except in the case of China, which chose tit-for-tat escalation. While the inconsistency of response complicates exact impact calculations, the prior analysis primarily illustrates the terms of trade mechanism by which tariffs affect revenue-generation and aggregate consumption. Therefore, the flat tariff scenario provides a valuable reference point for broadly assessing the potential effects of sizeable tariff hikes, illustrating the trade-offs posed by such policies, regardless of final tariff rates.
Looking ahead
Navigating the complexities of tariff policy involves balancing three critical objectives—revenue, restriction and reciprocity—often creating a policy trilemma known as the impossible trinity. Prioritizing one goal can inadvertently undermine the others. For instance, maximizing government revenue through high tariffs can conflict with the goals of maintaining open foreign markets for U.S. goods and securing reciprocal trade concessions. These high tariffs may restrict imports excessively, harm industries that depend on foreign inputs, escalate trade tensions and provoke damaging retaliatory actions from trading partners, as evidenced by historical episodes such as those during the Great Depression .
Additionally, using tariffs to protect domestic industries can lead to market inefficiencies and resource misallocation. This trilemma poses a significant challenge for policymakers striving to develop effective trade policies that use tariffs judiciously. While higher tariffs might benefit certain sectors and encourage some firms to relocate production to the U.S., the broader economic impacts—including effects on consumer prices, consumption and global supply chains—are also ambiguous and can intersect with other economic and policy goals.
Moreover, these policies carry implications for redistributive fiscal policy. Gaining a deep understanding of the nuanced historical impacts of tariffs and the mechanisms through which they operate is crucial for crafting trade policies that minimize economic distortions, anticipate interactions with other policy priorities, and strike a balance between the protective and revenue-raising functions of tariffs and the advantages of reciprocal free trade.
To read the full analysis as published by the Federal Reserve Bank of Dallas, click here.