Note: this unedited article may be used within a new chapter in my inflation primer.
The topic of tariffs became of extreme importance in 2025, courtesy of American President Trump’s trade war on the rest of the world. In the modern meaning, a tariff is a tax on imports or more rarely, exports. (In practice, “export taxes” seems to be used in the financial media.) The origin of the term is that it referred to tables, coming from the Arabic ta’rif (a notification or announcement, see reference by Paul Anthony Jones below). The tables were of fees paid by traders, and so the meaning of the word in European languages evolved to refer to fees. In English, the meaning became more specialised to just refer to import/export taxes.
(One hard to prove argument is that President Trump was able to get greater support for tariffs due to lack of familiarity with the term, if they were marketed as “import taxes,” they would be less palatable to the American public.)
Who Pays the Tariff (Technical Answer)?
One of the points of debate around the 2025 tariff policy was: who pays the tariffs? President Trump argued that foreigners would, which was disputed by his political opponents.
The initial technical answer is straightforward: whenever goods are imported (legally) across borders, there is a party to the transaction called the importer of record. (See the primer by Susan Redding in the references for more discussion on this and other basic concepts behind the procedure.) Either the importer or the exporter can be the importer of record, and who takes the responsibility is part of the trade negotiation.
As was found out the hard way in 2025, tariffs are imposed (typically as a percent of the value of the imported goods) at the moment in time the goods cross the border. The problem was that many goods imported to the United States from China that needed to sail across the Pacific Ocean, creating a long time lag between the agreement to import the goods and the goods reaching an American port. The President of the United States decided it was a good idea to raise the tariff rates on Chinese goods to 104% or more (URL: https://www.cbsnews.com/news/tariffs-trump-in-effect-104-percent-china/) with a relatively short implementation time, which created a financial time bomb for whichever party made the mistake of being the importer of record when the goods arrived. (Although there was a reason to expect a tariff hike, nobody was expecting increases of that magnitude.)
However, if the tariff rate is known in advance (the usual situation in sensible countries), both the importer and exporter are aware of it and their negotiation will take it into account. As such, we then get to the question of more interest — who absorbs the tax: the domestic importing firm, the foreign exporting firm, or domestic consumers?
Who Pays the Tariff (Long-Term)?
Let us look at a hypothetical situation for a Canadian firm that sells a consumer good to an American retailer. We first have a situation of no tariffs, then a 10% tariff, and we want to look at a long-term change in prices.
Let us assume that the Canadian firm can produce the good at the equivalent of $80 U.S. dollars. (For simplicity, all figures here are in U.S. dollars, and we assume that the exchange rate is stable, and/or the Canadian firm has hedged the currency.) They sell the good to the American retailer at $100, generating a gross $20 profit margin.
The American retailer sells the good to American consumers for $120, generating a $20 gross profit per item. (Since the retailer has to cover store rents, salaries, shipping costs, etc., the net profit margin would be smaller.)
The Americans then put a 10% tariff on the imported good. There are three ways in which a single party of the transaction can absorb the cost of the tariff.
The Canadian firm can drop its selling price by 10% (to $90.91 rounded). This makes the total cost of the good plus the tariff equal to $100, which is what the American retailer was already paying. (Which party transmits the $9.09 tariff is not material.) Since the price paid is unchanged, the retailer can keep the consumer price unchanged to keep its profit margin unchanged. The loser in this case is the Canadian firm, which has its profit margin drop to $10.91 from $20.
The American retailer can absorb the cost in its profit margins. The Canadian exporter keeps the export price at $100, and there is a $10 tariff on top of that. The retailer maintains the consumer price at $120, so its gross profit margin drops to $10.
Both firms keep their profit margins, and the American consumer pays a higher price. If the retailer wants to keep its gross profit margin stable, it would charge consumers $132 (20% markup on the $110 total cost of the item), that is the consumer price rises by the same percentage as the tariff. (If the retailer just wanted to keep its per unit profit unchanged at $20 it would raise the consumer price by $130.)
What will happen in practice depends upon the business strategies of the firms, as well as the competitive situation. It is extremely likely that there will be a mix of outcomes: firm profit margins shrink, and the consumer price rises by less than 10%. Although one could use a model to come up with an answer, any reasonable model will have an output that is based on unknown parameters describing firm behaviour — and we did not have a lot of modern data to calibrate those models. I will just offer some hand-waving stories explaining why each outcome might happen.
The Canadian firm might be in direct competition with American firms. For example, the competitors might be charging $100 for an effectively identical product. The Canadian firm would then be forced to absorb the tariff in order to retain market share.
The retailer might absorb the tariff if the Canadian firm has a unique product and is in the position to keep its profit margins unchanged — or if competing American firms raise their prices by 10% (since they know they can get away with it). The retailer might absorb the margin loss if it feels that consumers would be unwilling to absorb a price change — for example, they substitute with different products.
Consumers end up with higher prices if firms do not want to reduce their profit margins and do not substitute away from the more expensive good.
The key thing about this example is that the tariff increase can be absorbed completely by the producer/retailer profit margins. If the tariff were instead above 50%, there is no way of the firms being able to produce/sell the good at the unchanged price of $120 without one or both of them losing money. Since firms generally cannot sell products at a loss forever (although retailers can have a few “loss leaders” to attract consumers), consumer prices would have to rise.
Short Term More Complicated
In the short term, what happens is less clear. Importing and exporting firms are going to be more willing to take losses on a few shipments in order to keep existing business relations. Also, firms will have goods in inventory bought at pre-tariff levels, and so the retailer might do something like make a small immediate price hike that increases the profit margin on existing inventory, but with reduced profit margins on newly imported goods.
A complicating factor in 2025 is that the consensus in the financial markets and in the business sector was that the tariff levels set by Trump were unsustainable, and so firms might keep prices steady and wait for a reversal. There is also the possibility that firms might find way to avoid the tariffs, and so the effective tariff rate would end up being lower than projected based on the statutory tariff rate changes. As such, I would find it unsurprising that retail consumer good prices will rise by less than implied by tariff changes in the short run. (The outcome is unknown at the time of writing.)
Why Impose Tariffs?
There are two conventional reasons for a country to impose tariffs.
Tariffs require very limited state capacity when compared to other taxes. All a government needs to do is monitor ports and land frontiers — which they need to do anyway.
They are a way to protect domestic firms from foreign competition. Although this can easily lead to corrupt dealings between firms and the government imposing tariffs, there are good faith reasons to want to protect “infant industries.” (For example, tariffs were a part of Canada’s “National Policy.”)
The state capacity argument is of limited use once countries have implemented an income tax and/or Value-Added Tax (VAT). In particular VAT’s are quite effective, since the payment/rebate chains they imply create an incentive for compliance (see appendix).
The “protect infant industries” story has attraction for both the left and some on the right (like President Trump). (Being against tariffs — i.e., favouring “free trade” — is standard free market dogma.) The problem with the strategy is that unless one wants to pursue autarchy (making a country self-sufficient via cutting off international trade), you need to think about what industries you want to protect, and you will likely face unhappy trade partners that want to protect the exact same industries. Although malcontents like to complain about “free trade” neoliberal dogmatism, the post-1980s order is better described as “managed trade”: countries have created a web of largely bilateral trade deals (mixed in with a few wider regional agreements) that set limits on countries’ trade actions. Trade partners are not going to be happy with unilateral attempts to rewrite trade deals — like President Trump has done in 2025 — and so industrial policy has to either be domestic-focussed (as attempted by President Biden) or trade agreements need to be renegotiated or face retaliation.
Why Will Consumer Prices Rise?
Buried in the description of why retailers would raise prices in response to the example tariff hike was an important point: domestic producers will take advantage of the tariff to raise prices themselves.
Since one of the justifications of tariff use is to protect domestic producers, we need to think about how that works. If domestic producers keep their prices unchanged while their foreign competitors have to absorb the tariff, the domestic producers would gain market share. If they had the excess capacity to completely replace foreign suppliers, then they might not see any reason to adjust prices. But if domestic firms cannot supply 100% of the domestic demand, they might as well raise their prices so that their new price is close to where the foreign producers’ is after the tariff is imposed, since those foreign firms will be needed to fill the demand gap anyway. (This ties into the concept of “sellers’ inflation.”)
The price hike by domestic producers implies higher profit margins, and theoretically will draw in new domestic supply. However, building a new manufacturing plant is a multi-year project, so this supply response will only show up in the long term.
Intermediate Goods
The example used was for consumer goods, which are sold directly to consumers. If there is a tariff on a good that is an input to a domestic firm’s production process, the tariff only represents a fraction of the final product’s production cost.
In this case, if the increase in the input costs are not too drastic, there is a decent chance that the domestic firm will not raise its price on its final product, rather it would absorb the added cost in its profit margins — in the short run, at least. Outside of strong inflationary regimes, firms tend to prefer to keep prices constant and only periodically raise prices. As such, the higher cost may only passed on much later than the effective date of the tariff increase.
One-Time Effect or Inflation?
Imposing a new broad tariff is likely going to cause a one-time jump in the affected goods. One can draw a distinction between a one-time jump in the price level versus a continuous rise over a multi-year period (inflation). As such, one can attempt to argue that a tariff hike is not “inflationary.” However, as seen in the post-2020 pandemic reaction, “inflation” in practice means the current annual rate-of-change in the price level. Until the one-time effect drops out of the annual comparison, the inflation rate has risen — and people are not entirely sure how much of that is truly a one time effect.
To the extent that the rise in the price level raises wages in bargaining as well as cost-of-living adjustments (as well as affecting “inflation expectations”), even a one-time price level change can trigger a more sustained rise in prices.
Concluding Remarks
A tariff increase represents a one-time increase in the cost of doing business. The pass through to consumer prices (“inflation” under the usual meaning) is somewhat uncertain, as firms may decide to absorb the cost in their profit margins. Nevertheless, profit margins are generally not exceptionally wide, so their capacity to absorb high tariff rates is limited.
Appendix: Value-Added Taxes
One of the justifications made by President Trump to justify his spree of tariff hikes was that foreign countries “cheat” on international trade by having Value-Added Taxes (VAT) — the United States is one of the few developed countries without a VAT. President Trump is an extremely unreliable source of information, but his statements seemed to reflect arguments by a small handful of American economists who are unhappy with free trade.
The Americans’ arguments seem to be incorrect, and I would point to the article by Janering and Buteyn in the references for more details. I will just offer an overview of how VAT systems operate.
As the name suggests, there is a tax imposed on the value-added by firms. On each transaction in goods and services (but not things like financial transactions), a tax is levied as a percentage of the value of the transaction.
For a final consumer of a good, a VAT acts like a sales tax — they pay the VAT based on the full value of the transaction. The difference from a sales tax is that firms get to recover the VAT on their purchases.
For example, imagine that there is a 10% VAT on a good that a retailer pays $100 for and sells for $120. The final consumer pays $12 in VAT on the final sale, and the retailer paid $10 VAT to its supplier. The retailer can then recover the $10 paid out of the $12, so its’ net VAT payment is $2, which is 10% of its profits (value added).
(Note that countries handle how consumer prices are posted differently. Canada adds its VAT (the Goods and Services Tax — GST) on top of the posted price, while European countries tend to embed the VAT in the posted price.)
These rebates work their way down the chain, so a distributor will reclaim part of the VAT it pays to manufacturers, manufacturers can reclaim the VAT paid on inputs, etc. The chain of rebates makes VAT very efficient for collection: each link in the chain wants to get the VAT rebate on its inputs, so it has an incentive to declare those transactions — which means that the source of the good or service has to also declare the VAT on its outputs.
The alleged “unfairness” appears to be that American firms have no VAT on their rebates to reclaim when selling into a country that has a VAT. However, if they do not have VAT on inputs, that means that they have cheaper inputs than the foreign firms that do have VAT payments to reclaim. If they want VAT rebates, all they need to do is buy foreign goods that have a VAT embedded in their prices.
Reference:
Since the objective of this text is to discuss tariff price effects and not become a treatise on international trade, there are no advanced references.
The article “Why is a Tariff Called a Tariff?” by Paul Anthony Jones was the source for comments about the word origin. URL: https://www.mentalfloss.com/why-is-a-tariff-called-a-tariff
A few of the assertions in the text are based on “Tariffs 101: What are tariffs and how do they impact international trade?”, March 2025, by Susan Redding, Export Development Canada TradeInsights. URL: https://www.edc.ca/en/article/how-tariffs-work-for-business.html
“VAT Versus Tariffs”, March 27, 2025, Rob Janering, Gregory J. Buteyn, Crowe. URL: https://www.crowe.com/uk/insights/vat-vs-tariffs
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