Macro Signposts | 20 February 2025
Reciprocal Tariffs: The Trump Administration's New Trade Strategy
The Trump administration's 13 February executive order expands on the ideas and policies introduced in prior announcements on U.S. trade policy, directing agencies to investigate foreign trading practices that contribute to the nation's large and persistent trade deficit. The order aims to impose reciprocal tariffs that match trade barriers faced by U.S. exports while broadening the definition of non-tariff barriers, including value-added taxes (VATs), extraterritorial taxes, currency policies, foreign government subsidies, and regulations that disadvantage U.S. trade.
We estimate this executive order could lead to substantial increases in the average effective tariff rate on imports, potentially ranging from 1 to 10 percentage points or more, depending on how the administration assesses these non-tariff barriers. Solely seeking reciprocity just in outright tariff rates - whether at a product or country level - would raise the average effective tariff rate on U.S. imports by an estimated 1 to 2 percentage points (ppts). This would be only somewhat larger than the approximately 1.2-ppt increase from tariff policy in Trump's first administration, and all else equal it could add perhaps 10 to 20 basis points to U.S. inflation.
However, depending on how the administration defines non-tariff barriers, these policies could substantially raise U.S. imports tariffs by 10 percentage points or more, especially on countries with the largest trade deficits with the U.S. It's also worth noting that further policies are likely still to come, such as steel and aluminum tariffs announced last week (slated to take effect in March). Another key date is 1 April, when federal agencies are due to deliver their reports, and we could see further action on reciprocal tariffs.
Addressing trade deficits: a new strategy
While markets appear to focus on the relative tariff rates between the U.S. and other countries, we think the aim of the Trump administration's strategy is potentially larger in scale and scope than just matching our trading partners' tariff rates. As we've discussed recently (see the 17 December 2024 Macro Signposts, "Will We See Bold Policy Choices in the U.S.?"), the administration sees the U.S. trade deficit as symptomatic of decades of unfair policies of our trading partners, which have disadvantaged the U.S. In the administration's view, foreign currency manipulation and implicit or explicit foreign government manufacturing subsidies have reduced U.S. manufacturing as a percentage of GDP, driven up foreign excess savings, and increased demand for U.S. Treasuries (and other U.S. assets) that serve as a stable store of value.
While administration officials have hinted at a willingness to negotiate - suggesting that few or no tariff changes could occur if favorable deals are reached - the overarching message remains clear: The U.S. intends to take a more aggressive stance against trading partners perceived as unfairly disadvantaging American goods. Some countries may simply choose to reduce their tariff rates in response to U.S. reciprocal tariffs; reducing the tariff rates on U.S. exports in key industries such as autos, energy, and food seems very plausible. However, it's yet to be seen whether Trump can negotiate broader-based structural reforms, or push for greater domestic fiscal stimulus among serial trade surplus countries to rebalance their economies toward more consumption and defense spending, for example.
Targeting major trade partners
We think the aim of Trump's "Fair and Reciprocal Plan" is to increase scrutiny on countries that run serial trade surpluses - including China, the European Union, South Korea, Japan, Mexico, and Canada. As scholar Michael Pettis pointed out in his 28 June 2024 article, "Trade and the Manufacturing Share," large surplus countries are also those with the largest shares of manufacturing output as a percentage of GDP. Manufacturing has migrated to these countries because they are the ones with the largest explicit or implicit manufacturing subsidies, which tend to distort competitive market dynamics and in turn have contributed to the U.S.'s lower share of manufacturing as a percentage of total output.
During Trump's first administration, the U.S. Trade Representative investigated China for unfair trade practices, including intellectual property theft, forced transfer, and other implicit manufacturing subsidies. The second Trump administration has already raised tariffs on Chinese products by 10 percentage points, bringing the average effective tariff rate to roughly 20%, and could raise tariffs further.
Federal agencies' investigations into trade policy will likely have broader implications for other countries accused of having elevated non-tariff barriers:
Tariff disparities and their implications
Equalizing tariff rates across countries and products would also have implications, although on aggregate such a policy would only raise the effective tariff rate by 1 to 2 ppts, by our estimates. Countries with much higher tariffs on U.S. exports, including India and Korea, are likely to see substantial increases, although imports from these countries make up a smaller proportion of overall trade. U.S. exports to India encounter tariffs that are 7 to 10 percentage points higher than those imposed on Indian imports, while Korea's disparity is 6 to 12 percentage points.
Even Mexico and Canada, with whom the U.S. (at the moment) has free trade agreements, impose tariffs averaging 3 to 5 percentage points on American goods, often due to differing environmental and health regulations - limiting processed food imported from the U.S. (due to higher restrictions on food additives) is one example. These countries have also negotiated tariff shelters for specific industries. Canada shelters its dairy industry with tariffs greater than 200% on above-quota imports, while Mexico similarly shelters its sugar market. Rules of origin requirements are also at the heart of tariffs on auto parts traded among the U.S., Canada, and Mexico.
The role of value-added taxes
The Trump administration also hinted at potential inclusion of foreign value-added taxes (VATs) in reciprocal tariff calculations. Theoretically, while VATs should not change a country's relative competitiveness (see the 1990 study by Feldstein and Krugman1 for more explanation), an empirical study by economists at the IMF2 found VATs have improved trade balances, particularly in the euro area, due to limited currency adjustment and/or price adjustment. This is likely motivating the Trump administration's choice to potentially include VATs.
Navigating economic volatility
Overall, the Trump administration's aggressive trade policy aims to rectify the U.S. trade deficit through increased tariffs and scrutiny of foreign practices. Trump has signaled he is willing to negotiate. However, the structural reforms likely needed in the countries with the largest trade surpluses (and manufacturing bases) aren't likely to be negotiated easily. Structural changes in the U.S., including reducing government fiscal deficits, are also likely going to be difficult given slim Republican majorities along with political and legal constraints.
In the absence of reforms, the Trump administration can look to force these changes by trying to engineer an effective dollar devaluation. The administration could attempt some combination of raising tariffs and trying to limit the offsetting dollar depreciation - although without a coordinated global intervention or a material reduction in the fed funds rate, neither of which seems likely, it's not obvious how the administration could accomplish this.
All of these policies and negotiations are likely to coincide with some economic disruption and market volatility in the near term, even if we eventually see medium-term benefits of a more balanced and stable global trading system.
How much volatility is tolerable is still the key question for the outlook, in our view. So far this year, the overall market reaction to Trump's trade moves has been surprisingly muted across currency, bond, and equity markets. Perhaps markets reflect a relatively sanguine outlook among investors about U.S. trade policy, or perhaps investors believe tougher policies are still likely to come. Regardless, the relatively muted response could embolden the Trump team to take more aggressive actions ahead.
1 Martin Feldstein, Paul Krugman, "International Trade Effects of Value-Added Taxation," a chapter in "Taxation in the Global Economy" (Assaf Razin, Joel Slemrod, editors), University of Chicago Press, January 1990
2 Ruud de Mooij, Michael Keen, "'Fiscal Devaluation' and Fiscal Consolidation: The VAT in Troubled Times," International Monetary Fund (IMF) Working Paper, March 2012 .
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