Understanding Tariffs: Their Mechanisms, Motivations, and Impacts

Headlines around tariffs have taken over the news cycle so far this year as the market has struggled with high levels of uncertainty.

Below is a summary of how tariffs work and their impact on the economy.

How Tariffs Work

At its core, a tariff is a tax imposed by a government on goods and services imported from other countries. The tax is typically paid to the government by the importer, who may pass the cost onto consumers through higher prices or try to negotiate new pricing with the source company. Tariffs can be specific (a fixed fee per unit) or ad valorem (a percentage of the value of the goods).

Why Countries Implement Tariffs

Countries implement tariffs for several reasons:

• Protect Domestic Industries: By making imported goods more expensive, tariffs can help protect nascent or struggling domestic industries from international competition.
• National Security: Tariffs can safeguard industries crucial to national security, ensuring that the country is not overly dependent on foreign suppliers for essential goods.
• Revenue Generation: Tariffs can be a source of revenue for governments, although this is less common in modern economies compared to other forms of taxation.
• Retaliation and Negotiation: Tariffs can be used as a tool in trade negotiations, to retaliate against unfair trade practices, or to pressure other countries into making concessions.

Impact on the Broader Economy

The broader economic impact of tariffs can be complex and multifaceted:

• Inflation: Tariffs often lead to higher prices for producers and consumers, as importers pass on the additional costs. For example, in 2024, importers paid an estimated 2.2 cents in duties for every dollar of goods imported. With additional tariffs, this cost can rise significantly.[1] This can reduce consumer spending and overall economic growth.
• Domestic Production: Tariffs can boost domestic industries by reducing foreign competition. Tariffs can also lead to inefficiency and higher production costs if domestic producers do not face competitive pressures. Depending on the industry or product, developing manufacturing capabilities onshore can take a significant amount of time and prolong the effects on prices. In some cases, tariffs have led to a 30% increase in costs for certain sectors.[1]
• Trade Relations: Tariffs can strain international trade relations, leading to trade wars where countries impose retaliatory tariffs on each other. This can disrupt global supply chains and negatively impact economic stability and inefficiency.

Impact on Companies Within the Economy

For companies, the effects of tariffs can vary widely:

• Competitive Advantage: Domestic companies that compete with imports may benefit from reduced competition, potentially increasing their market share. This may allow domestic companies to increase production and jobs.
• Increased Costs: Companies that rely on imported materials or components may face higher costs, which can squeeze profit margins. These companies might pass on the costs to consumers.
• Supply Chain Alteration: Tariffs can disrupt supply chains, forcing companies to find alternative suppliers or to absorb higher costs. Supply chain diversification is not inherently bad but can lead to short-term delays and increased operational complexity.
• Investment Uncertainty: The imposition of tariffs can create uncertainty, making companies hesitant to invest in new projects or expand operations. This can slow economic growth and innovation.
• Currency Fluctuations: Tariffs may contribute to a weaker dollar, making foreign investment more challenging. This can incentivize companies to build new plants or expand operations domestically, as the relative cost of investment in the U.S. becomes cheaper.
• Revenue & Earnings Uncertainty: During the COVID-19 pandemic, many companies successfully passed increased costs from supply chain disruptions to consumers. This challenged the traditional notion that higher input costs necessarily reduce earnings. However, consumer balance sheets were bolstered by Federal stimulus at that time and future dislocations may not play out the same way.

Conclusion

While Tariffs can protect domestic industries and generate government revenue, they also have significant implications for consumer prices, economic growth, and international trade relations. Companies and consumers need to work to navigate these challenges to mitigate negative impacts and capitalize on any potential benefits. And, of course, the lasting effects of changes in international trade relations can take years to work through.

Regardless of the headlines, it’s important for investors to focus on their long-term financial goals and avoid knee-jerk reactions. The best way to think about a potential change to your financial plan is to do so methodically and with your advisor to determine if any financial plan adjustments are needed.

Want to read more? Check out Staying the Course: The Benefits of Sticking to Your Asset Allocation During Market Volatility.

Sources:
[1]Federal Reserve Bank of Richmond, "Tariffs: Estimating the Economic Impact of the 2025 Measures and Proposals."

Investment advice offered through OneDigital Investment Advisors LLC.

This is for informational purposes only and should not be interpreted as specific investment advice. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

Investors should understand the risks involved in owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal.

Past performance does not guarantee future results.

Views and Opinions expressed herein are provided as of 4/3/25.

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