Trump’s misguided tariff formula

Hong Kong is recognized by the World Trade Organization as a separate customs territory from mainland China. It imposes no tariffs on US imports. However, it will still face tariffs exceeding 100%.

Trump's "reciprocal" tariffs use a unique formula. The tariff on any country, k, is set at either 10% or 0.5 times k*. Here, k* represents the comprehensive tariff equivalent of all trade barriers that country imposes on the US.

This calculation uses k’s trade surplus with the US in 2024. It divides this surplus by its exports to the US for that year.

If a foreign country has a trade deficit with the US, it faces an extra 10%. If it has a large trade surplus, like 60% of its exports to the US, it faces a 30% tariff.

To support Trump's tariffs, the Office of the US Trade Representative cites academic studies. These studies claim to show how import prices respond to tariff hikes and how volumes decline as prices rise.

However, Trump's formula has two major flaws. The first flaw is its belief that US trade deficits come solely from foreign trade barriers or unfair practices. Textbook economics shows that trade balances reflect national savings and investment differences.

For example, South Korea runs a trade surplus because it saves more than it invests. In contrast, the US runs a deficit due to low savings relative to investment.

Many factors can influence this saving-investment ratio unrelated to trade policies. A shale-gas discovery in Texas could boost expectations of future wealth in America. This would lead to increased consumption and decreased savings, widening the trade deficit.

Under Trump’s framework, any increase in deficits would be blamed on unfair practices abroad. This idea suggests that countries with surpluses must be engaging in unfair policies.

By Trump’s logic, since the US has a large service surplus with many countries, it must also be practicing unfair trade. In reality, this surplus reflects America's strength in high-value service sectors.

The second major flaw is assuming higher tariffs will reduce imports without hurting exports. Tariff increases often lead to retaliatory measures from other countries.

For instance, China plans to impose an 84% tariff on US goods after Trump set a 104% tariff on Chinese goods. Even without retaliation from other countries, American exports are likely to decline anyway.

With unemployment near historic lows in the US economy, there is little slack available. Tariffs may help uncompetitive firms expand but at the cost of competitive companies losing resources.

Thus, any reduction in imports due to tariffs will likely cause export declines too. This principle explains why Trump's tariffs might shrink both exports and imports rather than reducing the overall trade deficit.

To truly solve the trade deficit through tariffs would require raising them extremely high—like up to 500%. This would effectively shut down all trade and resemble North Korea's economy which maintains balance by eliminating both imports and exports.

While Trump claims his trade war will strengthen the economy, stock market reactions tell another story. After his April announcement about tariffs, both S&P 500 and Nasdaq dropped around 12%, erasing trillions in market value.

The negative impact extended beyond US markets as well: Japan's Nikkei fell by 7.8%, Hong Kong's Hang Seng dropped by 13.2%, and Europe's Stoxx declined by 4.5%. China's Shanghai Composite Index also fell by 7.3%.

Stock prices reflect investors' expectations for future corporate earnings; thus their decline indicates skepticism about Trump's claims regarding long-term benefits of tariffs for the economy.

As a result of these developments, American households now face declining retirement savings alongside rising prices.
Shang-Jin Wei is a former chief economist at the Asian Development Bank and currently teaches finance and economics at Columbia University.