Can you replace the income tax with tariffs?
A picture from the wonderful world of autarky. Photo by Lucas Campoi on Unsplash
Can you replace the income tax with tariffs? Yes, you can. It is totally possible to replace an income tax system with a tariff system to finance your government. I don’t think you should, but it is possible.
Special thanks to Wasserschweinchen for a great question about this in the comment section as well after my last piece on tariffs. I love feedback and ideas for future columns! This is actually a hotly discussed topic and Wasserschweinchen’s comment helped encourage me to write this column today. Thank you!
I hope my discussion below gives you help thinking through the topic.
Whatever You Tax, You Get Less Of
We all know this rule. If you want less smoking, tax cigarettes. If you want to discourage pollution, tax it.
This effect is the exact reason that, when income taxes get high, we see people shift their “income” to other sources so you get “less” income. The wealthy, in particular, move their funds into tax-free or deferred-tax investments. Businesses, additionally, offer their managers cars and other amenities in lieu of higher income to help avoid taxes.
There are many mechanisms through which this works. In the end, higher taxes on something means you get less of it.
An All-Tariff versus an All-Income-Tax System
Now let’s see what this implies for considering tax systems to fund our government. And, to keep things simple, we’ll imagine a world where this one system finances everything completely. That is, for simplicity, we’ll consider all-income-taxes versus all-tariffs.
While higher income taxes mean more people spend money to avoid them, everyone in the entire society can’t claim zero income. They may work their magic to reduce it on paper, but even the dumbest collection of politicians and government bureaucrats won’t believe no one earned any income!
The same is not true for imports. Tariffs are taxes on imported goods. Not only could an economy, in theory at least, import nothing and hence generate zero tax revenue for the government, but less imports and maybe even zero imports is sort of an implied goal of proposing tariffs in the first place.
Just this week, Trump told Canada that they needed to get their trade deficit with the USA down (ideally to zero…although I don’t know if he actually said “zero”). And there’s an active conversation - at least among the talking heads on news shows - that “we’d” like the USA to be totally self-sufficient. That literally means zero imports, but people don’t always make that connection in public.
Publicly people advocating for tariffs frequently argue that “some industries” should be self-sufficient but maybe not all industries. They usually list security/defense-related industries first. Everyone agrees we should be capable of providing our own energy if we were in a war, for example, especially one against a supplier of said energy. So this line of argument quickly gets listers to agree.
Listen closely, however, and they’ll soon slip in other industries. Computer chips show up early as a potentially security/defense related good. AI and other cutting edge technologies often soon follow. Then, wherever they live or have political constituencies will dictate the next industries they feel we should be self-sufficient in. Some will even ask: If America is big and diverse, why should we import anything? In reality this is all slippery slope stuff and there’s no logical end to it once you put your mind to it.
I won’t get side tracked down that rabbit hole today, however. Suffice it to say, you don’t want to live in a 100% self-sufficient economy for the same reason you don’t want to live as a 100% self-sufficient person where you make your own clothes, grow all your own food, etc. Autarky is a horrible goal. People don’t last long in truly self-sufficient, autarkic economies.
Back to tariffs…
The point here is that, in the limit, we can have zero imports but not zero income. And, it’s hard to even know how much revenue across-the-board tariffs would generate. When you raise the tax on an import you’ll generally get a lot less of it very quickly1. It follows, then, that you can’t just take the current import numbers, multiply them by, say, 25% and calculate how much revenue the government will get from tariffs. You have to know by how much imports decline as tariffs rise and we actually don’t know that. It will definitely be a lot in some industries and less in others, but imports decline as tariffs go up which is part of the point of the tariffs in the first place.
I do not think an all-tariff tax system would be feasible. I think it’s an excellent academic question to consider, fun to discuss in a classroom or theory paper, and it may even have policy implications. Economists might even calculate the optimal tariff-income tax combination. But, switching one system for the other just isn’t feasible in my view.
Historically in the USA…
In 1913, the United States of America passed the 16th Amendment to our Constitution allowing the Federal government to impose a Federal income tax. Before that, the federal government primarily raised revenue via tariffs! So, it is possible.
But, I find there’s a lot of insight from considering why tariffs might have been more common in, say, the 1800s than federal income taxes. States at that time in the US primarily used property taxes, as far as I know. So we had mostly tariffs and property taxes.
What would be easy to identify and collect taxes on in 1800? Income or imports?
If you are the government in 1800 and want to tax income, then you have to find all the people in the country and accurately identify their “income”. Do pelts they trade count? What about one farmer helping another build a farmhouse? How would the federal government even know about it or know where those farmers, pelt traders, and others live, for that matter?
Now consider tariffs. There were known ports of entry into the USA. They were identifiable and you could count the goods taken off and put onto the ships. Much easier!
The argument for property taxes for states would have been similar. There would have been local land registries where states could see who lives where, find them, the size and quality of their land, and so on. I can imagine disputes over the value of the land, but still, it’s easier than settling disputes over the value of their income.
Today, all of the above are equally easy. Income might be the easiest to identify and count, especially compared to land and its value. Companies have to report payrolls, governments can see into bank accounts, banks must report numbers, etc. This means that today, in Connecticut where I live, I now “get to pay” both property and income taxes. Ugh.
The fact that, 200 years ago, we had gold coins or more tariffs than income taxes is not an argument to do the same today.
Again, as an economist, I think it’s a valid discussion and worthy of consideration. We can learn something by thinking about it, but I don’t think it’d be good policy.
Tariffs are Taxes and they are paid by Americans!
One final pet peeve of mine: I keep hearing politicians, including Trump himself, say that China will pay us a ton of money when we put tariffs on Chinese imports.
The buyer, not the producer, pays the tax. When you go into the store to buy something, you pay the cost of the good and the tax on it. The store collects both payments from you and passes one of them on to the government. But the buyer physically pays both.
The same is true on imports. The American buyer, distributor, importer, retailer or whoever ordered the Chinese goods pays the tariff, not the Chinese.
Tariffs are taxes on Americans. Plain and simple.
I believe Trump actually understands this. He and his policy people seem to have in mind a combination of higher tariffs and lower other taxes (like income taxes) so the combination is relatively neutral as an overall tax burden. It will dramatically change who pays the taxes, but could be done in a way to keep the total amount of taxes collected about the same. But, make no mistake, the domestic residents pay the tax2.
He and his team would surely argue there is some optimal mix that would stimulate domestic business and not be overly burdensome and therefore generate growth. I suspect he’s right in the short run and wrong in the long run. Everyone today is focused on the short-run costs, but I believe the longer-run ones are the really bad ones. (See my other column on my thoughts on tariffs: Thinking Through Trump Tariffs, Nov 10, 2024)
Hope that helps you think through the issues being discussed. I think we will see some more tariffs and some other lower taxes, and I don’t think it will be the end of the world. In my preferred world, I’d like to see tariffs at zero except for real security/defense reasons, but that’s not the world we live in.
Please share comments or suggestions for other topics of interest. I love to hear from you!
Thank you, as always, for reading.
Yes, it depends on the elasticity of demand for that import. But, my guess is we have no idea what the elasticity numbers are for imports to the USA. We might have some ideas in areas where tariffs have been used off and on in recent years like steel or automobiles. But we don’t likely know for most goods and we certainly don’t know elasticity numbers for large changes like a 25% tariff.
Economists will notice I’m focusing on who pays, not on “who bears” the tax more in the market. That depends on the relative elasticity of supply and demand. It’s very likely that the Chinese will bear more of the burden of the tax since they have fewer markets to substitute with the USA. That’s certainly Trump’s reasoning for using them as leverage. But the conversation I’m commenting on is the one claiming foreigners pay the tariff, not Americans.
Thanks for the insights