In a recent piece for the Hoover Institution’s Defining Ideas publication (“Clearing the Air on Tariffs and Deficits,” 24 April 2025), my co-blogger David Henderson introduces two compelling justifications for maintaining non-zero tariffs. One such justification relates to the structure of an optimal tax regime:
A noteworthy intellectual argument in favor of tariffs is their potential role within an optimal tax framework. The federal government levies taxes on various entities—individual and corporate incomes, capital gains, and commodities like gasoline. How can we definitively assert that a positive tax rate on imports doesn’t fit into an optimal tax system? We cannot. What we do understand is that the deadweight loss—the total loss from the tax minus the government’s gain—grows disproportionately with the square of the tax rate. For instance, if we double a tax rate, the deadweight loss quadruples. Consequently, it’s plausible that lowering the top marginal income tax rate from 37% to 35% and offsetting it with a 5% tax on imports could diminish overall deadweight loss.
Expanding on David’s insights, I wish to highlight a distinctive characteristic of tariffs that elevates them beyond mere taxation. First, however, let’s dismantle a prevalent myth regarding free markets and free trade: the notion that they equate to the absence of taxes (including tariffs). In my view, free markets signify non-distortionary taxes. Simply put, taxes ought to generate revenue as neutrally as possible. While all taxes introduce some level of distortion, our aim should be to minimize these effects. To echo Adam Smith:
When all systems of preference or constraint are entirely removed, a straightforward system of natural liberty will naturally establish itself… The sovereign is relieved from a duty that inevitably exposes them to countless errors, a duty that no human insight could ever fulfill; namely, overseeing private enterprise and directing it towards the most beneficial societal interests (Wealth of Nations, Book IV, Chapter IX, paragraph 51, pg 687).
Smith elaborates in Book V (Chapter 2) his tax maxims designed to minimize distortions:
- Taxes should be proportional,
- Taxes should be certain and not arbitrary,
- Taxes should be levied at a time convenient for the payer, and
- Taxes should be structured to minimize the amount taken.
(Notably, he identifies protective tariffs as a direct violation of this last maxim).
To quickly summarize this tangent: free markets do not necessitate the absence of taxes; a government can exist harmoniously alongside a free market. Similarly, tariffs can coexist with free trade. The real issue arises when taxes and tariffs become distortionary and non-neutral, meaning they attempt to manipulate economic activities.
Returning to the main topic, tariffs stand out among taxes in a significant way.
Most taxes are domestic, whereas tariffs target imports, making them inherently international. With domestic taxes, how they are perceived by foreign governments is mostly irrelevant (unless, of course, you have a leader who confuses a VAT with an export subsidy). Tariffs, on the other hand, can be misconstrued as political threats even if that wasn’t the intent. This misinterpretation could provoke retaliation from other nations, rendering an otherwise optimal tax suboptimal.
The risk of retaliation has long been recognized as a core issue in the theory of optimal tariffs. In his 1987 article “Classical and Neoclassical Roots of the Theory of Optimum Tariffs,” Thomas Humphrey notes that early theorists of the optimum tariff, such as J.S. Mill, acknowledged that the primary flaw in their theories was the potential for retaliation (see page 27).
Thus, a theoretically optimal tariff might very well turn out to be practically suboptimal if it’s misinterpreted by foreign governments. This potential for misunderstanding does not exist with domestic taxes.
In a related context, Edwin van de Haar discusses the security dilemma among nations:
In a world lacking a supreme authority, all states encounter a security dilemma (Booth and Wheeler 2008). They cannot rely on the existence of a stable and peaceful order, even if such an order would be optimal for human welfare. The threat of one state, or a coalition of states, exploiting the absence of a global government is ever-present. This dilemma is existential; states must prioritize their security, particularly militarily, to ensure survival. Leaders and elites can never fully trust the intentions of other states, even when there’s no desire to do harm. Thus, arms acquired for self-defense can be perceived as offensive by others. In a world of uncertainty, perceptions are crucial (Human Nature and World Affairs: An Introduction to Classical Liberalism and International Relations Theory, pg 78).
Consequently, a nation enhancing its military for self-defense might inadvertently increase its vulnerability to invasion if misunderstood by other governments.
This “tariff dilemma” mirrors the security dilemma: a tariff could be part of an optimal scheme, but if perceived as a hostile act by foreign governments, it could lead to retaliatory measures, transforming an optimal tariff into a suboptimal one. Moreover, such scenarios frequently lead to escalations in rent-seeking and lobbying as domestic firms lobby for subsidies or protections from retaliation, further distorting the economic landscape. [1]
Considering these political distortions, it might turn out that the optimal tariff is indeed 0%. To expand on David’s earlier example, absent retaliation, a 5% tariff alongside a 35% top marginal tax rate might appear optimal. However, if retaliation occurs, then a 37% rate with no tariff could actually prove to be the optimal solution.
At the conclusion of his post, David expresses surprise at the Trump Administration’s failure to frame tariffs as elements of an optimal tax system:
Curiously, I haven’t seen any of Trump’s economists present this argument. Perhaps that’s because doing so would require admitting that tariffs are taxes and that they impose costs on those who pay them. Is it conceivable that Trump wants his supporters to remain oblivious to these costs, much like the MAGA dairy farmer in upstate New York?
Since David penned those observations, the Administration and its allies have begun to acknowledge the costs of tariffs, albeit with inconsistent messaging. I find his assessment compelling; there’s always an inclination to obscure the costs associated with political initiatives.
However, allow me to propose another explanation for the absence of “optimal tariff” discussions: the Trump Administration is unabashedly mercantilist. The continual critiques of trade deficits suggest that the tariff policies are driven by distortionary political objectives rather than any genuine pursuit of optimal taxation.
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[1] In a related note, Dom Pino reports that lobbying expenditures have surged by 277% compared to last year due to tariffs. The individual who vowed to “drain the swamp” appears to be deepening it.
