When Are Tariffs Optimal?

When is a good time to use tariffs? Never, generally speaking.

Tariffs, or taxes levied on imported goods, have been a contentious policy tool throughout history. Standard economic theory consistently demonstrates that tariffs alter prices, alter production and consumption patterns, distort markets, reduce overall welfare and trigger costly trade conflicts.¹ Despite this broad consensus among economists, policymakers frequently resort to tariffs to address various economic and political objectives.

Perhaps the most top-of-mind example would be the tariffs recently imposed by the U.S. targeting primarily imports from China, steel and aluminum imports from several countries and other selected products. The U.S. has also levied a baseline tariff on the rest of the world. These tariffs were explicitly justified by three main objectives:

• Reducing the U.S. trade deficit
• Reviving domestic manufacturing industries
• Generating additional government revenue

While such policy goals may resonate politically, they have sparked vigorous debate concerning their economic validity and effectiveness.

Economic theory does acknowledge a set of very specific circumstances under which tariffs could theoretically enhance national welfare. Known as "optimal tariffs," these scenarios include situations where countries have enough market power to influence international prices to their advantage or when temporary protection is necessary for important industries to develop and mature.

In this article, I discuss the optimal tariff argument from the perspective of mainstream international trade theory. The upshot of this discussion is that the assumptions underpinning optimal tariffs are unlikely to hold in practice. I also highlight recent empirical research that finds at best no effects of an optimal tariff on economic well-being.

The Economic Case Against Tariffs

Classical trade theories establish a firm theoretical foundation favoring free trade. These theories demonstrate that countries maximize welfare by specializing according to their comparative advantage, thus enabling efficient allocation of resources and greater global production efficiency.

Tariffs disrupt this efficiency by artificially inflating prices for imported goods. More specifically, tariffs distort the relative prices between goods and across countries. This leads to inefficient resource allocation and suboptimal domestic consumption patterns. Tariffs introduce deadweight losses, which are economic inefficiencies arising from distorted price signals. Domestic consumers bear higher costs and face diminished product choices, while domestic producers are shielded from competitive pressures, reducing incentives for productivity improvements and innovation. Furthermore, retaliatory tariffs from trade partners compound initial inefficiencies, potentially escalating into damaging trade wars.

Empirical research supports these theoretical predictions.² Possibly the best-known example of the potential consequences of tariffs is the well-studied Smoot-Hawley Tariff Act of 1930, which is widely recognized as exacerbating the severity of the Great Depression through reduced international trade and retaliatory measures from other countries. More recent empirical analyses of tariff policies (such as those imposed by the U.S. in 2018) also illustrate significant economic harm (including higher consumer prices and disrupted supply chains) without achieving stated policy goals.³

Thus, although tariffs may superficially offer protectionist benefits or revenue generation, robust theoretical foundations and extensive empirical evidence strongly suggest their use ultimately undermines economic welfare.

The Optimal Tariff Argument

However, economic theory recognizes a specific set of conditions under which a country could, in principle, enhance welfare with tariffs. These "optimal tariffs" were initially formalized by Harry Johnson in the 1953 paper "Optimum Tariffs and Retaliation" and later refined by Jagdish N. Bhagwati and T. N. Srinivasan in their 1983 monograph "Lectures on International Trade."

The argument relies crucially on the concept of market power, specifically the ability of a large country to influence international prices through its trade policies. The intuition is that an external tariff improves a country's terms of trade (the relative price of exports in terms of imports) by lowering the world price of its imports. The optimal tariff thus generates a transfer of income from foreign exporters to domestic consumers by artificially restricting demand for the former's exports while improving the purchasing power for the latter.

However, the optimal tariff argument holds only under quite strict assumptions:

• That the imposing country is large enough to affect global prices significantly
• That trading partners do not retaliate

Even under these conditions, the benefit derived from terms-of-trade improvements must outweigh the welfare losses stemming from distortions in domestic consumption and production patterns.⁴

The empirical evidence on optimal tariffs is mixed at best, largely due to the difficulty of isolating the precise conditions identified by theory. In an influential paper, Christian Broda, Nuno Limão and David E. Weinstein offer perhaps the best empirical support for the optimal tariff argument.⁵ Their study investigates whether countries exploit their market power by imposing higher tariffs on goods that are supplied inelastically.

The authors estimate disaggregated foreign export supply elasticities and find that, prior to World Trade Organization (WTO) membership, countries set import tariffs approximately 9 percentage points higher on inelastically supplied imports than on those supplied elastically. This effect is comparable in magnitude to the average tariffs in these countries, indicating that market power plays a significant role in tariff variation.

Additionally, the study observes that U.S. trade restrictions not covered by the WTO are significantly higher on goods where the U.S. has greater market power. These findings provide robust evidence that importers possess some market power and use it when setting noncooperative trade policies.

The study's empirical evidence offers some degree of support for imposing optimal tariffs, suggesting that countries with sufficient market power can and do adjust their tariff structures to influence international prices in their favor.⁶ However, the authors also emphasize that such practices are often constrained by international agreements like those of the WTO, which aim to mitigate the negative effects of unilateral tariff manipulations.

Retaliation and Optimal Tariffs

Optimal tariffs can therefore in principle be used as strategic tools, enabling a country with sufficient market influence to improve its terms of trade. As such, they likely invite retaliatory measures. However, the traditional optimal tariff argument is fundamentally static, analyzing a one-time imposition of tariffs without accounting for subsequent international responses.

In practice, trade policies are dynamic, with countries continually reacting to each other's actions. When an initial tariff prompts retaliation from trading partners, and the original country responds with further tariffs, this tit-for-tat escalation can lead to a full-fledged trade war. Such a scenario could culminate in an equilibrium where all parties are worse off compared to free trade, since the supposed terms-of-trade improvement is negated at every alternative stage of imposing retaliatory tariffs. In the end, international relative prices may stay the same, and trade may decline because of tariff levels that shut down the international exchange of goods. This outcome underscores the inherent risks in presumed unilateral tariff strategies.

Formalizing these ideas, Constantinos Syropoulos examines how country size impacts the outcomes of tariff wars in the 2002 paper "Optimum Tariffs and Retaliation Revisited: How Country Size Matters." He suggests that larger countries with significant market power are more likely to "win" tariff wars by imposing optimal tariffs. However, this advantage depends on the relative size and economic influence of the countries involved, highlighting that smaller nations are more vulnerable in such disputes.

These studies underscore the complexity and inherent risks of applying the optimal tariff to real-world trade policy. While a theoretical possibility, the dynamic interplay of retaliatory actions often negates any benefits. The escalation of tariffs can lead to outcomes where all involved nations suffer economic losses, emphasizing the importance of cooperative trade agreements and the risks associated with protectionist policies.

Growing Industries and National Welfare

Another often discussed rationale for tariffs is that of infant industry protection, which posits that temporary protection can enable nascent industries to mature and achieve international competitiveness. Similarly, the strategic trade policy argument rests on the idea that government intervention can improve national welfare when markets exhibit imperfect competition and increasing returns to scale.

However, both arguments require careful conditions to be effective. Empirical evidence often highlights that governments frequently lack both the information and the ability to effectively target industries, leading to prolonged inefficiencies and entrenched protectionism rather than temporary support. Paul Krugman lays out the rationale for these arguments in his 1987 article "Is Free Trade Passé?" and discusses their validity.

In addition, Gene M. Grossman and Elhanan Helpman discuss an almost unavoidable byproduct of tariffs: rent-seeking (or engaging in nonproductive efforts to extract resources and wealth) and other political economy considerations. In their 1994 article "Protection for Sale," they show that tariffs frequently reflect political pressures rather than optimal economic logic, serving as a vehicle for rent-seeking and protection of special interest groups. Such political capture can entrench tariffs, reduce overall economic efficiency and complicate subsequent liberalization efforts.

Conclusion

Tariffs are generally not optimal from an economic perspective. The rare theoretical cases where they can be ultimately beneficial — such as the optimal tariff from the perspective of a large economy that can bend the terms of trade in its favor — often fall apart in practice due to other factors, such as retaliatory tariffs. Policymakers should thus approach tariff implementation cautiously, prioritizing multilateral cooperation and market-based solutions to trade disputes.

Thomas A. Lubik is a senior advisor in the Research Department at the Federal Reserve Bank of Richmond.

To cite this Economic Brief, please use the following format: Lubik, Thomas A. (May 2025) "When Are Tariffs Optimal?" Federal Reserve Bank of Richmond Economic Brief, No. 25-21.

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Views expressed in this article are those of the author and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.