Understanding the Economic Effects of Taxes and Tariffs
Policymakers adopt various methods to impose taxes and raise revenue, each with distinct trade-offs. Different types of taxes, even if generating the same revenue, can impact the economy differently.
How the General Equilibrium Model Illustrates Tax Trade-offs
At the Tax Foundation, we utilize our General Equilibrium Model to illustrate the trade-offs of various taxes. This model estimates the effects of tax policy changes on returns to capital and labor and how these changes influence overall economic output.
When modeling tax policy changes, the impact on economic output is a reflection of how the change alters the after-tax return to capital and labor, rather than the amount of revenue raised.
Evaluating the Impact of Tax Policy Changes on American Incomes
In assessing the effects of tax policy changes on American incomes (measured by GNP), we assume the U.S. is a small open economy. This means changes in U.S. government borrowing do not significantly alter global interest rates, but rather influence incomes through changes in interest payments on U.S. debt, affecting the debt-to-GDP ratio.
The Example of Carbon Taxes and Tariffs
For instance, a carbon tax is modeled as an excise tax—a narrowly targeted consumption tax. Such taxes create a gap between earnings and post-tax consumption, reducing real after-tax wages and thus reducing incentives to work and economic output. Similarly, tariffs, another form of excise tax, increase prices for goods, lowering demand and economic output.
Using this methodology, we estimated that the 2018-2019 trade war tariffs would decrease U.S. long-run output by about 0.2%. Other empirical studies have found effects ranging from -0.17% to -0.50%.
Tariffs: A Closer Look
Tariffs, although aimed at protecting domestic industries, ultimately result in a net negative economic impact. They reallocate activities and redistribute income, leading to losses exceeding the benefits. For example, steel and aluminum tariffs increased production for certain firms but led to larger production losses downstream and high costs per job saved.
Conclusion: Informing Policymakers
Understanding the economic effects of different taxes is crucial for policymakers. While the revenue generated by tax increases can be used for various purposes, how that revenue is raised significantly impacts the economy. Clear insights into these trade-offs lead to more efficient revenue-raising decisions.
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