Political bias might be interfering with the accurate dissemination of information on how the tariffs on China will impact the U.S. economy. The players opposing tariffs say it will reduce GDP and those supportive of this tariff suggest it will increase GDP. So which is it?
The outcome is rather unclear. The GDP impact depends on a combination of economic interactions that could lead to either side being correct depending on what assumptions are used and what retaliatory actions result. In order to cut through the political bias, it is important that we understand the underlying mechanisms.
The impact of tariffs is of high importance to market participants as it directly impacts which way the market moves.
GDP is calculated using personal consumption expenditures, gross private domestic investment, government consumption and investment, and net exports. The tariff on China will likely impact (directly or indirectly) all four of the GDP inputs to varying degrees.
Impact on each variable
Consumption spending will likely go down as a result of tariffs. If one solely considers the consumption of Chinese goods, the increased expense of consumption will reduce the volume of purchases. Some purchases will be redirected and others will be foregone. Those that are redirected will go to either domestic purchases or imports from a different country.
Additionally, domestic investment will likely increase due to the supply chains of domestic companies being interrupted, some will replace the supply with other sources. Any moves toward made in U.S. products will increase investment in the production of those products, while moves to other import sources such as other southeast Asian countries will have no impact.
Government spending will likely increase at a scale that approximates the tax revenues generated by the tariffs. This should not be substantial as most of the purchases that would generate tariff tax dollars are likely to be redirected to other non-Chinese goods that are not subject to the tariffs. That is, tariff tax dollars are going to be far smaller than current imports subject to the tariffs multiplied by the percentage of the tariffs.
Furthermore, net exports will likely go up to the extent that the tariff reduces imports. Purchases that are redirected domestically will reduce imports while those that are redirected to other countries will have no impact on imports.
Whether this is overall positive to GDP will be determined by a set of yet unknown assumptions with the biggest ones being the portion of consumption that is foregone, the portion of reduced imports that turn into domestic purchases and the extent to which companies more their supply to the U.S.
Should the tariffs be considered in insolation, it could be positive for GDP. Consumers looking to buy a product are unlikely to forego purchases rather than switching. Thus, the negative hit to consumption will be substantially smaller than the collective positives of the other three variables.
Does this mean the tariffs are good and that GDP will increase from the tariff on China? Not necessarily.
Tariffs usually result in some form of reprisal. This could come in the form of China increasing the scope or magnitude of their tariffs on the U.S. or more direct reprisal against American companies operating in China.
Any retaliation would likely hurt the GDP of the U.S. China putting tariffs on the U.S would decrease our exports, particularly those coming from the agricultural sector. Thus, this could easily undo the benefits to GDP and could possibly more than undo the benefits making the trade war a net negative to GDP.
Given the degree of unknowns, it is far too early to say whether the impact of the tariffs on GDP, along with the ripple effects, will be positive or negative. However, it befits us to understand the equations and mechanisms by which it impacts GDP such that we can better react as the hard data comes in. It is of extra importance to know the underlying mechanisms here because there is no historical data that we can reliably point to.
Size of impact
In 2018, according to data from U.S census, the U.S imported $539B from China. Overall GDP as of the first quarter of 2019 was tracking at about $21 Trillion. Thus, Chinese imports are of a size that is about 2.5% of GDP.
Given that the difference between China’s economy and the U.S economy, quarter-on-quarter is about 180 basis points of growth in GDP, there is potential for a trade war to have a significant impact on the U.S. economy rather than China per se.
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