Investopedia/Evan Tarver: How do tariffs protect domestic industries?

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How do tariffs protect domestic industries?

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By Evan Tarver
Updated Jul 24, 2018

Tariffs are essentially taxes or duties placed on an imported good or service by a domestic government, making domestic goods cheaper for domestic consumers and imported goods more expensive for companies exporting goods from their industry into the domestic industry.

Tariffs are normally levied by a domestic government as a percentage of the declared value of the good or service and act similar to a sales tax. Unlike sales tax, however, tariff rates often vary depending on the good or service and do not apply to domestic goods, only imports coming into the domestic industry.

When high tariffs are levied by a domestic government, it reduces the imports of a given product or service because the high tariff leads to a higher price for the domestic consumer and a higher import cost for foreign suppliers or producers. Tariffs are also used to create favorable trading conditions between certain countries, while hampering the trading conditions of other countries.

There are two general types of tariffs levied by domestic governments: ad valorem tax and a specific tariff. Ad valorem tax is a percentage of the value of the good or service, while a specific tariff is a tax based on a set fee per number of items or weight of the items.

Tariffs are usually levied by domestic governments to protect new industries against foreign competition, to protect aging industries against foreign competition, to protect against foreign companies offering their products for a price lower than their costs and to raise revenue.
Do Tariffs Protect Infant Industries?

Many development policy analysts and industry-specific advocates argue it's sometimes necessary to implement import tariffs to protect infant domestic industries from foreign competitors. This argument has existed for centuries: Adam Smith, for example, directly advocated for it in The Wealth of Nations, but in practice, infant industry techniques have a poor track record. There are many possible explanations for this, some economic and some political.

The infant industry argument does not extend to all types of producers. Industries requiring high economic capital have the most apparent need for state protection from foreign competition. This is because manufacturing and technological production is important to building long-term economic growth, yet establishing these types of firms is both risky and time consuming.

Even though it likely results in forcing local consumers to pay a higher price for domestic goods, proponents of this theory suggest that the initial disadvantages are outweighed by future gains. However, potential success stories are few and far between. Economists disagree about the importance of tariffs in developing markets in the United States, Germany and Japan during their respective industrialization periods. Similar tariffs have been tried for key industries in India, Malaysia, Indonesia, Singapore and Hong Kong with very poor results.

One common criticism is that protectionism only works if the domestic firms are well-run and if other government laws allow for sustained growth. Companies still require access to capital and competitive tax rates. Additionally, other countries may respond by instituting their own sanctions. Others have theorized that development only occurs where there are gains from trade and that tariffs distort trade, investment and consumption too much for those gains to be realized.

(For more, see: The Basics of Tariffs and Trade Barriers.)
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