The United States is in a major trade war with China that imposes 25% tariffs on $200 billion of goods imported from the country and has just averted a similar trade dispute with Mexico. In order to coerce Mexico’s cooperation in stemming the flow of illegal immigrants across its borders into the United States, the Trump Administration threatened on May 30 to impose 5% tariffs on all goods imported from Mexico that could ultimately rise to as high as 25%. Over the weekend, U.S. President Donald Trump agreed to suspend the tariffs on the strength of certain promises made by Mexico.
Nonetheless, the Trump Administration’s tariff strategy begs the question as to who actually pays for these duties. Does the American consumer pay through higher prices and efficiency losses caused by disruptions in the global supply chain as Liberty Street Economics argues in a recent article? Or, as Peter Navarro, assistant to the president and director of the White House Trade and Manufacturing Council contends: “China bears the burden of the tariffs in the form of lower exports, lower prices for their products, lower profits for their companies…The government of China has borne the burden of those tariffs in the form of lower tax revenues and a lower rate of growth…The governments of China and Mexico will pay for it and the producers in Mexico and China pay for this.”
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In reality, the issue is much more complicated than either Liberty Street Economics or Navarro suggest. The real answer to the question is: “It depends.” Who pays for tariffs depends on specific circumstances such as the economic makeup of the country involved, the industry, the product, and the competitive situation, among other factors. Specific circumstances surrounding the countries of China and Mexico, as well as a key industry like autos, illustrate the point.
The United States is the largest market for both China and Mexico. In 2018, China sold $539.5 billion of goods to the United States, while Mexico exported $346.5 billion of goods to its neighbor to the north. Chinese exports to the United States account for less than 5% of the country’s Gross Domestic Product, while Mexico’s U.S. exports account for over 28% of its economy.
In 2018, China exported $20 billion of auto parts to the United States, but less than $2.0 billion of complete vehicles. By comparison, Mexico sent $59 billion of auto parts and over $50 billion of cars and delivery vans across its northern border. While China’s $22 billion of auto related exports to the United States account for less than 5% of the country’s total U.S. exports, Mexico’s $109 billion of auto related exports account for nearly one-third of its exports. Unlike China, which has a very large domestic auto market, Mexico’s auto industry has grown based on sales to American consumers. Since the signing of the North American Free Trade Agreement (NAFTA) in 1994, Mexico’s overseas automotive sales have multiplied by a factor of 11, and have grown by an average of 11% annually. Since NAFTA, international car companies—and their suppliers—have rushed to establish operations in Mexico to take advantage of lower labor rates to serve the U.S. market.
Generally, companies will move to lower cost countries if they can achieve savings of 10% or more. Assuming that 10% represents the approximate amount of savings that the international car companies and suppliers realize from their Mexican factories, a 25% tariff would more than wipe out the advantage of manufacturing in Mexico. Because the auto industry is extremely competitive, the car companies have little flexibility to increase auto prices to consumers by any significant amount. As a result, high tariffs would force the international car companies to move their factories back to the United States to avoid tariffs; accept lower profits and pressure suppliers for price reductions to make up for the savings they might lose from being in Mexico.
In the case of Mexico and its auto industry, the international car companies and their suppliers, as well as the Mexican economy, would wind up bearing the cost of high tariffs, and the price of an automobile to consumers would be little affected, if at all. In this context, it is no wonder that auto stocks took a hit when President Trump announced the possibility of high tariffs on goods from Mexico, and the Mexican government’s immediate response to the threat was to send a high-level delegation to Washington to work out a deal.
The auto industry in China is completely different. By and large, auto factories have been established in China to supply the country’s fast growing auto market, which is now the largest in the world. While many manufacturers export certain components to the United States, China’s auto industry and its auto suppliers do not depend on the U.S. market. Moreover, China’s large domestic market provides the scale needed to manufacture many components and assemblies that are capital intensive and require large investments to establish advanced machining, casting and forging capabilities. For such components, a significant portion of the global capacity may be in China where component manufacturers enjoy economies of scale based on sales to domestic customers. Due to the amount of capital required, as well as the absence of a domestic market, new capacity for such products cannot be easily moved to Vietnam or other low cost Southeast Asian countries.
In this context, the additional cost of high tariffs will most likely be borne by the importers and their customers. In the absence of any real competition from lower-cost countries for many components, Chinese manufacturers may be inclined to reduce prices by a percentage point or two, but they have no reason to reduce prices dramatically. Chinese auto suppliers whose products fit in this category have told us that, when 10% tariffs were first levied on goods from China, they accommodated their customers by granting small price reductions, but told the importers that larger reductions were not possible. Since May 10 when the tariffs rose to 25%, the importers have continued to purchase their products, without bothering to ask for further price concessions.
Although it is such a big part of China’s overall economy, the auto industry may be somewhat unique due to its manufacturing sophistication and capital intensity. Many products made by Chinese factories, of course, do not share the same characteristics and, therefore, production may move more easily to lower cost Southeast Asian countries. In these cases, Chinese manufacturers and the Chinese economy would bear the major portion of the additional cost of higher tariffs; consumers would be little affected; and smaller, emerging economies would be the winners. Analyzing complex economic relationships is seldom simple and straightforward. Based on the above examples, Liberty Street Economics and Navarro are both right and wrong in their assessments of who actually pays for high tariffs. In reality, it all depends on the country, the industry and the product affected.