What is a tariff? Definition, examples & how it affects the economy

Every type of tax has pros and cons. As policies change over time, such as those on international tariffs, people often want to know more about how these charges affect their everyday lives. Tariffs can be especially confusing when it comes to how they connect to other sources of federal revenue.

Let's take a closer look at how tariffs work and what they mean in the bigger financial picture.

Tariffs are a tax on imports from other countries. It's usually a percentage of the product's value. For example, the U.S. might impose a 10% tariff on steel from China, meaning that if a company imports $100,000 worth of steel, it would pay $10,000 in tariffs. The importing country pays the tariff, and that cost is often passed to businesses or consumers that purchase the products through higher prices.

Tariffs are typically used by the U.S. government in these situations:

• If other countries use unfair business practices, like unsafe working conditions or copying protected ideas, the U.S. government may impose tariffs to level the playing field and make competition fairer for competitive American-made products.
• Tariffs also can make imports less appealing and encourage businesses to develop U.S. industries instead. This can mean more jobs for American workers.
• As a type of tax, tariffs generate revenue for the federal government. For policymakers who want to lower income or business taxes, adding tariffs can create an alternative source of government funding.
• Tariffs encourage people to buy U.S.-made goods by making imports more expensive. However, they don't make locally produced goods cheaper. That's why tariffs often lead to higher prices overall and sometimes are called import taxes, customs duties or trade tariffs.

Tariffs can be complex, but many are calculated ad valorem, which means "based on value." Let's say a gallon of ethanol from another country has a 10% ad valorem tariff and originally costs $3 per gallon. The price would go up to $3.30 per gallon, with the importer paying $0.30 per gallon in tariffs.

To maintain production and profit, importers may pass these costs to consumers with higher prices.

The company bringing the goods into the country, the importer, pays the tariff. Because tariffs add extra cost, importers generally can't afford to cover it on their own. They may raise consumer prices, try to negotiate with exporters or just accept lower profits. Exporters might lower their prices, some to stay competitive, but overall prices still usually go up.

Consumers don't pay tariffs directly, but they often experience consumer price inflation as businesses pass on the added costs. The extent of this impact depends on the price elasticity of demand—goods with fewer substitutes tend to see more pronounced price increases. In some cases, consumers may shift to domestic alternatives, a behavior that is referred to as the import substitution effect.

Tariffs are taxes paid by the importer of foreign goods and are often used to influence trade and economic policy. Sales tax is paid by the consumer when making a purchase, and the business simply collects on behalf of the government. The goal of sales tax is to generate government revenue. Both tariffs and sales taxes are forms of indirect taxation, but they serve different purposes and are collected at different points during the transaction.

Protective tariffs are meant to help U.S. industries grow by making imported goods more expensive. For example, in the 1800s the federal government used high tariffs—sometimes up to 33%—on manufactured goods to help local businesses compete. In situations like that, even if American-made items are more expensive than the imported equivalent, the U.S. manufacturer can undercut the competition because of the tariff charge.

The stock market is influenced by many factors other than tariffs. The whole outlook for the near future matters here. However, introducing and changing tariffs can potentially affect the stock market in these ways:

Any time tariffs are introduced—especially suddenly—they can shift market expectations and create uncertainty, a condition known as market volatility. Investors and traders who were expecting certain industries to prosper may change their opinion after a tariff is imposed.

Tariffs can have broad impacts, especially if U.S. industries rely on imported goods as raw materials or components. In the short term, people may simply buy less if prices go up, which can reduce corporate revenues and earnings. While policymakers who create the tariffs often expect these reductions will be temporary—assuming the market will resettle and domestic industry will grow—there is usually an economic slowdown in the near term.

Investor sentiment about the coming financial season is likely to change when widespread tariffs are introduced. Protectionist tariffs take time to produce benefits because domestic companies need time to start up and scale production. Meanwhile, investors may be concerned that lower corporate earnings combined with high market volatility will lower U.S. gross domestic product (GDP). Though tariffs alone don't cause recessions, they can contribute to investor fears along with other economic pressures.