How Tariffs Work & Impact on China

We’re sharing this recently received summary from our colleagues at Manulife Investments*. We found it to be quite informative & insightful:
With all the talk about the U.S. – China trade war and the potential for increased tariffs causing uncertainty about global growth, we figured it would be a good idea to tackle the question of just how exactly these tariffs work and what their impact is, if any, on the Chinese & American economies.
As the tweet below demonstrates, President Trump continues to (falsely) promote the idea that when tariffs are imposed on a country, it’s that targeted country that has to pay out of pocket to cover them (ie. The U.S. is charging and receiving money from the Chinese in the form of tariffs).
However, if it isn’t the Chinese paying these tariffs, who is and how? These are exactly the questions we will try to answer below, with the help of information found in a New York Times article published in November 2018.

Who Pays for Tariffs?

Contrary to popular beliefs, it’s neither the targeted country (in this case China), nor American companies that are directly paying these billions of dollars in ‘Trump’ tariffs. In fact, it’s usually the middleman (the importer of record) that ends up paying.
Most American companies don’t handle all of the importing paperwork on their own, they hire an importer of record to help them with the intricacies of the United States Customs and Border Protection’s system for inspecting imports and levying any duties on them. As such, the importer of record initially gets the bill for the tariffs but tends to pass it back on to the contracting company. In other words, a company that contracts with an importer will almost always see the costs of that contract rise after a tariff has been imposed on goods it imports. So now the company is paying 10 to 25% more to bring in the exact same product it imported before the tariffs.
With contract costs being increased by tariffs, companies are now faced with the question of what do to with these extra costs – which can be narrowed down to three main options:

Option 1:

The company can choose to pass on these costs to consumers in the form of higher prices. This is usually the easiest and simplest option, especially in a competitive market where the supply chain is inflexible.

Option 2:

Companies can try to minimize tariffs by switching suppliers or changing the products they sell. In the case of China tariffs, that could mean moving a factory from Beijing to Vietnam (which can be expensive in its own right). In this case, no one pays the tariffs – the company is making an end-run around them.
Alternatively, an American company could negotiate concessions from a Chinese supplier, likely by threatening to shift production. In that case, the Chinese supplier’s profits would fall, and it would bear at least some of the cost of the tariffs.

Option 3:

In certain instances, companies may choose to absorb the extra costs themselves by temporarily accepting lower profits. In this case, they wouldn’t raise prices nor immediately pay to shift production, based on the idea that the most economically efficient price to charge for the product is not changed by the existence of tariffs.
That could be the case with companies such as Apple: It can charge such a premium for iPhones that it might decide to accept smaller profit margins on them for a while.

How is China Impacted?

Although China is never directly billed for these tariffs, there are indirect ways in which they can hurt the Chinese economy.

  1. If companies move production to Vietnam, China would see less economic growth — though that itself is not a direct benefit for American production, and in the short term would be a headache for companies that have to find new factories.
  2. Chinese companies forced to cut costs could have their profits pinched and could reduce hiring or close entirely. That could put pressure on them to move to places like Vietnam.
  3. Americans may buy fewer Chinese goods as the prices rise. That’s a loss for China, but it’s also a tax on Americans who buy things.

So while the United States government is not “charging” China or the American people, in many ways, consumers are the ones paying the costs.
We have to see what happens from now until March 1st, the deadline Trump has set for the U.S. and China to reach a trade deal. It goes without saying that things might get worse before they get better as Trump has threatened to increase tariffs from 10% to 25% if no deal comes to fruition by that date.
However, given the economic impact these tariffs are having on companies, consumers and both economies, we believe there is enough ‘pain’ going around to warrant the likelihood that some sort of trade deal will be made before that deadline.

* Reproduced with permission from Robert Wernic MBA, District Vice-President, Manulife Investments.

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