The idea of using high tariffs to fund the government feels like a relic of the 19th century. In Canada and the U.S., it was the primary source of federal revenue before the introduction of the income tax more than 100 years ago. Today, President Donald Trump is proposing a return to this model, suggesting a dramatic use of tariffs not just as a tool for trade protection but as a major source of revenues to offset the fiscal cost of domestic tax cuts.
This has, predictably, been met with alarm by most mainstream economists and policymakers, who have for decades operated under the consensus that tariffs are an unmitigated bad: a tax on consumers that raises prices, stifles trade, and hurts the economy. However, a new study published this summer, entitled “The Tariff Tax Cut: Tariffs as Revenue,” by a group of economists presents a provocative counter-analysis, suggesting that we might be asking the wrong questions.
It’s not the tariff, it’s how you use the money
The research—conducted by economists George Alessandria and Jiaxiaomei Ding from the University of Rochester, Shafaat Yar Khan from Syracuse University, and Carter Mix, an economist for the board of governors of the U.S. Federal Reserve System—argues that when tariff revenue is used to finance specific fiscal reforms, it can actually boost economic activity and national welfare. The conversation, they suggest, has been too narrowly focused on the tariff itself, ignoring the effects of how the resulting revenue is spent.
The authors’ model simulates what happens if the billions of dollars raised from a 20 percent import tariff are funnelled directly into cutting other, more distortionary taxes. The results are striking. Using tariff money to subsidize investment in new equipment and factories could increase American welfare by nearly 1.5 percent, they claim. In stark contrast, if the same revenue is simply rebated to the public as a lump sum cheque (the assumption in most standard models), it results in a welfare loss of 1.2 percent.
The key, they argue, is the theory of the “second best”: in an economy already distorted by taxes on labour and capital, adding another—a tariff—could actually improve the situation if it’s used to counteract the existing (and worse) policy problems.
Why an investment subsidy is the “secret sauce”
According to the research, the most potent policy combination is a unilateral U.S. tariff of around 18 percent where the revenue is dedicated to an investment subsidy. The researchers highlight why this is more effective than simply cutting capital taxes.
Because a significant portion of American investment goods—from machinery to advanced electronics—are imported, a tariff makes these items more expensive, discouraging capital accumulation. A direct subsidy for investment, however, more than offsets this price hike, creating a powerful incentive for companies to expand. The model shows this approach boosts the long-run capital stock by a remarkable 23 percent, an effect not seen with other tax cuts.
This dynamic creates a powerful, front-loaded stimulus. The study finds that when a tariff is first imposed, revenue surges because it takes time for businesses and consumers to find alternatives to imported goods. The model predicts an initial revenue jump to over 2 percent of GDP. Over the long run, as supply chains reconfigure, that revenue falls. This means the biggest fiscal boost comes right at the beginning.
What happens if the world fights back?
The analysis draws a sharp distinction between a unilateral tariff and a global trade war. If other countries retaliate, as Canada surely would, the economic benefits for the U.S. are severely diminished.
Still, they are not entirely erased. The study finds that even in a trade war, using tariff revenue for fiscal reform can mitigate economic damage.
A permanent global trade war would result in a welfare loss of 3.5 percent if revenue is rebated in a lump sum, but that loss shrinks to just 1.5 percent if the money is used to subsidize investment.
The view from north of the border
For Canadian policymakers, this research should be a wake-up call. It suggests the debate over trade and tariffs in the U.S. is shifting from a simple free-trade-versus-protectionism binary to a more complex discussion about fiscal strategy.
If a future U.S. administration pursues this “tariffs for tax cuts” model, Canada will face a difficult new reality. Retaliatory tariffs would still be on the table, but we would need to understand that we are fighting a policy that has a coherent, if controversial, domestic economic logic. It also raises questions for our own fiscal policy. Canada faces its own challenges with sluggish business investment and productivity. While a high-tariff strategy is likely a non-starter here, the core insight—that different taxes have different economic costs and that policy should aim to use the least distorting ones—is a lesson we should take to heart.
The debate south of the border is a reminder that the old economic orthodoxies are being tested, and we need to be prepared for the consequences.
Generative AI assisted in the creation of this article
