Rethinking tariffs: A new report shows using trade taxes to cut other taxes might be a winning economic strategy

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