Replacing the Income Tax With Tariffs?

During the 2024 campaign and since, President Trump has mused about replacing the income tax with tariffs. Trump believes that tariffs will put the burden of financing the U.S. government on the backs of foreigners.

Nice idea. Who wouldn’t want somebody else paying our government’s bills? To support his case, Trump correctly points out that until the modern income tax was adopted by the 16th Amendment in 1913, the United States collected the bulk of its revenue through tariffs (customs duties) and manufacturers excise taxes (discussed below).

So why can’t the U.S.do that again? If foreign producers of products imported into the U.S. in fact pay tariffs, it might be good idea. The problem is that’s just not how it works.

What is a Tariff?

A tariff (or customs duty) is an excise tax on foreign products brought into the U.S. An excise tax is imposed on a specific product or activity. Examples of excise taxes on products are those on cigarettes, alcohol, and gasoline.

A tariff is paid by the domestic importer, not the foreign producer. For example, suppose ABC Imports, Inc., a U.S. corporation, brings $1 million of home goods into the U.S. from Mexico. At the point the products are received in a U.S. port, ABC Imports pays the tariff to the U.S. government. The amount of the tariff is based on the specific goods in question. Different products have different rates. The amount also depends on the foreign source of the product. Products from China may carry a heavier tariff than products from the European Union, for example.

The price of the tariff gets folded into the overall cost that ABC Imports pays for the product. That price is passed on to the retailer, and then to the final purchaser. As such, when a foreign product is sold in the U.S., the tariff is ultimately paid by the end-user of the product. President Trump’s apparent belief that foreign producers take the hit on tariffs ignores the economic reality that corporations don’t pay taxes; people do. Corporations invariably pass production and distribution costs on to consumers in the form of higher prices for goods, or lower quality goods at the same price.

The economic reality of a tariff is that U.S. consumers pay it, not the foreign producer or foreign government. That makes foreign products more expensive for U.S. consumers.

Why Impose Tariffs?

1. Raising revenue. Raising revenue to help fund the government is one reason to impose tariffs. However, the revenue raised from tariffs by the federal government in the present era is insignificant. In 2024, the U.S. collected about $4.92 trillion in revenue from all sources. Only about 2 percent of that came from tariffs.

To consider replacing all income taxes with tariffs, there would have to be massive increases in tariff rates, on a huge number of and from most nations. This would have substantial negative economic effects, not the least of which is substantially higher prices on consumer goods, and likely a substantial reduction in consumer options as foreign products become increasing unavailable. At a minimum, such a move would trigger retaliatory tariffs by other governments. We are already seeing some of this with the new tariffs.

2. Encouraging and protecting domestic investment and production. As stated above, tariffs make imports more expensive. Because those products are more expensive, they become less desirable to U.S. consumers. This can favor U.S. producers. For example, suppose a U.S.-produced home good sells at Walmart for $25. A comparable un-tariffed Chinese product with a wholesale cost of $10 sells at retail for $20. Consumers will generally choose the less expensive Chinese product.

In the simplest scenario, if the government imposes a 50% tariff on the Chinese product, the wholesale cost goes from $10 to $15, and the retail price goes from $20 to $30. That imported product now costs $10 more than the similar domestic product. This can have the effect of encouraging domestic production of that product.

The irony is that increased tariffs on foreign products can reduce tariff revenue. A seminal economic principle is that what you tax you get less of. When you tax foreign products, you get fewer foreign products. High tariffs incentivize manufacturers to produce their product domestically so as to avoid the tariff. Likewise, customers are incentivized to purchase lower-cost domestic products. In both cases, people stop paying the tariff, undercutting the goal of raising revenue.

3. Addressing market distortions. A “distortion” is a phenomenon that leads people to do something they otherwise would not do; or discourages people from doing something they otherwise would do. All taxes cause distortions at some level. Graduated income taxes, for example, cause distortions in that they discourage production because the more money one earns, the higher the rate of tax is paid; thus, the less a person benefits from his own labor and industry.

Tariffs can mitigate market distortions caused by foreign governments flooding U.S. markets with subsidized products or those produced with (by U.S standards) artificially cheap labor.. The Chinese workforce does not enjoy the luxury of U.S. labor unions, minimum wage laws, workmen’s comp protections, medical insurance, and retirement benefits, etc. Because of that, Chinese products are frequently far cheaper than comparable U.S. products. The distortion is that U.S. consumers are driven to purchase the lower-cost product, where they might otherwise purchase the U.S.-produced product at a comparable price.

4. Retaliation and negotiating leverage. Tariffs can be used to retaliate against other nations that are trading unfairly.. In this regard, tariffs serve to level the playing field between nations. The U.S. imposes tariffs and then promises to remove them if the unfair behavior stops. This undercuts both the goals of domestic production and of raising revenue, since the entire point of the tariffs is to eventually negotiate them away.

5. National security. The U.S. may impose tariffs on certain foreign products deemed essential to U.S. national security. High tariffs on such items discourage imports, thus protecting domestic producers. This helps to ensure that the U.S. does not become dangerously dependent on foreign products that are integral to national security and defense.

Can Tariffs Replace the Income Tax?

The president argues that because the United States operated chiefly on tariffs and manufacturers excise taxes in the past, it can do so again. The reason that the federal government could operate on tariffs 125 years ago is because the federal government spent very little money. Its need for revenue was nowhere close, even in inflation-adjusted numbers, to what federal spending is today.

Between the years 1895 and 1910, federal spending went from about $366 million (not billion) to $758 million per year. Today, the federal government spends over 1,300 times more than that on interest payments alone.

During that same period, around 60 to 70 percent of federal revenue came from tariffs. The balance came from excise taxes and other insignificant sources. The modern personal and corporate income tax did not begin until after 1913.

To make Trump’s idea work, the federal government would have to slash its spending considerably. And by that, I don’t mean by 3 to 5 percent, or even 10 to 20 percent. Even cutting spending in half would require the federal government to collect about $3 trillion in revenue from a system that currently collects only about $100 billion.

And even if that would work to raise enough revenue, it would be impossible for Trump to accomplish his other tariff goals, such as encouraging domestic production or negotiating better trade deals. Tariffs work against themselves, which is one of the reasons they are such a destructive tax, one the U.S. should avoid layering on top of its already uncompetitive tax system.