In recent weeks, there has been much discussion about the inflationary effect of Trump tariffs. This is sparked by Donald J. Trump's proposal of a 10% revenue tariff. Interestingly, the idea of a 10% revenue tariff was first discussed during his first term. At that time, it was considered as a potential source of additional revenue to offset the Trump tax cuts enacted during his first term.
The challenge in passing finance bills in the U.S. lies in the legislative process. Finance bills can only be easily passed if they are reconciliation bills, meaning they have no effect on the budget balance. When a finance bill does not affect the budget balance, it requires only a simple majority in the U.S. Senate to pass. However, when a finance bill increases the budget deficit, it requires at least 60-votes in the Senate, making such bills much harder to pass.
During Trump's first term, the administration found that by reducing certain tax write offs or tax cuts for specific states, they could pass the overall tax bill without effecting the budget balance. This allowed significant tax cuts for individuals and a major corporate tax cut, reducing the U.S. corporate tax rate from 35% to 21%. Now, as Trump seeks to cut corporate taxes again—this time from 21% to 15%, matching the German corporate tax rate—he needs additional revenue to balance the bill. This is so he can pass it as a reconciliation bill, requiring only 51 Senate votes. This has led to renewed discussions about the 10% revenue tariff.
In contrast to the European Union, where a value-added tax (VAT) would be a straightforward solution, implementing a VAT in the U.S. is effectively impossible due to constitutional constraints. A VAT would require unanimous agreement from all states. This is impossible in practise. So, the idea of a 10% revenue tariff has resurfaced.
Critics, particularly within the Democratic Party, have argued that such a tariff would be highly inflationary. However, when questioned during confirmation hearings, Trump's Treasury secretary nominee, Scott Bessent, referencing optimal tariff theory, explained that a 10% revenue tariff would increase the U.S. dollar exchange rate by 4%. We note that this would result in a maximum inflationary effect of 6% only if 100% of domestic goods were imported. Given that only 13% of domestic goods are imported, the actual inflationary impact would be just 0.8% on the Consumer Price Index (CPI). This makes the tariff effectively inflation neutral.
This idea was discussed by a panel of distinguished economists at the American Economic Association Convention in January, including Jason Furman, Christy Romer, Ben Bernanke, and John Cochrane. Cochrane noted that historical instances of tariff increases, such as in the 1890s and 1930s, did not lead to inflation because monetary policy was tight. He argued that the inflationary impact of tariffs depends entirely on the Federal Reserve's monetary policy. If the Fed maintains a firm stance, there would be no inflationary effect.
Trump's current plan is to pass a comprehensive bill that includes the Reciprocal Trade Act, corporate tax cuts, and the 10% revenue tariff. Peter Navarro, in a CNBC interview on 21 January, estimated that the revenue tariff could generate between $US350and$US400 billion, offsetting the cost of the tax cuts and making the bill feasible as a reconciliation measure.
With the Republican Party holding enough Senate seats, the legislation could pass by the end of April. The inflationary impact of the tariff, estimated at 0.8%, can be easily managed through moderately tight monetary policy by the Federal Reserve.
Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.
