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Alternatives to tariffs for policy goals
Globalization provides an economy with export wealth that could be spent on a range of things. In particular, depending on its fiscal priorities, a small open economy could use some of the country’s expanded income to fund policies that help people adjust to a new production mix that plays to its strengths. If a government has a policy reason to interfere with the global trading equilibrium, it makes sense to use the least distortionary tool it has to meet its goals. So what are the better policies that could replace a tariff?
Tariffs distort decisions on both the production and the consumption margins, which is usually one margin more than necessary. A better approach is to aim the policy-necessitated distortion as close as possible to the goal. If the government wants to address unemployment related to globalization, for example, it might provide direct financial support to displaced workers while they retrain; if a specific amount of production is deemed essential to provide security or self-sufficiency, bring that about with a subsidy tied to output in that sector. If the problem is a social goal of restricting its citizens’ use of harmful or undesirable products, then a consumption tax is the better tool.
Achieving a given level of self-sufficiency and restricting consumption of a problematic good are noneconomic goals: they represent political or social objectives, rather than correcting an externality or technological distortion. A tariff can be used to achieve these outcomes and many more, but it is a blunt instrument. A production subsidy is less utility reducing than a tariff if the goal is to expand output in the domestic import-competing industry. A consumption tax costs less in utility terms than a tariff if the goal is to lessen consumption of the imported good. As the diagrams make clear, these two policies have different costs in utility terms; however, a tariff would always cost more.
For a small open economy considering its policy options, better interventions can generally be found. In a simple two-good world, the inferiority of a tariff shows up when both production and consumption are distorted simultaneously. To reduce the cost of a policy in terms of consumption benefits or utility, directing an intervention to the specific policy objective avoids the inadvertent consequence of a tariff.
