You’re a policymaker in a country where people buy widgets that are produced both at home and abroad. You can set (separate) excise tax rates on domestic production and imports. (The tax on imports is, of course, what we usually call a tariff.) What tax rates should you set?

The Economics 101 answer makes two assumptions:

1. You care only about the economic welfare of your citizens (and not at all about foreigners).

2. You can’t affect foreign prices (i.e. your country is a negligible portion of the world market for widgets). The fancy way to say this is that the supply of imports is perfectly elastic.

From these assumptions, it follows that both tax rates should be zero. In fact, we can relax assumption 1) and allow you to care as much as you want about the welfare of foreigners; the conclusion doesn’t change.

But suppose we relax these assumptions in a different way:

1A. You care about both the economic welfare of your citizens and (separately) about the tax revenue earned by your government. (I continue to assume, however, that you don’t care about foreigners.)

2A. The foreign supply curve might not be perfectly elastic. Contrary to the Economics 101 assumption, this gives you some market power that you might want to exploit. (I continue to assume, though, that you take the foreign supply curve as given. In particular, this means that your policies do not affect foreign tax rates, so I am assuming away things like retaliatory tariffs.)

Now what’s your best policy? I can’t answer that because you have two competing goals (economic welfare and tax revenue) and I don’t know how much weight you put on one versus the other. But surely if I can show you that Policy A delivers on both goals better than Policy B, you’ll want to reject Policy B. The existence of Policy A leads me to call Policy B inefficient, and surely you’ll want to reject any inefficient policy.

So which pairs of tax rates are efficient?

Continue reading ‘Efficient Tariffs’