Tariffs will Make It More Expensive to Invest in America

By Kyle Pomerleau.

"Over the past several months, several commentators have referred to tariffs as a consumption tax (here, here, and here). There is a certain intuition behind this—an excise tax is levied on the purchase of imported goods, many of which are final consumer goods. However, there is an important difference—tariffs apply to capital goods like machinery and equipment used by businesses. This means that tariffs, unlike consumption taxes, can penalize investment.

The structure of consumption taxes can vary, but they all share a key feature—they do not apply to saving and investment. For example, value-added taxes apply to all business sales but provide firms a refund for any tax paid on purchases from other businesses. Retail sales taxes exempt all business-to-business transactions and apply only to sales to end consumers. The Hall-Rabushka Flat Tax exempts capital income earned by individuals and excludes investment from the base of the business tax by allowing firms to fully deduct investment costs.

Tariffs, in contrast to consumption taxes, apply to both consumer goods and business inputs, including capital goods. Capital goods or fixed assets are purchased by businesses as investments and are used in their production process. For example, a truck is an investment when purchased by a transportation company. Tariffs can either apply directly to imported capital goods or apply indirectly by increasing the cost of inputs used to manufacture capital inputs in the United States.

Tariffs that raise the relative price of capital goods distort investment by increasing its cost much like an income tax. A higher relative price for capital goods means that firms need to earn a higher pre-tax return to provide the same after-tax return for shareholders. This can make certain projects no longer viable, reducing overall investment.

Intuitively, one can think of a tariff that raises the price of an imported capital good as a negative investment tax credit—a tax that increases the acquisition cost of an asset. For example, a machine that requires a gross return of 20 percent and costs 10 percent more due to a tariff, would need to earn a 10 percent higher return (22 percent) to cover its higher price. If shareholders demand a net return of five percent, a two percentage point increase in the cost of capital is equivalent to applying an additional 28 percent corporate income tax to this asset.

Tariffs on capital goods not only raise the overall cost of investment, but they also distort the relative price of different types of investment made by businesses. Businesses use a range of fixed assets in their production processes, such as machinery, equipment, software, intellectual property products, land, and inventories. Some of these investments would be affected by tariffs and some would not.

Even if tariffs applied to all types of capital goods equally, they would still distort investment decisions across assets. Unlike a corporate income tax, which applies to the net return to new investment, tariffs apply to the entire cost of a capital asset. This is equivalent to taxing the gross return of an asset. Thus, tariffs place a greater burden on shorter-lived assets for which net returns are a smaller share of their gross returns. The result is a larger tax burden on machinery and equipment than structures and inventories.

The taxation of capital goods is not necessarily a small issue. According to the World Bank, roughly one third of all imports are capital goods in 2022 and another 26 percent of all imports are raw materials and intermediate goods, which could be used in the production of capital inputs used by businesses in the United States. However, not all imported or produced capital goods are ultimately used in the United States, so import values likely overstate the potential economic effects.

The fact that tariffs apply to capital investment means that many are understating the economic harms of tariffs when they assume they operate like a textbook consumption tax. This also strengthens the case that these tariffs will more than offset the economic benefits of the tax cuts being debated in Congress. Furthermore, placing a burden on investment, especially machinery and equipment, will make manufacturing more expensive in the United States.

Tariffs’ negative impact on investment is another reason these taxes are a poor source of federal revenue."