Dallas Fed says, no one wins a trade war

DALLAS – A new report published today by the Federal Reserve Bank of Dallas’ Global Institute examines how tariffs can impact U.S. consumer spending by shifting terms of trade.

The analysis finds that if the U.S. imposes tariffs without facing retaliatory measures from other countries, consumers may see benefits through improved terms of trade. Lower foreign prices and the rebating of tariff revenues can help offset some of the increased costs. However, the report also warns that these consumption gains are likely to dissipate if trade partners respond with retaliatory tariffs, leading to higher domestic prices and reduced purchasing power.

The report was authored by Enrique Martínez García, assistant vice president in the Dallas Fed’s research department and deputy director of the Global Institute, and Michael Sposi, associate professor of economics and director of doctoral studies at Southern Methodist University.

“Navigating the complexities of tariff policy involves balancing three critical objectives —revenue, restriction and reciprocity —often creating a policy trilemma known as the impossible trinity,” the authors write. “Prioritizing one goal can inadvertently undermine the others.”

The authors’ analysis underscores the complex trade-offs policymakers face when implementing tariff policies, highlighting the following key findings:

Throughout U.S. history, tariffs have played varying roles. While early policies focused on generating revenue and protecting domestic industries, the post-World War II period has been characterized by reciprocal tariff reductions and opening foreign markets for U.S. producers, driving global economic integration.

The report finds that the revenue-maximizing tariff for the U.S. without foreign retaliation is achieved with a 70 percent tariff hike, generating significant government income equivalent to nearly 2 percent of consumption after adjusting for inflation. However, if other countries retaliate, the optimal tariff to maximize revenue drops to 30 percent and inflation-adjusted revenue is halved, illustrating how reciprocal trade responses can diminish fiscal gains.

When focusing on consumption rather than revenue, a 25 percent tariff maximizes potential gains for U.S. consumers, increasing by the equivalent of 0.5 percent of U.S. real consumption if the revenues generated are rebated, for instance, through tax cuts. Yet, these gains are unevenly distributed, with some states—due to their demographics and economic structure—experiencing up to a 2.3 percent increase in consumption while others face declines as steep as 0.8 percent.

Coordinated international responses can mitigate some of the economic losses from U.S. tariffs while, if applied unilaterally, retaliation tends to be self-defeating. The analysis reveals that Canada and Mexico could see consumption losses of 1.6 percent and 1.1 percent, respectively, under a 25 percent U.S. tariff with retaliation—less severe than the 1.8 percent losses projected without retaliation. For the U.S., however, retaliatory tariffs exacerbate regional disparities and lead to net national losses of almost 1 percent in U.S. consumption.

“Trade wars tend to result in losses on all sides, underscoring the dangers of escalation,” the authors write.