Board of Governors of the Federal Reserve System

July 07, 2025

Trade-offs of Higher U.S. Tariffs: GDP, Revenues, and the Trade Deficit

Sharon Jeon, Ricardo Reyes-Heroles, Abhi Uppal, Eva Van Leemput, and David Yu¹

1. Introduction

In recent years, protectionist trade policies have gained momentum globally, reversing decades of increasing globalization. This shift is driven by growing skepticism about the benefits of free trade, national security concerns, geopolitical considerations, and efforts to enhance economic resilience in the wake of COVID-19. Additionally, tariffs are increasingly considered as a tool for revenue generation. These trends have heightened the need to assess the economic consequences of protectionist policies, particularly their impact on growth, trade flows, and government revenues.

This note examines the economic impact of higher U.S. tariffs using the quantitative multi-country, multi-sector trade model from Reyes-Heroles, Traiberman, and Van Leemput (2020).² The model captures key features of global trade, including multiple countries, sectoral input-output linkages, three factors of production (capital, skilled, and unskilled labor), and endogenous investment.³ Fundamental to this class of trade models—i.e., Ricardian trade models—is that countries gain from trade by specializing in goods where they have a comparative advantage. This note examines how tariffs disrupt this process, leading to inefficient resource allocation and economic losses. Concretely, higher U.S. tariffs raise intermediate goods prices, reducing domestic production efficiency and GDP, though the resulting tariff revenue—if redistributed to consumers—may offset some of the losses. For affected trade partners, lower demand for their competitive exports shifts resources to less productive sectors, lowering overall GDP.

Using our model, we estimate the long-run GDP effects of higher U.S. tariffs on the U.S., China, and other countries under three scenarios relevant to ongoing trade policy discussions, outlined in Table 1.⁴ Our analysis shows that higher U.S. tariffs have significant negative effects on global GDP, reducing it by 0.8 percent in a broad tariff scenario. The U.S. and China face the largest economic losses.

Table 1: U.S. Trade Policy Scenarios

We also show that the impact on the U.S. economy depends on the scope of tariffs and the extent of the trade deficit reduction. A tariff on Chinese imports alone has minimal effects on U.S. tariff revenues due to trade diversion. However, broad-based tariffs generate substantial revenues, partially offsetting GDP losses. That said, if those broad-based tariffs also lead to a reduction in the U.S. trade deficit, less tariff revenues are collected, highlighting the trade-off between revenue generation and deficit reduction.⁵

It is important to acknowledge that governments may impose tariffs for economic and strategic reasons beyond the scope of our model. For instance, tariffs can be used to support domestic production of goods critical to national security, such as military equipment. Additionally, they may serve as a tool to reduce reliance on concentrated foreign suppliers, enhancing economic resilience—an objective that has gained prominence following the disruptions following the COVID-19 pandemic. Furthermore, some policymakers view tariffs as incentivizing domestic innovation and strengthening long-term competitiveness in key industries.

2. Quantitative Analysis

In this section, we estimate the economic impact of the trade scenarios in Table 1. For each scenario, we apply additional tariff increases and solve for a new steady-state equilibrium using our trade model. We then measure the resulting changes in long-run real GDP for the U.S., China, and other countries relative to this baseline.

Scenario 1: China-Specific Tariffs
Panel (a) of Figure 1 shows the estimated long-run GDP effects of higher U.S. tariffs under scenarios 1 and 2. In scenario 1, where the U.S. raises tariffs on all Chinese imports by 60 ppt., global GDP declines by 0.6 percent, driven mainly by losses in the U.S. and China. The U.S. and China experience GDP declines of 2.7 and 2.1 percent, respectively, which are significant economic impacts. The substantial U.S. GDP losses stem from higher tariffs raising import prices, reducing consumer purchasing power, and weakening firms' competitiveness. In China, the long-run GDP decline reflects a loss of international competitiveness, leading to lower exports to the U.S. and a shift of production resources into less productive sectors.

Figure 1. Economic Effects under Scenarios 1 and 2

Interestingly, the model estimates slightly larger GDP losses for the U.S. than for China. This is due to the composition of U.S. imports from China, which includes many investment-intensive goods. Higher tariffs raise the relative price of capital, dampening U.S. investment. This highlights China's key role as a supplier of intermediate and capital-intensive goods for the U.S.

The structure of our model, which accounts for multiple countries and input-output linkages, allows us to analyze spillover effects on other countries. Some countries may experience losses due to reduced demand from the U.S. and China, particularly as these two nations shift resources to less productive sectors and reduce imports. However, other countries could benefit from trade diversion or lower import prices from China, boosting their international competitiveness and increasing consumer purchasing power.

The dark blue bars in Panel (a) of Figure 1 display the estimated impact on real GDP for other countries and regional aggregates.⁶ Generally, we find positive spillovers for most countries. As such, benefits from U.S. import diversion outweigh the negative effects of reduced Chinese demand. Notably, some countries experience significant gains. For instance, Mexico's long-run GDP is projected to rise by 2.8 percent. Additionally, countries in Asia (excluding China) see considerable GDP increases as U.S. import demand shifts from China.

An important feature of our model is its consideration of tariff revenues, which are assumed to be fully redistributed to consumers. This redistribution increases household disposable income and may help offset some of the GDP losses. Panel (b) of Figure 1 shows the combined effects on GDP and tariff revenues. In Scenario 1, we find that tariff revenues decrease slightly, contributing to an overall U.S. economic loss of 2.8 percent. This result is driven by two factors: First, higher tariffs on China reduce U.S. demand for Chinese imports, leading to lower tariff revenues. Second, by imposing tariffs only on China, trade shifts to other countries, like Mexico, which have lower tariff rates, further reducing U.S. tariff revenues. Therefore, raising tariffs on China alone may not increase U.S. tariff revenues.⁷

Scenario 2: Broad Tariff Increases
Next, we consider a scenario with broader tariffs. The light blue bars in Panel (a) of Figure 1 show the long-run GDP effects if the U.S. raises tariffs by 60 ppt. on all Chinese imports and by 10 ppt. on imports from all other trading partners, with no retaliation. Under this scenario, global GDP declines by 1 percent—0.4 percentage points more severe than the previous scenario. The losses remain concentrated in the U.S. and China, where GDP is estimated to fall by 3.6 percent and 2.4 percent, respectively.

In this broader tariff scenario, Mexico no longer benefits from trade diversion as much as it did in Scenario 1. Higher U.S. tariffs on all trading partners reduce competitiveness, leading to lower exports, which is especially detrimental for Mexico given its strong trade ties with the U.S. Additionally, as all trading partners face higher tariffs, global demand for Chinese intermediate inputs declines further, exacerbating China's GDP losses.

Panel (b) of Figure 1, which incorporates tariff revenues into the GDP effects, shows that the overall economic impact on the U.S. is somewhat mitigated. Total U.S. GDP is estimated to decline by 2.3 percent, a smaller drop than in Scenario 1, where tariffs were imposed only on China. While it may seem counterintuitive, this result reflects the additional tariff revenues generated from broad-based tariffs, which help offset some of the economic losses.

Scenario 3: Broad Tariff Increases with Trade Deficit Reduction
In all previous scenarios, we assumed an unchanged aggregate U.S. trade balance.⁸ In our final scenario, we relax this assumption, recognizing that broad-based U.S. tariffs would likely reduce imports and shrink the trade deficit. We analyze a scenario on top of Scenario 2 in which the U.S. trade deficit shrinks by 25 percent.⁹

Figure 2 illustrates the U.S. effects—including tariff revenues—across all scenarios. The gray bar shows that if the U.S. raises tariffs by 60 ppt. on China and 10 ppt. on all other trading partners while its trade deficit shrinks by 25 percent, long-run U.S. GDP is projected to decline by 2.9 percent. This decline is larger than in Scenario 2, where the trade deficit remains unchanged. The key driver is the reduction in tariff revenue collection as U.S. imports fall. Thus, assessing the impact of broad-based tariffs highly depends on how the U.S. trade deficit adjusts.

Figure 2. U.S. Economic Effects under Scenarios 1 - 3

To illustrate the sensitivity of tariff revenues and U.S. economic losses to changes in the U.S. trade deficit, Figure 3 compares these under Scenario 2 with additional scenarios where the trade deficit gradually decreases. The green bars show that if the U.S. trade deficit remains unchanged, tariff revenues could be substantial, reaching approximately 1.3 percent of GDP. This helps somewhat cushion the GDP losses from broad-based tariffs, resulting in a 2.3 percent decline in U.S. GDP. However, as the trade deficit shrinks, tariff revenues decline, and economic losses grow. For example, under Scenario 3, where the aggregate trade deficit falls by 25 percent, tariff revenues drop to 0.8 percent of GDP, and GDP is projected to decline by 2.9 percent. In a more extreme case, where the trade deficit shrinks by 50 percent, tariff revenues decline sharply to just 0.3 percent of GDP, and long-run U.S. GDP is projected to contract by 3.4 percent.

Figure 3. U.S. Economic Effects under different U.S. Trade Deficit Assumptions

3. Conclusion

Our analysis finds that tariff increases—whether targeting China alone or applied more broadly—can result in significant economic losses for the U.S., China, and the global economy. In both scenarios, according to the model we have used here, U.S. GDP declines by more than 2 percent. However, tariff revenues can partially offset these losses, but their effectiveness depends on key conditions. First, tariffs on China alone may not significantly boost U.S. tariff revenues due to trade diversion. In contrast, broad-based tariffs reduce trade diversion, leading to higher tariff revenues. Second, the impact of tariff revenues is closely tied to changes in the U.S. trade deficit. A sharp decline in imports reduces tariff revenues, creating a trade-off between generating revenue and lowering the trade deficit. These findings highlight the complexities of tariff policy, underscoring the trade-offs between growth, revenues, and the trade deficit.

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Appendix

In our analysis, we include 30 separate countries and a rest-of-the-world (ROW) entity modeled as one aggregate block.¹⁰ The model includes 40 sectors, of which 20 are tradable and 20 are non-tradable, as shown in table 2. We collected data on (1) trade flows, (2) tariffs, (3) input-output structures, sectoral consumption and investment shares, (4) sectoral gross output and value added, and (5) capital stocks and labor endowments of low- and high-skilled workers from several data sets.

Table 2: Sectors

1. Bilateral Trade: We use bilateral trade from the United Nations Statistical Division Commodity Trade (UNCOMTRADE) database for 2016 at the Harmonized System 6-digit (HS-6) level.

2. Bilateral and Sectoral Tariffs: We collect sectoral tariff data from the United Nations Statistical Division-Trade Analysis and Information System (UNCTAD-TRAINS) and Most-Favored Nation (MFN) databases for 2014 and 2016, respectively. The UNCTAD TRAINS data contain bilateral tariffs at the HS-6 product level. The MFN data provide importer-specific MFN tariff rates. We then aggregate bilateral tariffs at the HS-6 level to sectoral bilateral tariffs for the tradable sectors in Table 2 using bilateral trade weights. All told, we compute 31 by 31 bilateral tariffs for each of the 20 tradable sectors in 2016 and assume infinitely large trade barriers for the 20 non-tradable sectors to serve as our baseline. The implemented and proposed tariffs are computed using the lists released by the USTR and China's Ministry of Commerce.

3. Input-output tables, sectoral consumption and investment shares: We use the World Input-Output Database (WIOD) for 2014 to compute the input-output coefficients as the total dollar value of an input sector's intermediate goods divided by the total dollar value of the output sector's inputs.¹¹

4. Gross output and value added: We use sectoral gross output and value-added data from the OECD STAN database for 2016.¹²

5. Capital stocks and labor endowments of low- and high-skilled workers: We use the Socio-Economic Accounts for 2014 to get the capital stocks and labor endowments of low- and high-skilled workers.