Abstract:

We study trade policy in an environment with intermediate and final good trade. Real-world import tariffs tend to be higher for final goods than for inputs, a phenomenon commonly referred to as tariff escalation. Yet, neoclassical trade theory – and modern Ricardian trade models, in particular – cannot easily rationalize this fact. We show that tariff escalation can be rationalized on efficiency grounds in the presence of scale economies. A unilateral tariff in either sector increases a country’s relative wage and boosts the size and productivity of each sector, both of which raise welfare. While these forces are reinforced up the chain for final-good tariffs, input tariffs raise final-good producers’ costs, mitigating their potential benefits.  A quantitative evaluation of the US-China trade war demonstrates that any welfare gains from the increase in US tariffs are overwhelming driven by final-good tariffs.