KEY INSIGHTS
- Optimal tariffs need silence: A large country can gain from unilateral tariffs only if its trading partners decline to retaliate in kind.
- Europe subsidises the experiment: By holding fire, the EU lowers the cost of tariffs for the United States and weakens the deterrent against further increases.
- A fiscal devaluation in disguise: Tariffs paired with corporate and income tax cuts make imports dearer while lightening the burden on domestic production and investment.
- Partners pay the bill: The costs of the package fall largely on trading partners, who face sharper tax and location competition from the United States.
- The deal is not stable: Washington has reopened steel, car, and digital tax issues since April 2026, so Europe must cut its dependencies and build a credible capacity to respond.
For decades, one of the central principles of international economics has held that, under standard assumptions, trade barriers reduce overall welfare. Economists and international institutions duly forecast that broad-based tariffs would weaken economic growth and impose significant costs on the US economy. Since 2025, however, the United States has nonetheless implemented some of the most extensive tariff increases in nearly a century.
A substantial part of the expected economic costs was attributed to heightened uncertainty and the risk of retaliatory measures by trading partners, as Paul Krugman, among others, argued in April 2025. Yet many major trading partners refrained from imposing broad-based retaliatory tariffs, which blunted some of the adverse effects originally anticipated. At the same time, tariff revenues have helped to finance the substantial corporate and income tax cuts enacted alongside the tariff agreements in the summer of 2025, measures that the Congressional Budget Office expects to deliver a sizeable fiscal stimulus.
This raises two questions. First, how should the macroeconomic effects of tariffs be assessed when major trading partners do not respond with equivalent retaliatory measures and tariff revenues are used to support domestic tax reductions? Second, why have major US trading partners such as the European Union and Japan refrained from broad-based retaliation?
The standard argument for free trade is that it allows countries to specialise according to their comparative advantages, raising productivity and living standards. Free trade remains the benchmark under standard assumptions, but international trade theory has long recognised important exceptions, including infant-industry protection, production externalities, strategic trade policy, and the optimal tariff. Harry Johnson’s seminal 1953 contribution showed that a sufficiently large country may raise its national welfare by imposing a unilateral tariff.
The underlying mechanism is straightforward. Unlike a small economy, a large country is not merely a price taker in world markets. By reducing import demand through tariffs, it may induce foreign exporters to lower their export prices. Part of the tariff burden is therefore shifted onto foreign producers through an improvement in the country’s terms of trade. This mechanism features in standard textbooks such as International Economics by Paul Krugman, Maurice Obstfeld, and Marc Melitz.
Whether the optimal tariff argument can be applied to the US tariffs of 2025 is the subject of a current debate, to which Kimberly Clausing and Maurice Obstfeld, as well as Stephen Miran, have recently contributed.
It is undisputed, however, that retaliatory tariffs imposed by trading partners significantly reduce, or even eliminate, the welfare gains from tariffs.
Non-Retaliation Makes the Tariff Pay
If other countries respond with equivalent tariffs, any gains in import markets will be offset by losses in export markets. The result resembles a prisoner’s dilemma: while each large country has an incentive to impose tariffs unilaterally, mutual retaliation leaves all parties worse off than under free trade.
For this reason, much of the economic literature has regarded the practical relevance of the optimal tariff argument as limited. Although the theory demonstrates that a large country may benefit from unilateral tariffs under certain conditions, these gains have generally been expected to vanish once major trading partners respond with equivalent countermeasures.
Recent developments since 2025 invite a reconsideration of this assumption. While the United States has imposed substantial tariff increases, several major trading partners have largely refrained from tariff retaliation. This does not demonstrate that the United States has implemented an optimal tariff. It does, however, strengthen the case for tariffs: if large trading partners do not respond with equivalent tariffs, they reduce the costs of tariffs for the United States.
From a macroeconomic perspective, the overall effects of US tariff policy remain ambiguous. On the one hand, tariffs may stimulate domestic production by shifting expenditure away from imports towards domestically produced goods. On the other hand, higher import prices reduce households’ purchasing power and raise production costs for firms that rely on imported intermediate inputs. The net effect therefore depends on a range of factors, including price elasticities, market structures, exchange-rate movements, and fiscal policy.
Much of the criticism of the Trump tariffs emphasised not only these direct distortions but also the risks arising from policy uncertainty and potential retaliation by major trading partners, as Krugman and, more recently, Clausing and Obstfeld have stressed. To the extent that broad-based retaliation has not materialised, one important source of the expected economic costs may be smaller than initially anticipated.
In optimal tariff theory, tariff revenues are an essential component of the welfare calculation. The economic effects of tariffs therefore cannot be assessed solely in terms of higher import prices or trade distortions. From a macroeconomic perspective, they also depend on how the resulting revenues are used. If tariff revenues are employed for fiscal consolidation, their effects are in general contractionary. If, by contrast, they finance lower taxes or higher public expenditure, they may partly offset the potential contractionary effects of the tariffs themselves.
In the United States, tariff revenues, projected in February 2026 at roughly 400 billion US dollars a year, are of a similar order of magnitude to the fiscal cost of the corporate and income tax reductions enacted under the One Big Beautiful Bill Act, according to the Congressional Budget Office. Although the estimated tariff revenues were revised downwards after a number of adjustments, this suggests that the current tariff regime should not be analysed in isolation as a trade policy instrument, but rather as one component of a broader macroeconomic policy package that combines trade policy with fiscal policy. This perspective is broadly consistent with the interpretation of tariffs as part of a wider low-tax strategy advanced by George Alessandria and his co-authors, and by Miran.
This policy package also shares important characteristics with what economists describe as fiscal devaluation. In its textbook form, fiscal devaluation shifts the tax burden from domestic production to consumption: a reduction in payroll taxes on employers is financed by an increase in value-added tax, thereby improving international competitiveness without changing the nominal exchange rate. A closely related theoretical approach combines import tariffs with export subsidies to achieve similar effects, as Emmanuel Farhi, Gita Gopinath, and Oleg Itskhoki, and later Christopher Erceg, Andrea Prestipino, and Andrea Raffo, have shown.
Rather than relying on higher consumption taxes, the recent US package combines import tariffs with reductions in corporate and income taxation. It is therefore not a textbook case of fiscal devaluation. Nevertheless, the policy package may generate similar effects. Imported goods become relatively more expensive, while lower taxation may strengthen incentives for domestic production, investment, and capital inflows. To the extent that tariff revenues help to finance these tax reductions, the overall package may reinforce the attractiveness of the United States as a production location, much as in the textbook case of fiscal devaluation.
Europe Faces a Sharper Location Contest
For trading partners such as the European Union, this implies that the effects of US tariffs may extend well beyond their direct impact on trade flows. If tariff revenues contribute to financing lower business taxation, the policy package may intensify international tax and location competition against Europe. The overall policy package may strengthen production incentives in the United States while weakening the relative competitiveness of European producers.
The macroeconomic consequences are therefore likely to reach beyond the short-run price effects usually associated with tariffs. Over time, they may increasingly shape firms’ investment decisions, production locations, and the international allocation of capital. The quantitative importance of these medium-run channels remains an empirical question and depends on many factors, not least the persistence of the current policy regime.
Recent theoretical work by Anna Ignatenko and her co-authors estimates an optimal US tariff of around 19 per cent under specific model assumptions. If these estimates provide a reasonable benchmark, tariff rates of around 15 per cent may lie within the range in which positive effects remain theoretically possible.
This shifts the focus of the European policy debate. If non-retaliation reduces the economic costs of the US tariffs for the United States, it also reduces the deterrent against further tariff increases.
The European Commission has justified its cautious approach by pointing to the risks of escalation as well as to broader economic and security dependencies.
However, should these dependencies deepen further in the context of the emerging trade agreements, which envisage increased European purchases of US energy and military equipment, the question of how Europe can preserve its long-term economic autonomy will become increasingly important.
Recent developments also raise questions about the stability of the new framework. The US administration has repeatedly reopened issues that appeared to have been settled, which suggests that further renegotiations cannot be ruled out. In April and again in June 2026, the treatment of steel and aluminium products was revised, including changes to the valuation of duties and to the scope and rates applied to derivative products. In May 2026, the US administration threatened to raise tariffs on automobiles to 25 per cent rather than the 15 per cent rate envisaged under the agreement. One month later, it threatened tariffs of up to 100 per cent in response to digital services taxes or similar measures affecting US technology companies.
These developments suggest that the agreement should not be regarded as a reliable long-term foundation for transatlantic trade relations. Beyond the general economic objections to non-retaliation discussed in this article, the repeated reopening of negotiated commitments illustrates the vulnerability created by asymmetric economic dependencies. Rather than allowing external dependencies to become instruments of political leverage, Europe should therefore reduce its strategic dependencies and develop a credible capacity to respond to future trade coercion.
Source: www.socialeurope.eu
