Why a 5 Percent Tariff on Mexican Products Doesn't Matter

This is the last of a series of posts on Trade.  Warning:  Contains Math.

Recently there has been a great deal of discussion about a 5 percent tariff on Mexican goods.  This blog will explain why this would not have made any difference in the U.S. and would have only made a minor difference in Mexico.  However, a 25 percent tariff, which has been considered could have a major impact on the Mexican economy, and encourage the thing the administration is trying to stop, illegal immigration.

A Numerical Example

Let's say you are in the market for a VW Jetta that is assembled in Mexico.  Furthermore let's say the price of the Jetta is 380,000 pesos and the exchange rate is 19 pesos to the dollar.  The price of the Jetta is 380,000/19 or $20,000.  If the exchange rate does not change, a 5 percent tariff would raise the price to $21,000 (20,000+(20,000*.05)) if VW passed on the entire cost of the tariff to the consumer.  Since this is unlikely, let's say VW eats 25 percent of the tariff so the price to the U.S. consumer is $20,750.  This appears to be the mindset of those who supported and opposed the tariff.  This analysis is simplistic and wrong.

Changes in exchange rates blunt the impact of tariffs.  There are few countries that have the power to completely manage the value of their currencies and conduct independent monetary policy and Mexico is not one of them.  The day the possible tariff was announced the value of the peso fell by about 3.5 percent.  When the President announced the tariffs would not go into effect, the value of the peso rose by 2.0 percent.

It is well within the realm of possibility the value of the peso would have declined by the full 5 percent if the tariff was instituted.  If that had happened, the value of the dollar would have increased to 19.95 pesos to the dollar.  The price of the Jetta in U.S. dollars would then decline to 380,000/19.95 or $19,048 and the price with the tariff would be (19,048+(19,048*.05) or $20,000, which is the same price as the price without the tariff at the original exchange rate.  Since the price to U.S. consumers is unchanged, VW would have a strong incentive to pass the full impact of the tariff on to U.S. consumers.

To summarize, a small tariff would have no impact on U.S. consumers.  Mexican consumers would be slightly less wealthy compared to U.S. consumers and as a result might slightly cut back on their consumption of U.S. goods even without enacting a counter tariff.  In a floating exchange rate system a tariff could have the impact of actually reducing exports without having any impact on imports.

The Impact of a Large Tariff

It has been proposed that unless Mexico controls emigration a 25 percent tariff should be imposed.  This would have a much bigger impact on Mexico.  A major tariff could lead to a run on the peso, which could dramatically reduce wealth and consumption in Mexico perhaps leading to a recession.  A recession would increase the unemployment rate in Mexico which could lead to increased emigration to the U.S.

In short, a small tariff has no impact on the U.S. economy and a large tariff could lead to the one thing the administration is trying to stop, increased illegal immigration.