The Hidden Costs of Trade Protection
What New Research Reveals About Tariffs and the US Economy
As trade policy continues to dominate headlines and shape investment strategies, Sujan Bandyopadhyay, Domenico Ferraro, Lorenzo Octavio, and Vera Bower, authors of the study “How do tariffs impact the US economy?”, published in the August 2025 issue of Economics Letters, provide important insights into how tariffs actually impact the US economy. Their research, conducted in the wake of recent trade policy changes, shows that tariffs do more than rattle trade partners—they leave a lasting scar on the U.S. economy, permanently lowering GDP and driving fiscal costs that outweigh their short-term benefits.
What the Researchers Examined
The researchers tackled a fundamental question in economics: What happens to the broader US economy when import tariffs suddenly increase? Their analysis examined the ripple effects across the entire macroeconomic landscape. The researchers employed a statistical model (structural vector autoregressions, SVARs) that helps track how different parts of the economy react over time when tariffs rise. They analyzed data spanning from 1989 to 2019, creating an import-weighted average of tariff rates using product-level data from the World Integrated Trade Solution.
Their analysis focused on seven critical economic indicators:
Real GDP growth
Inflation rates
Trade balance
Federal deficit
Net international investment position
Stock market performance
Federal funds rate (monetary policy stance)
What makes this research particularly valuable is its focus on "tariff shocks"—unexpected increases in import duties that catch markets and businesses off guard, similar to real-world policy announcements that often come without warning.
Key Findings: The Anatomy of Economic Contraction
Tariffs are contractionary. When the US unexpectedly raises import tariffs, the economy responds much like it would to any negative supply shock, with consequences that extend far beyond the immediate trade effects.
Permanent GDP Losses
Tariff increases create permanent economic scarring. The research shows that a temporary tariff hike reduces real GDP growth immediately, and the economy never fully recovers. Five years after a tariff shock, real GDP remains permanently below where it would have been without the trade restrictions. This isn't just a temporary slowdown, representing a permanent loss in economic output and productivity.
Mixed Inflationary Effects
While conventional wisdom suggests tariffs drive up prices, the reality is more nuanced. The study found that inflation initially increases following a tariff hike but then falls below average levels for several years. The overall impact on the general price level turns out to be minimal, suggesting that the contractionary effects on demand offset much of the initial price pressure.
Financial Market and Fiscal Consequences
The research documents temporary, but significant drops in stock market valuations relative to GDP following tariff increases. This reflects investor uncertainty and reduced growth expectations.
On the fiscal front, tariffs worsen the federal deficit despite generating additional government revenue. The economic contraction reduces overall tax receipts more than the tariff revenue increases, creating a net negative fiscal impact.
These findings are mostly consistent with those of The Budget Lab at Yale, a non-partisan policy research center that provides in-depth analysis of federal policy proposals for the American economy. Their August 2025 study, based on tariff policy as of August 6th, assuming they stayed in place in perpetuity, and concluded:
· Current Tariff Rate: Consumers face an overall average effective tariff rate of 18.6%, the highest since 1933. After consumption shifts, the average tariff rate will be 17.7%, the highest since 1934.
· Overall Price Level & Distributional Effects: The price level from all 2025 tariffs rises by 1.8% in the short run, the equivalent of an average per household income loss of $2,400 in 2025 dollars. This assumes the Federal Reserve does not react to tariffs and so the real income adjustment comes primarily through prices rather than nominal incomes; if the Federal Reserve reacted (tightening monetary policy), the adjustment could in part come in the form of lower nominal incomes. Annual pre-substitution losses for households at the bottom of the income distribution are $1,300. The post-substitution price increase settles at 1.5%, a $2,100 loss per household.
· Commodity Prices: The 2025 tariffs disproportionately affect clothing and textiles, with consumers facing 39% higher shoe prices and 37% higher apparel prices in the short run. Shoes and apparel prices stay 19% and 18% higher in the long run, respectively.
· Real GDP Effects: US real GDP growth over 2025 and 2026 is -0.5 percentage points lower each year from all 2025 tariffs. In the long run, the US economy is persistently -0.4% smaller, the equivalent of $125 billion annually in 2024 dollars.
· Labor Market Effects: The unemployment rate rises 0.3 percentage point by the end of 2025 and 0.7 percentage point by the end of 2026.
· Long-Run Sectoral GDP and Employment Effects: In the long run, tariffs present a trade-off. US manufacturing output expands by 2.1%, but these gains are more than crowded out by other sectors: construction output contracts by 3.6% and agriculture declines by 0.8%.
· Fiscal Effects: All tariffs to date in 2025 raise $2.7 trillion over 2026-35, with $475 billion in negative dynamic revenue effects, bringing dynamic revenues to $2.2 trillion.
A May 2025 study by the European Commission found similar GDP effects: “The US economy is hurt by the tariffs, as falling exports and weaker domestic demand drive GDP 0.6-1.0% lower.”
Investor Takeaways
1. Rethink the "Trade War Winners" Narrative
The study challenges the notion that domestic industries protected by tariffs necessarily benefit in the long run. While specific sectors may see short-term advantages, the broader economic contraction creates headwinds that affect virtually all businesses.
2. Prepare for Market Volatility
Markets respond not just to the direct trade effects, but to the broader macroeconomic implications of reduced economic growth.
3. Monitor Monetary Policy Responses
The study examined different scenarios for Federal Reserve responses to tariff shocks. The research suggests that monetary policy can influence the magnitude of economic damage, with longer periods of accommodative policy potentially mitigating some contractionary effects.
There is also the risk that markets will react to the tariff policy by demanding an increase in the risk premium demanded by investors in order to hold US assets—driving capital flows away from the US to other countries, raising US interest rates and negatively impacting US equity valuations. And, perhaps most importantly, the research underscores that tariff-induced economic damage persists long after the initial shock.
Conclusion
While tariffs may achieve certain political or strategic objectives, their economic costs are substantial and long-lasting. For investors, this research provides a framework for understanding how trade policy shocks ripple through the economy and financial markets.
Rather than viewing tariffs as simply affecting specific industries or trade relationships, investors should recognize them as macroeconomic events with broad implications for growth, market valuations, and fiscal policy. In an interconnected global economy, the costs of trade restrictions extend far beyond their intended targets.
Post Script
There is another policy issue that negatively impacts economic growth.
Drop in Immigrations, Increase in Deportations: Impact on Economic Growth
If 3,000 unauthorized immigrants are deported every day, the labor force will decline by roughly 1 million people in 2025. Lowering the labor force by 1 million will reduce the participation rate by 0.4 percentage points, which will lower the unemployment rate, lower job growth, and increase wage inflation, particularly in the sectors where unauthorized immigrants work—namely construction, agriculture, and leisure & hospitality. And household formation could decline by 50% from 2024 to 2026 due to deportations and immigration restriction. A significant decline in household formations has important implications for consumer spending, housing demand and home prices. Bottom line: stagflationary effect.
According to a study from the Federal Reserve Bank of Dallas it is estimated that the drastic drop in immigrants across the southern border and increased efforts to deport more foreign-born workers could subtract 0.75 to 1 percentage points from GNP growth in 2025.
Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.